Annaly Capital Management Inc (NLY) 2012 Q3 法說會逐字稿

Good morning, and welcome to the third-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 speakers and participants are in a listen-only mode.

(Operator Instructions)

At the request of the Company, we will open the conference up for questions and answers after the presentation.

This earnings call may contain certain forward-looking statements within the meaning of Section 27-A of the Securities Act of 1933 and section 21-E 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 pre-payment rates, the availability of mortgage-backed securities for purchase, the availability of financing, and, if available, the terms of any financing, changes in the market value of our assets, changes in business conditions and the general economy, changes in governmental regulations affecting 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 would now like to turn the conference over to Wellington Denahan-Norris, Chairman and Chief Executive Officer. Please proceed, Ms. Denahan-Norris.

Thank you, operator. Good morning, everyone. Joining me on the call today Kathryn Fagan, our Chief Financial Officer. I also have with me Kris Konrad, who is co-CIO of Annaly; James Fortescue, who is Chief Operating Officer; and Kevin Keyes, who is President of Annaly. I am going to just start with some prepared remarks and then I will open up the call for questions following these remarks.

First of all, I want to acknowledge and sincerely thank all who offered such warm condolences for Mike Farrell. The outpouring of sympathy has been remarkable. I know Mike's family and everyone here at Annaly really appreciates all of the comforting thoughts and prayers we received. Our thoughts also are with all of those affected by the storm here in the Northeast.

I want to dedicate today's discussion to Mike, and our past earnings calls. Over the years, the daily macroeconomic and market debates of this entire management team have been manifested in Mike's very colorful commentary. Using personal anecdotes and humorous analogies, he uniquely described the state of the economic conditions through the Annaly lens. So I thought I would revisit some of the most important market themes our team routinely uncovered, well in advance of others. Themes which all remain very relevant today, and that Mike translated with such incomparable style.

The first theme is from the second quarter of 2006, when Mike delivered an anecdote titled The Goldfish Is Dead, Senator. The story centered on the passing of the family goldfish, which Mike related to the bursting of the tech and housing bubble. In an attempt to hide the tragedy from his young children, Mike recounted going to the store to secretly buy a replacement fish. The second fish, however, quickly suffered the same fate as the first. As the Annaly team predicted at this time, the bubble that we successfully migrated from technology to housing is breaking again. This time the consequences for our domestic and international economies are much broader than the breaking of a mere tech bubble. We surmised, at the time, that the next discussions will not be about the return on capital but the return of capital.

From the third quarter of 2007's earnings calls, Mike wrote a piece which he entitled Seduced By a Supermodel. The supermodel in this case was an analogy that refers to the complex financial models and financial engineering with which Wall Street became enamored in the years leading up to the financial crisis. As Mike expressed five years ago, structurers, traders, rating agencies, regulators, investors, all became enamored with the same super modeling techniques at the same time. The attractiveness of structured products blinded love-struck market participants, and we all know how painful, even today, the break-up continues to be.

In the first quarter of 2008, Mike retold a story first presented on the Twilight Zone called To Serve Man. In this particular episode, a seemingly benevolent species of aliens called the Kanamits came to earth under the auspices of elevating our standard of living. In the end, the real motive of the Kanamits was to make humans complacent, fatter, and healthier for their eventual consumption. As Mike noted back in 2008, these aliens represented the leveraged profile of the global financial system, a boon to our everyday existence until the inevitable consequences became apparent. This story, again, is just as relevant today as it was when Mike first told it. With the Federal Reserve supplying the market with seemingly unlimited liquidity, one has to wonder if another round of quantitative easing really is the best recipe for the market, or if it is simply another chapter in the Kanamit tale.

