Annaly Capital Management Inc (NLY) 2011 Q3 法說會逐字稿

Good morning, and welcome to the third-quarter 2011 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 the 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, 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 ability 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 revelatory 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 call over to Mr. Michael Farrell, Chairman, Chief Executive Officer, and President. Please proceed, sir.

Thank you, Sue. Good morning, everyone. Welcome to the third quarter 2011 earnings call for Annaly Capital Management. I am Mike Farrell and joining me today are Wellington Denahan-Norris, our Chief Investment Officer and Chief Operating Officer; our Chief Financial Officer, Kathryn Fagan; and our General Counsel, Nick Singh.

As is our custom, I will begin our call with some prepared remarks, after which we will take your questions. A written version of our remarks, complete with any reference graphs, is available on our website, www.Annaly.com.

Today's missive and commentary is entitled lessons from the emergency room. The patient is in distress. He arrives at the hospital with multiple symptoms all signaling a major infection. Rushed into the intensive care unit, all sorts of measurements and tests are taken in an attempt to assess the type of distress of the illness. The goal is to make a correct diagnosis and then prescribe the most efficient course of treatment.

As the medical team tries to determine whether the patient is suffering from either a bacterial or viral a disease, these tests are essentially a process of elimination from worst case to best case.

Bacterial infections must be identified and either ruled out or dealt with immediately. They can spread voraciously, so the first and best course of defense is to assume that the infection is bacterial and aggressively attack it with powerful antibiotics while the stress tests are being run.

Many times the cause is not bacterial, but it's viral. In those cases, sometimes the best course is to allow the patient's natural immune system to gradually perform its natural healing function. But if the problem is viral, continual administration of powerful antibiotics can oftentimes create more problems than it solves by preventing white blood cells from doing their job.

Of course the patient in this story is the global financial system and the ER doctor is our policymakers.

The defense of the financial system in 2008 was an all-out war of the symptoms of what was assumed to be the bacterial infection of subprime mortgages. All around the world emergency measures were thrown at the symptoms of the global financial meltdown. In the absence of a complete diagnosis, it was the right thing to do, staunch the bleeding and stabilize the patient.

In the daisy chain of connected economies and stakeholders, however, the weakest links gave out first and the medicines induced to combat this brought risk of a larger, stronger link in the chain being infected through side mechanisms or other holes in the system.

Subprime wasn't the only problem. It was just the external agent that activated the dormant virus of over leverage, falling asset values including the oversupply of homes in the US and structural, fiscal, and current account imbalances.

As the patient seems to be stabilizing, the realization that the conditions are not bacterial but rather viral have gotten lost in the treatment. Delaying the inevitable elements as a worst-case scenario through increasingly aggressive investment policy-making is simply reopening the wounds of 2008 market by market, country by country, and consumer by consumer.

As the American consumer drives the US economy and is thus a key component of global growth, I would like to take a moment to update you on how the Grimm family is doing through all of this. You will recall that I introduced the prototypical average American Grimm family in my first quarter of 2010 earnings call comments, which you can find on our website.

Back then, we estimated that based on the median family income of $52,029, after taxes, insurance, and debt service, the Grimm's had approximately $730 per month left over to pay for essentials like food, car, phone, cable and Internet, and an occasional movie. As we said then, they juggle their payments. They are occasionally late, but they are barely just above water long enough as they stay employed. Not a lot of room for error.

How are the Grimms doing today? After all policy prescriptions that have been thrown at the economy, they are all essentially in the same place and here's why. Yes, their debt service is falling thanks to Federal Reserve efforts to lower rates across the yield curve and if you assume that the Grimms are good candidates for the new, improved HARP program, the graph that you'll find on my written version of remarks, shows that the financial obligations ratio has been on an improving trend for several years.

The problem is that while debt service is falling, the Grimms family income is also falling. As the graph found in my written remarks shows, median household income has been on a decline since 2006. Meanwhile on an inflation-adjusted basis, the Census Bureau reports that incomes fell 2.3% from 2009 to 2010, thus lower interest rates and HARP adjustments may help but they are offset by the reduction in income.

In a macroeconomic sense I believe that the stimulative effect of policy will be offset by the structural issues of unemployment and lack of high income growth. Assuming that HARP 2.0 comes in at the high end of its advertised success range of 3 million mortgages, we estimate that the HARP 2.0 produces $9 billion a year in stimulus but the Grimms of America have probably all but lost that in their buying power.