Finally, in the third quarter of 2008, Mike's earning piece was titled It's Contained, It's Decoupled, It's Only Notional. The basic tenet of this piece was to take aim at these three popular phrases, which we believed were and remain as dangerous as they were inaccurate. Mike stated at the time that the only decoupling occurring was that the Eurozone's desire to fight inflation versus asset deflation, and he echoed the sentiment that Europe needs its own Alexander Hamilton. Today, the Eurozone remains in a precarious situation, another current market reality that the Annaly team, through Mike's voice, identified over four years ago. These perspectives that Mike shared on a quarterly basis were both entertaining and prescient. His commentary was simply designed to shine a light on certain market perspectives from the Annaly point of view.

Most of the critical elements Mike related to years ago still remain. Going forward, Annaly will continue to try and synthesize all that is happening on the global stage for the betterment of our shareholders.

With that, I will open the call up to questions.

(Operator Instructions)

The first question comes from Bill Carcache of Nomura. Please go ahead.

I wanted to start off, if I may, with some questions on your buyback announcement, and I just wanted to get a little bit more color on that. Can you talk about how likely you are to execute on the buyback authorization? With the shares currently trading where they are relative to your book value? If you could just give some perspective on that, and what would you envision as a source of funds for any buybacks?

First of all, if anybody has known us for a long time has known that Management has never announced a share buyback. Actually, I'm sorry, we may have back in 1999 when the Company was trading below book for a brief period of time. We take these things very seriously, and given the backdrop of what I just described with the Fed's influence on the market, the Management here just wants to maintain maximum flexibility for shareholder value.

And if the Company is trading below book for a significant period of time, and for a significant amount, we want to maintain the option to go ahead, given the backdrop of the investing environment, to go ahead and retire some of the stock. We get a tremendous amount of principal in interest every single month that we can either allocate to new purchases or we can allocate to a share buyback.

And the principal and interest each month, if they get allocated to buyback, would that bring down the leverage ratio further?

It would maintain it fairly constant, actually it might go up slightly until more principal interest come in. But we would constantly monitor a comfortable leverage level, given everything that's going on.

Okay, and along those same lines, in order to just have an understanding, and make sure understand how this works, so in order to have your income remain exempt under REIT taxation laws, does the income that gets applied to share buybacks get treated as distributed?

We're still going to pay out the dividend based on taxable earnings. But just with the amount of principal alone that we get in every month, we would have enough to do the buyback. But we would not necessarily take buyback enough that it would affect retired capital.

Okay. And then shifting over to prepayment speeds, even though your prepayment speeds only up went to 20% CPR from 19% CPR, the spread compression that we saw during the quarter, it makes it seem like you have some higher yielding securities in your portfolio that are pre-paying. Can you talk about whether you're seeing faster pre-payment speeds on some of your higher yielding securities and any commentary you can give on that would be helpful.

Sure, this is Kris. Definitely, prepayments picked up during the quarter, as we reached new levels of mortgage rates. I would characterize it as the bulk of the pickup coming from some of the securities that we own that are either faster in prepayment or shorter securities, whether they are 15 years or CMOs. So, as they gravitate more towards -- as we receive more principal from those types of assets and they pay off, which is the case in some of the CMOs, we are forced to realize more of the premium.

And just to put into perspective, when you get the Q, you will see we got about $10 billion in principal this quarter, which compares to around $8 billion last quarter.

Okay, thank you very much. I appreciate it.

The next question comes from Jason Arnold with RBC Capital Markets. Please go ahead.

My condolences again on Mike's passing. I know he will be missed by all of you, and certainly he will be missed by us in the investment community as well. But I guess, Wellington, I was curious about the comment that you made on the relative value opportunities across the asset classes on both sides of the balance sheet out of the release. I guess there's some reference of buyback in there, but I was curious if you could comment on any other items you might have in mind?

Like I say, with the Feds being such a large and active player, we do have an election year that hopefully we'll get some clarity today. The way I see it is if Obama wins, that we potentially see more policy meddling. And there could be the point at some time where you actually see assumability in mortgages. There was a time in the past that mortgages were assumable and if house prices don't allow for mobility in the system, I could see them instituting policy that would make it so that people could still move around and maintain their very low coupon mortgage.