Data out from the Bureau of Economic Analysis on Friday, October 28 showed that personal income was effectively flat in the third quarter, rising a meager 0.08 from June to September. Real personal income actually fell 0.7 during the same period. Consumption rose 1.7% during the third quarter on a nominal basis and 1% on a real basis.

So while incomes are falling, how are the Grimms finding the resources to spend? Unsurprisingly, spending was driven by a drastically declining savings rate, which fell from 5.3% in June 2011 to 3.6% in September of 2011. While good for quarterly GDP reporting, this may not be the healthiest thing for the Grimms to do.

Circling back to the metaphor, wherever you are in the emergency room, in America, Europe, or Asia, the correct diagnosis is the problem is not bacterial, it is viral. It needs to be allowed to run its course. True valuations need to be established. Clearing prices need to be set by capital allocators who can determine valid unsubsidized risks and rewards. The longer the globe waits to admit this assessment, the greater the risk that the virus mutates.

As we have all witnessed, viruses have a way of mutating into a new more viral form. For problem like we have now, to create a destruction of capitalism is the best medicine.

Again my remarks can be found at our website along with our companion video. Operator, we will now take questions.

(Operator Instructions). Bose George, KBW.

Good morning, everybody. I had a couple of things. One, I just wanted to start with leverage. Your leverage seems to be at a historic low. Was this partly just slow deployment of the capital after the raise or could it go up a little bit back to that 6 times? Just any comment there?

No, it's all by design. I think anybody who's paying attention to the headlines and the volatility in the market and other people can manage their books in different ways, we tend to be a bit more conservative. Leverage is a very easy thing to take up. It's not always a very easy thing to take down as some of the recent headlines have demonstrated.

So it's something that we feel more comfortable with. Again, as market conditions change, we can always adjust it. But we feel comfortable where it is.

Okay, makes sense. Thanks. And then actually a broader question, I just wanted to ask about the Financial Stability Oversight Council has -- they've issued guidelines on institutions that are systemically important. One threshold they have is the $50 billion in assets. You guys have $100 billion and that could grow. I'm just curious in your thoughts about what could happen if Annaly is deemed systemically important by the FSOC?

Well, I think that the FSOC conditions are really going to focus on companies that are primary, systemic integration problems. And I point to some of the large financial companies as well as some of the large insurance companies as a result of that. Certainly in the 20 or so criteria that FSOC has got out there, we are big enough to fall into one or two of those categories but we are certainly captured underneath many of the different aspects of the rulemaking that's going to be followed by the people that we integrate into.

So I think one of the things -- just to follow up on Wellie's point of view, the way that I look at what we've prepared the Company for is I think our balance sheet is in a war chest position. We've got $3.5 billion worth of cash or cash equivalents on the balance sheet. We are using as you pointed out very well I think, historically low leverage to create a middle teens ROE, which is consistent with the highest returns that we've created in the market over time since our inception.

We think that there's going to be a number of assets coming to market. We think from the perks that we see a lot of things are going to be delevered and the FSOC rules are going to change around that.

If you want to look at MF Global, that's a very easy thing for us to compare because in my mind, MF Global is about the same size as many small European banks who are long-sovereign credit and those kind of conditions especially with that $0.50 haircut on the derivatives market and the CDS market is very telling to me about the way that policymakers are going to try to ignore long-term problems, kick them down the road, and punish risk takers. So that's going to be mean more and more assets coming to market.

We now are in a great position to acquire those assets at higher yields.

Okay, great. Thanks a lot.

Mike Widner, Stifel Nicolaus.

Good morning, guys. Thanks for taking the question. I'm wondering if you could talk a little more about the HARP 2 exposure that you guys see potentially within your portfolio and sort of how you're positioning around that?

You know, I think the broad market and I think we are representative of the broader market that the expectations are anywhere from 5 to 10 CPR increases. Again we expect about half of the impact on HARP 1. So about 400,000 or so loans would be impacted.

I think it's all at the margin, Mike. All of this stuff is fringing around at the margin. It is the big push in payments that you saw in refinancings that you saw in this latest quarter was really we think a reaction to the cap being lowered on conventional loans from $729,000 to $625,000 and allowing that to expire on October 1. A lot of banks were pushing in there and a lot of borrowers trying to get 30-year money at 4% or so as government guarantees.

I think that that's going to be an offsetting characteristic or element to some of the things that they're trying to push through in HARP, so the success of that program I think is that question, but it is a marginal program.

If you think about my opening remarks about the Grimm family, they are the prototypical people who would be eligible for that. They have been making their payments. They are on time. They're upside down in their house. You know what? Those are good people. Those are people who struggle from paycheck to paycheck. If they get extra money, given what we've seen happen to their income, they are going to pay down other credit card debts or they are going to pay down -- they're going to put it in a savings account. They're not going to go out and buy a big screen TV with it.