For us, we continue to try and just assess within the confines of the market where the best relative value is among the various sectors we deal in. Whether you want to own a mortgage that has significant amount of prepayment protection, that ultimately may be good for a couple of quarters, but that payoff may not get the value in the repo markets. It may not get the value in the TBA markets, there's a lot of difficulties that go with turning your balance sheet into a trading strategy versus an investing strategy. We have maintained a fairly conservative stance, rightly or wrongly, as we have navigated through these markets.

We have never had such a large uneconomic competitor, and so to adjust the entire strategy of the Company for a couple of quarters to make sure that you can survive through that uneconomic presence is, the way I look at it, we need to be a little bit more long-term in our view. And so if we have a quarter or two where the kind of assets that we own are not performing as well as they would over the long term, as we expect them to over the long term, we would make adjustments. We are constantly assessing, knowing all that we know from the asset and liability side of how these assets are viewed to make sure that we are doing all that we can to maintain shareholder value in the long term.

Okay. Great. Thank you for the color there. One other quick follow-up on the repo rate side. Little bit higher here this quarter, I assume due to greater utilization of some term repo to carry you through year-end, but maybe you could expand on that as well. Thanks.

Okay. Jimmy Fortescue is here, who was Head of our Liabilities, as well, I'll have him go into a little bit more detail. But again, we look at this rate landscape and the fact that you have a lot of shifting regulatory pressures on balance sheets of large banks and everybody struggling for return on capital. So, you have to deal within the confines of what your counterparties are looking for versus what you are looking for. And so we make adjustments in our repo position to help manage those varying cross-currents that we are running into. I'll let Jimmy expand on it.

At the end of the day, what we were always taught by Mike is to have a fortified balance sheet and not to build the business for one quarter, but we're building a franchise. We continue to get the unique opportunity because we're credit-worth to extend liabilities, you've had the Fed say things that are unheard of before about a policy extension of 2015. So there are opportunities to expand and add life insurance to some of our positions here.

And with all of the regulation that's coming down the pike, we're plugging it in across the sector to try to make safe and sound rules for the system. We may not all love the rules, but I think everyone wants to plug into them properly, and what we are seeing is with this next leg of regulation is just a lot of the bank balance sheets wants to extend liabilities and to make continued profits with all of the cash that is in the system. So we consider ourselves fortunate to have those opportunities and work with our partners in that.

Excellent. Thanks for the color. I appreciate it.

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

Thanks. I was wondering on the pick up and premium amortization, is that all related to the current experience or is any of that accounting for future increases?

No. We tend to do what our actual experience is. Keeping in mind that our portfolio has been around for a while and you may have securities that were purchased at much lower dollar prices. Yet you continue to have, in those securities, you didn't have as much prepayment protection as you do in some of your newer purchases. But, nonetheless, we try not to take just a one-sided view with our assets.

We do have securities that may underperform in an environment like this, which will clearly outperform, let's just say, given a change of administration, which is possible. But we try and strike a balance between the types of assets that we buy. We don't ever take a one-sided view with the portfolio. It is not a trading strategy.

Great. And then just given what rates have done since then, what would be your view for prepayments in the fourth quarter, and heading into 2013?

I think a lot of that will hinge upon what happens tonight. And certainly there are a lot of challenges to this economy that will be in the forefront very soon, whether it's the fiscal cliff and as, certainly the market is contending with potentially better growth, at least until the recent developments from Sandy. So as Wellington said, we're always trying to strike a balance on how much call protection we have in the portfolio. There is certainly a cost for that protection, and we have certainly managed this portfolio through different markets where that cost was virtually nothing.

Doug, I would say that if Obama maintains office, that you will continue to see policy meddling, and you will continue to see attempts at making sure the borrowers continue to have the flexibility. So I would see an elevated level, all else being equal, in prepayment.

Great. Thank you.

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

Wellington, you got a couple of questions from Douglas and Jason about the premium amortization.

Right.