So that behavior I think is over in the markets and I think this is a last ditch attempt by the government to try to save who they can, really, in the market.

Well, it's an attempt, whether it's the last ditch or they can find a couple more ditches is --

That's another reason why we run leverage where we run it. That's just another element of uncertainty out there.

I'm sure you guys know this, but that financial obligations ratio is -- calculated as a hypothetical ratio. It assumes people actually can refinance at current low rates.

Yes, you're right.

So the practical number may be quite a bit different. Just following up then on the refi issue, is it fair to say that you guys think that going forward we might see kind of Q4 levels? Maybe you could comment on your October prepay speeds. But Q4 levels kind of in line with Q3 levels and then all else equal, yield curve kind of stays where it is, maybe that flattish to down as opposed to ramping up next year.

I think I would like to see what the Fed says this afternoon, but my gut is that if you look at the programs in general, QE1 and QE2 have been not providing the stimulus that the Fed thought. It is not helping to make their mandate. Unemployment is staying high.

Operation twists, the full effect of that since it is announced it about 4 basis points of flattening. Nothing material really on the front end of the curve from the selling and the buying that's going on there.

So these programs, it's not about low rates. I think we can all agree with that as investment professionals here. It's not about low rates. If you had access to low rates, you've been taking the advantage of them. It's really about what's the loan to value ratios and this kind of interference by HARP programs or by zero balance interest rates for an extended period of time do nothing but make markets in this price risk and that's the point in my opening comments is we can try to extend this by making it spiral down at a slower rate through policy but at the end of the day you were going to wind up with a mess that's morphed into a different virus. And everyone thinks that the [vocal] rule can kill risk. To me it's like Jurassic Park. Life finds a way. Risk morphs into something else. It just becomes bigger risk.

It seems we have a couple thousand years of capital markets history that support your theory. But thanks for the comments, guys.

Mike Taiano, Sandler O'Neill.

Thanks for taking the question. So when you talk about this deleveraging that you expect to continue to happen and assets that will become available, anything more specific there? Are you primarily talking about MBS or are there other assets out there that you are interested in?

You know, I think its across the board in the three companies that we have a perch and also in our middle-market lending group as well as in our triple net leasing activities that we just started in the summer. We are seeing massive amounts of assets being shifted around and bid want it, in effect. I don't think this is a pricing exercise. This is a reshaping of global cash flows in a meaningful way.

I point to the CreXus transaction that we did earlier in the year where we partnered up with Barclays to take a major portfolio of American-based assets off their hands because that's no longer a core business with them to be operating in that market -- in that particular market. I think there's going to be a lot of transactions like that.

One of the headlines that shot across the Bloomberg the other day was that the bank of -- the Central Bank of Norway had effectively sold all of its mortgage backed securities positions in the United States and have gotten out. So I think all of this is going to occur across a lot of different asset classes. It's going to be everything from securities to properties and I think that REITs are uniquely positioned to take advantage of the long-term capital formation that's needed to do this. You have to be well-positioned to do it.

Okay, just a separate question on the -- the progression of the SEC comment letter and sort of where you see that going, how that has progressed so far, and what you think -- what your thoughts are on that?

The SEC letter is definitely -- I think the comment period is up in a week or so. You're going to hear comments from the trade groups, the various trade groups and stakeholders in the industry as well as from individual companies. I think there's a great deal of confusion about that especially in the sightings that they put out there about Carlyle as well as a mortgage banker and two private investment companies. There are -- there have been no sightings against any real estate investment trusts.

So at the end of the day, it would take an act of Congress we think to change the mandate that comes out of the exemption in the 40 Act and I think that's going to be evident from the filings that are put back out, the responses on a comment.

Okay, thanks a lot.

Mark DeVries, Barclays Capital.

Thanks, Mike, I'm interested to get your thoughts on the chance that the Fed emerges from their meeting today with a conditional pre-commitment on another round of large-scale asset purchases targeting the mortgage market. And in light of your comments about how an effective twist has been, with a real impact that should be on mortgage yields if they did that?

I think that the Fed has been in a valiant attempt to try to keep down rates for consumers since it started to purchase those assets about two years ago. I don't think that they want the balance sheet to be as big as it is. Obviously if you look at the conditions that just went on with, say, the Maiden Lane portfolio where they came back and they wanted to try to sell it, it caused major disruptions to the credit markets while they were trying to attempt to do that.