I heard exactly what you said about some bonds that carry more premiums, and make prepay faster in a particular period and create a higher percentage premium amortization, then would only be reflected by CPR. Because it is a big -- CPR is at 5%, premium amortization is up 50% on what is only a slightly larger portfolio. But you said it is really like responding to what you actually lose -- that $10 billion that Kathryn referred to that came in, in the quarter, net necessarily some adjustment of the future. At least that's what I heard you to say.

Help me understand that in the context of the spot spread and the spot yield at September 30 was 20, 25 basis points higher than actual, so you had a 102 spread for the third quarter with that premium amortization. But it seems to me that you are expect a spread that -- an asset yield that's going to be higher looking out here into the fourth quarter going forward. Help me understand that, please.

Steve, this is Kathryn. Maybe if you could just go through the calculation of how the amortization is determined. On the securities we come up with a yield to maturity. We base it on our expectations of prepayment fees for the life of the security.

Yes.

And you have to do both prospective and retrospective. So if there's an anticipation in the life of the security, it's going to be a lower-yielding asset, we do a retrospective adjustment also. And so you want to make sure that over the life of that security, you're capturing the actual yield. With that being said, you do see an increase but you also see more premium -- $900 million on the books at the end of the period. So as the purchase price picks up, you have more unamortized premium on the books that you have to take into consideration. With each individual bond and portfolio, we do a yield to maturity and then do the calculations prospectively and retrospectively.

Okay, that's helpful. That is what I understood it to be, and what you are saying there is that if your lifetime prepayment expectation changes in any quarter, that will result in a lower yield to maturity. So in that particular quarter, if you had not changed your lifetime speed expectations from quarter to quarter, then it may more or less be proportional, the premium amortization may be simply proportional to principal received, whereas if there's some change in the expectations, that could create higher amortization to get you to a lower yield to maturity.

Right, and with that being said, you don't want to be too aggressive. You really have to support the CPRs you used on every single security. So you don't want to over-amortize and be too, as Wellington pointed out, a dire situation on one of the securities, when that is not the reality of how it is going to perform. But also, if you're seeing a pickup and you expect that through the life of the security, you have to consider that. It is something that's heavily scrutinized by the auditors and by the PTOB, anything that's with income recognition, so this is really a hot topic that is checked very thoroughly here and by our auditors.

Understood. And that's appreciated. Thank you, Kathryn. One final one for Jimmy, because he talked about the longer-term repo. Their seems to be an increased availability on counterparties and you added $10 billion to your over 120-day bucket. I was wondering, Jimmy, how far not practically, can you go out? And can you give us some sense for if you're going out one to two years, how that pricing compares to the current 40 basis point type rates that we see on short repo?

Yes. I mean, I think with everything it's relative. You know if you think of [options] and versus swaps and certainly long-term repo, it is balance sheet and there's a cost to balance sheet. So there is a payoff to that. Again, we have done trades that I have never seen before in my career, being with Mike and Wellington 17-plus years. We did a $5 billion trade for five years that obviously fortifies pretty much everything that we need to do. We are seeing a lot of demand from the cash business all welled up on the sidelines. Everyone is looking for different conduits out there, because of the balance sheet regulation that's coming in.

What I will say is that with all the things going on in Europe, we were far ahead of this in the second quarter and late second quarter, and we have added a lot of that protection going into the third quarter. So, right now, there is not that need to add that stuff because the protection is in the portfolio. But it is a slight pay-up, but it definitely pays off in the long run. Guys are looking for returns for the cash. There is the demand but you have to be credit-worthy, and you have to have the right assets for that.

Yes, and Steve, we've actually been doing longer repo for some time now. It is not a new phenomena on our balance sheet.

Right. Well, thank each of you for the comments this morning.

This concludes our question and answer session. I would like to turn the conference back over to Ms. Denahan-Norris, for any closing remarks.

I want to thank you all again for the tremendous outpouring for Mike, and he certainly will be missed. We will continue to do all that he envisioned, and more. And I look forward to speaking to everybody on the next earnings call. Thank you.

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 10019907. This concludes our conference for today. Thank you for participating, and have a nice day. All parties may now disconnect.