So once again, I think that this is not about interest rates. This is about loan to value ratios, equity valuations underneath it, and they may come in and purchase more treasuries but MBS is actually one of the highlights I think of REITs over the past couple of years is we've actually been absorbing a great deal of the issuance into REITs that used to go into Fannie and Freddie's hands. So the capital markets is providing private capital solutions for this.

And it's very interesting to me to see how they have been so diligent at keeping down rates in general but that foreign sellers continue to sell into that bid. Like the Bank of Norway, for instance.

So there's lots of stuff to still come back home, trillions of dollars worth of deleveraging to go on and I think that the shape of the credit curve, not necessarily the treasury curve but the credit curve is going to reflect wider spreads as a result of that. That's why a company like Annaly can make the returns that it makes for its shareholders using the least amount of leverage in its history.

Thanks.

Jason Arnold, RBC Capital.

Good morning, guys. Mike, as usual, a great commentary. Just curious, you had an uptick in average borrowing costs this quarter. I assume you put on some term repo but maybe you can comment here, please.

Just a small change in the average borrowing costs. It has to do with just the day count. Also if you look at our convertible debt interest expense number, there was an uptick there because of a bifurcated embedded contingent option. So it may not be a cash change but an accounting change on that. But there is not a significant change in the borrowing costs. The weighted average days to maturity also went up slightly from 46 days to 57 days, so you are seeing a small tick up because of that.

Okay, terrific. Thank you. Just one other quick one, swaps are more or less still a lot cheaper now than they have really been ever. I was just curious if you can comment on your positioning of your swap book here. Do you feel like extending -- [10-year] makes sense or kind of sticking with the two-year net duration that you typically --?

Yes, we continue to adjust according to the market and so keeping in mind that you could get more purchases out of the Fed, you could get more attempts out of policymakers to try and induce a refi wave, so we just continue to try and match things up where we feel comfortable given the current market environment.

Okay, thank you very much.

Steve DeLaney, JMP.

Thank you. Good morning, Mike. I wanted to talk to you a little bit about Fed policy, but you have already made several comments on that. I guess on that just on the fringe of that, though, I'm not sure -- in '08 and '09, the Fed was the great stabilizer and I think we all know what we got there. Now they are trying to be an economic stimulator. I don't know about you, but it's not clear to me really what we are getting out of the Fed and I think you've sort of suggested that you might have that same view at least as far as the impact on the economy.

I guess my concern is this volatility in the 10-year yield, we've had 50, 60, 70 basis point swings from low to high here in the last month. Are you surprised by that? Do you think the Fed is contributing to that in any way with kind of mixed messages about policy? I guess specifically if you could, do you guys have any kind of view on where this 10-year might settle in over the next couple of months? Thanks.

Somewhere in a 60 to 70 basis point trading range. I will defer to Wellie on that.

Yes, I would say that a lot of the volatility you are seeing is not just coming from Fed policy, it is coming from overseas. Anytime we solve the Greek situation, it sells off and then people realize that actually it's not been solved. So I think this is just another reason why we sit at the leverage level that we do because there's a lot of forces weighing on what's going on in the marketplace. And so until you get some of the stuff out of the way, there's just so many things that are impacting rates of return that aren't normal contributors.

I think you're seeing -- I'm not sure that you're seeing Fed policy causing this volatility. I would suggest -- my speculation is you are watching a tremendous amount of liquidations and repositioning going on. Just look at the unwinding of MF Global, for instance, and extrapolate that over into companies that need to get their balance sheets in order or hedge funds that have to get their balance sheets in order leading into some of the Dodd-Frank or of the FSOC scrutiny. There's a huge amount of repositioning and unwinding that's going on that I think is actually hurting the opportunity for the Fed to do something more meaningful in some of these programs but simply because there is a weight of the supply in the market is so great.

There is a tremendous amount of bonds that are flowing around the markets from foreign sources as well as domestic sources that are repositioning to either escape currency risk or reposition for industry risk or a steeper yield curve or get out of prepayment risk. There's a lot of things going on, a lot of metrics and dynamics in this market that fascinating to watch day-to-day.

No question. I totally agree with Wellie's comment about the Greece situation. We almost see that -- it is a direct correlation to the 10-year on the hour almost. But I certainly can appreciate that whether it's swaps are your bond selection, it really is a challenging time for you when we have this kind of volatility in yields to try to match up funding and try to evaluate cash flows.

The life of the mortgage investor is always challenging. Just unfortunate that the challenges don't repeat themselves.

(multiple speakers) You're learning a new lesson every period, right? Thank you very much for the color.

Stephen Laws, Deutsche Bank.

Good morning. Most of my questions covering prepays and leverage and such I think you guys have covered, so just a quick one. I expect a pretty short answer honestly, but do you guys have any exposure to MF Global that you guys are worried about?

Nothing material. And just a note on that for the markets, as someone who has been at this for a long time, my observation this year is that -- I can't speak about commodity side of the business and the issue that may have occurred over there. But from a fixed income perspective, this looks like a totally normal Fed-supervised wind down, supervised, very tightly similar to what went on in Dexia. I expect all of this to unwind repos, or bankrupts or remote transactions and that will unwind first.

We have no material risk out to anyone, but just for everyone to know that that's what happens in these markets.

Great. Then I guess, Wellington, one quick question on the portfolio. The realized gains ticked up. I imagine it's just likely normal kind of portfolio positioning but can you maybe comment on that? Was it anything specific you guys were trying to do? Was it a decision specifically to take down leverage or was it just simply typical portfolio activity during the quarter?

I mean it's typical portfolio activity. Our team is very diligent about constantly combing through the portfolio to minimize our exposure to refi activity, to take advantage of outside premiums in the marketplace. And so you will see -- going back several years now, it's been a constant -- a constant presence on our balance sheet is the portfolio gains activity, which is a nice thing.

Yes, I imagine with the unrealized gain position and the marks, that we're likely to see that line item be positive for positioning near term?

Yes, I mean if the Fed comes in and does another wave of buying, it could have [4 at 110]. That would be nice. But I think the bottom line is, Steve, is that by being in this position which I think is a very powerful position, as I said, we've got a $3.5 billion cash war chest in addition to low leverage. The Company through 10/31 has doubled the return on S&P and far outweighs what happened on the Bloomberg REIT Index.

So I think the bottom line is that it validates what we have been saying is that wider spreads are probably here for awhile. This volatility is only going to shake those spreads wider along with the supply that we see coming from the perch in our markets, whether it's the Fed that's going to be selling assets eventually or the Fannie and Freddie portfolio being unwound or some sovereign wealth fund deciding that they want to get out or just in general, supply coming out of the US institutions, so we are downsizing their balance sheet exposure. This is a great time to have this kind of balance sheet to acquire those assets.

Yes, well you guys definitely have the dry gunpowder, so to speak, to take advantage of that. Thanks for taking my questions.

Joel Houck, Wells Fargo.

Good morning. I'm wondering what your views on inflation are longer-term. If you look at what happened in the treasury market this quarter, a little surprised you guys didn't take the swap book up a little more given that how much rally we've seen in treasury rates. Is this something that you guys would look to do in terms of locking in spread on a longer-term basis if we got another rally this quarter in treasuries from perhaps QE3?

You always have your swaps against a callable asset. And so we will always keep that in mind. You can have the lowest rates in your swap book but if you don't have the assets underlying to service it at the levels you need, you are going to run into issues. Anybody that was paying attention to Dexia, one of their problems was the fact that they had swaps at levels that they no longer could service as rates continue to go lower.

So we constantly will balance it out given the backdrop in the marketplace and what's going on with potential Fed purchases or refi activity and things like that. But yes, you are correct in saying there is -- it is definitely a very interesting time to be able to purchase insurance for the longer term. It's just we'd like to see a little bit more or a little less interference, if you will, which I know will impact those rates but it will also impact your asset yields.

Okay, when you say a little less interference I'm assuming you mean Fed intervention.

I'm meaning all different kinds of things, whether its policymakers coming out with HARP 3000 or whatever. So we just kind of want to just let some of this stuff fall by the wayside and get some of the noise out of the space before we do anything longer term. But again, we will always be somewhat conservative in our approach. We continue to have swaps roll down into the new market.

Our perception is that all of this continued deleveraging is deflationary over the short to the intermediate run. Ultimately it could have inflationary expectations built up into the system, but in my shelf life, most inflation has come from things like wage inflation that was built into things like union contracts, etc. I just don't see that occurring.

CPI is being driven by food and energy which they don't want to count in those numbers and I think that just eats into more discretionary spending. So consumer balance sheets are in good shape, better shape. They are making rational decisions. They just don't have as much money to throw around. So they're not going to go to McDonald's. They're not going to go -- they are going to use the money more wisely than they did in the past.

Okay, then kind of switching gears if you look the amount of homeowners that are underwater today and generally 10 degrees your comments in terms of near-term deflation, one would assume that home prices are probably not going up anytime soon. There are billions if not trillions of mortgage losses that have to be absorbed by somebody either the investor, the taxpayer.

Does Annaly have a sense or an estimate for how large those losses are that need to run through the system? Do you have a view on how those losses manifest themselves, split between taxpayer, investor, or any other entity?

We have a lot of work that we've done that is part of our proprietary projections and thoughts and speculations about how we think this is going to play out. But it's a $5 trillion government market, so any policy like HARP essentially is going to be additive to the deficit. But it's also going to have the side effect of destroying bank earnings because bank earnings are based off of premium amortization write-down. You saw our amortization go up this quarter. Think of that as long-term. That would hurt the private sector as well as the taxpayer.

I don't sense any appetite for that down in Washington in the discussions I had down there and I think that's a pretty big number. The other balance, the other $5 trillion or $6 trillion worth of non-agency paper, I think that anything written after 2007 is probably in decent shape assuming that the fundamentals of the economy stay around these levels with the 9% unemployment or so and low income growth. I think the loan-to-value ratios and underwriting standards that went in 2007 and forward were pretty good.

I think a lot of that stuff, though, will spill over into if not into the insurance companies who put on private mortgage insurance, it will also spillover into the banking sector again and then waterfall effect over into second liens.

So I understand the urgency of the Federal Reserve policy to make sure that everybody who can stay in their house will stay in their house. Alan Greenspan once said at a dinner that we were at in response to our question about why did he agree to the RTC so quickly, it was very simple. The Federal Reserve doesn't want to cut grass and it doesn't want to paint houses. And I think that is still there.

I think that we will ultimately wind up with some kind of RTC like solution to this. It's just question of having the right administration -- policies to do that.

I think the Fed is doing a disservice to the market by -- I mean to the banking sector ability to absorb the eventual impact by flattening the curve.

I agree. I guess it's kind of scary to think if they are not willing to let banks absorb losses now, just how stable -- or capital levels are banks sitting on? Anyway I appreciate the comments. Thank you.

[Dean Tossi], UBS.

Good morning. Thanks for taking my question. By my estimates, the dividend included a component of taxable income from gain on MBS sales. Can you just talk about how gain on sale fits into your dividend policy?

The gains on sale of securities have to be paid out 100% to avoid excise tax.

Do you look at it on a quarterly basis or an annual basis?

I typically look at it on a quarterly basis. There are some book tax differences and when we do declare the dividend, it is an estimate at that time because it's prior to quarter end. But I try to look at that quarterly. And then by year-end do an estimate to avoid excise tax and pay out that -- and declare that dividend at the end of the year.

Just keep in mind on the spread income, you have to declare 85%, which includes some carryover from a prior year. So it's not an exact number that you can tie back to because there are some book tax differences.

Okay, thank you. And then a question on the decline in book value in the portfolio. Can you provide a little color I guess on the net duration that you are running or any -- how we should think about it given that rates rallied in the third quarter and I think sold off in I guess October on the quarter to date?

The book value again will always just be a snapshot in time and there's a lot of moving parts with the swap position and the mortgage position and the impact that certain announcements will have on prepayment expectations and things like that.

So we try and keep the portfolio in a net positive duration, but as things move around, that can also move around. So again, but I would caution it is a snapshot.

Thank you for taking the questions.

David Walrod, Ladenburg.

Good morning. You commented you have no material exposure to MF. Can you provide some color on your counterparty exposure on the repos and the swaps as far as the number of agreements that you have and any significant exposure to any one or two counterparties?

No, we don't provide that.

Okay, we've obviously had a lot of concern several times in the last quarter about liquidity and that's just a question that pops up a lot. So (multiple speakers)

We dealt with that issue back in 2007 when we founded RCap.

Understood, thank you.

Stephen Mead, Anchor Capital Advisors.

Good morning. What has happened in terms of the repurchase market in terms of overnight funding costs? And -- because I noticed that three-month LIBOR has ticked up but I was just curious what's happening in the repurchase market?

It's actually very stable. The Fed is very active in there. Tie that into the previous question, the overall color that I would give you, Steve, is that I think the Fed is doing an heroic job at maintaining the balances and instituting new controls and supervision techniques into the market.

There was hardly a blip on the MF Global. The way that those things are generally broken down when you are a primary dealer is that the Fed puts out a team into your office and they start to unwind the matchbook first especially as it relates to the government securities. And they start to send back the collateral and check the cash balances, etc. across the board.

For those who are in constant dialogue with these borrowers, and in the case of Annaly where we borrow a lot of money from a lot of different people, we do have policies that we don't expose any more than, say 10% outstanding with our guidelines. But you learn a lot from those discussions and as we learned in 2008 when we avoided Bear Stearns and Lehman, that the practice of the lenders is really what comes under question.

I think that's what the lesson that the Fed has learned, that when you start to see things like excessive haircuts and excessive raises in interest rates on repo, it raises questions about the guy who's doing the lending, not the borrower.

So all of those supervisory techniques are in place. There are regular dialogues between the buyside and the sellside that did not exist prior to 2007 and I think that they are doing a very good job of being the policeman on the deck.

Can you comment on just the increase in the CPR in terms of what actually happened in your portfolio versus your expectations? And sort of what's happened since the end of the quarter?

We won't know the end of the quarter until this weekend when we start to see the prepayment rates come in. So whenever we do our dividend projections, we are always basing that off of a guess as to what the last month's activity would be. But in the second quarter's call, we made a point of trying to make people aware that the cap on conventional loans was dropping from $729,000 to $625,000 and that in fact some lenders had already cut off underwriting at that level because they didn't think they were going to get in all the loans that they thought or the refis that they thought they were going to get in by October 1. And that there would be a flush forward across the board of people who normally would not have qualified for any kind of government loan pushing through that window finally through October 1.

I think that's the balance of what you saw. It is not HARP-related. It's more about the dropping of that cap from $729,000 to $625,000. That's our best intelligence.

And then just -- but you don't know what sort of happened in October in terms of CPRs?

No, we could tell you -- we will know a lot. The whole market will know on Friday when the first [speeds] come out. I expect them to be balanced to moderately higher or lower, not anything outsized.

We continue to be conservative in our estimates.

Right, but I would just -- from my perspective, the 11 to 18 increase in the CPR --

Pretty big number.

-- as being a huge negative. That seemed pretty reasonable.

Don't forget that prior to 2008, a conventional loan in the United States was maybe $450,000 balance. During the crisis, the government raised that to $729,000 and now you are seeing that be unwound and that's the first blush of it, right? So there has been a number of problems raised in Congress about the inequities of that decision and in fact, they are trying to reinstate it back up to $729,000. But that cap has now closed, so that's taking away more credit from the market where eventually it will lead to slower prepayments, less money being originated at those levels. And also further pressure on house prices as a result, because real estate prices will fall to the level at which they can be financed.

Right, right, okay, thanks.

Douglas Harter, Credit Suisse.

Thanks, my questions have been asked and answered. Thank you.

Jay McCanless, Guggenheim.

Good morning, everyone. Thanks for taking my questions. The first one, I just wanted to revisit your commentary about ICA 40. Did I understand you right that you all believe there is going to need to be a legislative solution if the mortgage REIT industry were going to be governed or I guess regulated under ICA 40? Is that correct?

No, you're talking about -- on the 40 Act is really what the issue is, right? And if you look at the language for exception in their for mortgage interest and mortgage cash flows, it's a very broad definition. Even though the markets have morphed over the past 70 years and since mortgage rates in general are consistently issuers of securities and have to go through registration process, etc. and actually have a separate S11 that they sign and file when they do that, that's unique to mortgages.

That has always been reaffirmed during the course of that process through due diligence of underwriters and lawyers and accountants, et cetera. So literally, in order to change the mortgage REIT status, you would have to undo a great deal of what was done in the 1940 act, which is the territory of Congress, not of the SEC.

Okay, understood. Then wanted to ask about the foreign situation, and I guess it's a two-part question. Can you discuss the causality between what's happening in Europe and the potential deleveraging there relative to the amount of cash that you were carrying at the end of the quarter?

And then also if there is going to be a significant deleveraging by the European banks, do you all have any estimate of the amount of whether they're agency or non-agency MBS holdings in the larger European banks?

We do discuss some of that in our commentary that's on the website in general. We don't put specific numbers on it because we don't think the disclosure that's coming out of Europe is especially good. But I will say that as we demonstrated with the Barclays transaction and with other European banks that we are under nondisclosure agreements with, it's raining assets. And you want to be bulletproof as you can be during that period.

And I would just look at Annaly's return since inception is 618% through Halloween from IPO, most of which came back to investors in the form of cash compared to the S&P is just below 8%.

So the value of those cash flows is really what's going to be embedded into the market going forward. And you want to be in a position where you have a lot of dry powder to take advantage of that. It's not going to happen in the fourth quarter. We are not running the Company for one quarter; we are running it for the next quarter century. And the result is that we are going to be able to be very opportunistic as this stuff comes back.

Okay, and my last question, I know you've already addressed MF Global, but what are the opportunities for RCap in this environment? Does MF Global disappearing help RCap? Could you give us just kind of a snapshot of what's going on with that portion of your business?

You know, RCap is still in a growing phase. It's doing a very good job for us and helping us create a separate balance sheet, which we were concerned about in 2007, that allows us to have access to borrowers and lenders that we never touched before. The activities in there are growing, but you can be assured that it's going to be a consistent slow growth pattern for us just like the other businesses that we put in place. It could be tortuously slow for us to make sure that we're doing it correctly.

The opportunities I think are pretty wide open across the asset allocation market. And leverage, I think from the Federal Reserve's point of view, is going to be -- they are going to accommodate that through the low interest rate structure and through the supervision that they put in place.

The plumbing of the repo markets is working very efficiently and very well supervised. That's not what caused MF Global to blow up. They were long Italian debt, less than a year and a half duration I think Italian debt. And at 40 to 1 leverage, that's going to kill you no matter how short it is, right? So very unfortunate, very unfortunate.

Thanks again. I appreciate it.

Daniel Furtado, Jefferies.

Thanks for taking my time. I appreciate it. Mike, what are your expectations for a GSE pilot program to sell credit securities? I mean do you think it will happen and if so, do you foresee [FDAC] taking a role there?

That's a great question. Thank you, Dan. The Stackers program that they are talking about is I think another way that I would point to the markets that GSE reform is really back burnered. With 95% market share coming out of the agencies right now in terms of mortgage origination as well as the FHFA raising rates, not behaving like they're going out of business and along with the aspects of research and development going on, we are working with the GSEs on pilot programs like this. And yes, we think there are opportunities for us inside of our advisory company and as well as within our balance sheets to do that. I think we have a great opportunity within the three companies, actually.

Great, thank you for that. I don't know if you care to king of take a stab on kind of like a timeline but I mean do you see this as more of a near-term issue or is this kind of more down the road? Do you have any sense of potential timing of something like this?

I think it's going to become more urgent as we hit for the first half of next year because I sense in Congress -- I think Congress went home in August and came back beat up in the discussions that I've had down when I did testimony. I really sense with the Congressional audience that they are tired of getting beaten up by their constituents and voters on House pricing.

Someone said this to me. Realtors are the teachers of the national presence. There's realtors in every district and the screaming that's going on at some of these town hall meetings especially from people who are involved in property administration rights or realty is amazing for these congressional players. They realized that their fetes are at risk.

So I do sense that they've been thinking about these problems for a long time and they are waiting for private-sector solutions. The one thing that I learned from all my visits on the Hill regarding the SEC letter is that that is a bipartisan issue that everybody can agree on.

If you are on the far right and you want to kill Fannie Mae and Freddie Mac or if you are on the far left and you think we need four more of them, the one thing that you can all agree on is that they need more private capital and that we have been the providers of it in this sector.

Excellent, thank you so much for the color. I really appreciate it.

David Miyazaki, Confluence Investment Management.

Good morning. Thank you for your comments this morning. I was wondering during the summer when there was reported shortages of US dollar availability in Europe, did you see that affecting the willingness or the attitude of your European banks with regard to repo financing?

No, actually it was exactly the opposite. They were doing everything they could to get dollar denominated assets.

That's interesting. Do you think that as they move through their -- the deleveraging that you are anticipating that willingness will remain?

It depends on the swap agreements that the Federal Reserve entered into with the European Central Bank. Those expire in January. If they roll them over, that will slow down and let them spiral down at a slower pace. If the Fed cuts that back or if they make that a shorter period, then I expect that to be a faster pace. Those swap agreements were a very important element of what slowed down the discussions in Europe.

Okay, if we look at the other side of the world with a sharp move in the yen versus the US dollar, are you seeing that affect the appetite for repo financing from the Japanese banks?

We are actually seeing more allocation of dollar-denominated activities out of the Japanese banks. Actually I spoke with two of them in the past week and a half. They are shutting down European operations and they are moving more of that capital and resources into the United States. Actually --

So really --

(multiple speakers) I think there was a story about Nomura the other day. They had purchased the Lehman activities in Europe and they are taking that capital out and they're going to reallocate it into Nomura in New York.

Okay, that's interesting. Thank you very much.

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

Well, thank you all for being with us today. I hope you found this educational and helpful. We look forward to seeing you again at the next call.

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 10005691. This concludes our conference for today. Thank you for participating and have a nice day. All parties may now disconnect.