Annaly Capital Management Inc (NLY) 2013 Q2 法說會逐字稿

Good morning and welcome to the Second Quarter Earnings Call for Annaly Capital Management, Incorporated. At this time, I would like to inform you that this conference is being recorded and that all participants are in a listen only mode. (Operator Instructions). At the request of the Company, we will open the conference up for questions and answers after the presentation.

This earnings call may contain certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.

Forward-looking statements, which are based on various assumptions, some of which are beyond our control, may be identified by reference to a future period or periods or by the use of forward-looking terminology, such as may, will, 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 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 publically 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 Wellington Denahan, Chairman and Chief Executive Officer. Please proceed, Mr. Denahan.

Thank you Andrew. Welcome everyone to our Q2 2013 earnings call. Joining me on the call today will be Kathryn Fagan, our CFO.

This past quarter, the free market had to contend with the potential reality of being left on their own to determine the proper risk-reward balance, while relying on models that have been processing distorted data. Nonetheless, I applaud our Fed Chairman for attempting to wean the financial markets from easy money policy before he heads for the exits himself.

In seeking precedent for the rate move over the last quarter, we can look to the extremes of the '80s for a comparable percentage change in rates when the 10-year rose 66% from 9.5% to 15.8% in about 450 days. The current 66% move took a mere 70 days. As I have mentioned many times on these calls, the pricing distortions caused by Fed policy would be difficult to assess and therefore required caution in managing our portfolio and our business.

Over the last several quarters, we have continued to position ourselves to react to this expected uncertainty. We have increased liquidity by operating with lower leverage, protected capital by maintaining large interest rate swap positions, and reduced our overall exposure to the effects of a large-scale asset purchases by reallocating capital into less interest-sensitive strategies or our expansion into commercial assets.

With this volatility comes opportunity. Investment spreads have improved markedly. Risk has been more properly priced and demand for high-quality collateral in the funding markets remains robust. Regardless of the economic data, or who's the next Fed Chairman, it seems the Fed needs to reduce its purchases or risk becoming an even greater share of the market as both Treasury issuance and mortgage production decreases. As long-term investors in these markets, we welcome the return to a more normalized spread environment and remind investors that over the last 16 years as a public company, the vast majority of the more than 500% return delivered to shareholders has come from spread income.

Before I open it up for questions, I'd like to go over a few key data points from the release and our earning supplements.

The change in book value of $2.16 was largely comprised of $1.40 from changes in mark-to-market, inclusive of our hedges and $0.66 per mark-to-market loss on pay downs received during the quarter. During the quarter we brought leverage down from 6.6 to 6.2 times. Absent changes in mark-to-market, the leverage would have been approximately 5.5.'

On Page 6 of our Earnings Supplement, in light of the recent volatility, we provide a simple illustration of how asset selection, coupled with leverage impact potential book value moves going forward. And I'll go to that slide now and just have a brief discussion. We present on that slide just a quick snapshot of 30-year coupon stacks versus 15-year coupon stacks and we show the relative price change, given rate moves and you will see that a lot will depend on what you choose in either one of those stacks and the impact it will have on your price change. You know ARMs are a great example of seemingly low duration assets that can also experience some heightened volatility.

The next chart that I'd like to highlight is a presentation of the effect that allocating capital into the commercial space will do to the long-term stability and profile of the company. You know as we set out early on that we would do about 25% of our assets in other-than-agency securities, this chart just shows as you start that allocation, not only does your overall corporate leverage come down, but the unit of return per unit of leverage continues to rise.

And with that, I will open it up for questions.

(Operator Instructions). Arren Cyganovich of Evercore.

Thanks. You highlighted some potentially strong returns in the agency market, yet leverage was pulled down so it seems to indicate you're still acting somewhat cautiously in this environment. What would make you feel a little bit more offensive and start to put a little bit more money to work to take advantage of those higher returns?

You know, one thing we'd like to see, you know the Fed has mentioned that it wants to exit the market in some way and I will qualify that by saying the Fed's not going to sell. The Fed is going to stop buying and there's numbers out there that, whether it's $10 billion in mortgages each month less that they purchase, initially, and $10 billion in treasuries, the composition of the market is such that depending on the assumptions you make on prepayments and what is happening on the fiscal front, that the impact of what they -- their exit may not be as dramatic as the last quarter's selloff would suggest. And so we'd like to see them kind of lay out their plan and maybe get a better sense -- you know we have the other big caveat out there that you don't know whether you have a Bernanke clone or you have a Washington insider as the next Chairman of the Fed. So the nice thing about our leverage position is you can easily leverage back up. I think the market should understand that we have actively brought it down. We sold $32 billion in the last couple of quarters, pulling that income forward in the form of gain, but it was an active decision on our part. And you also still have regulation out there and potential disclosures will go there out there and so it's very easy --- I know I've said this many times -- it's very easy to purchase assets. And it's very easy to bring leverage back up now that 14% to 18% is new money type returns, I just don't think that this is the time to go ahead and say, the coast is all clear -- let's go ahead and put our foot on the gas.

Keeping in mind, too, as we ramp the commercial assets, we're looking at a pretty robust pipeline there. We expect to have roughly $2 billion on the books by year-end. We expect to effect our first securitization in the fourth quarter with those assets and so that is cash on cash returns that are -- their impacts by interest rate changes are somewhat not, I won't say immune, but there's more stability associated with that. Make no mistake about it, the mortgage market is going through a transitional period and whether Fannie and Freddie's earnings get them a more permanent seat at the table with position or -- there's a lot of things that still need to be answered.

Thanks that's helpful and on the commercial strategy, I guess about your comment about doing the securitization, you intend to add kind of a level of leverage, not additional repo or anything against that, but you expect to leverage those investments? And just to be clear, you said 25% of equity or 25% of assets that you feel comfortable with?

No, our charter allows 25% of assets. We have laid out roughly 25% of equity.

And on the leverage, would you intend to lever up some of this commercial (inaudible)?

You know, we could lever up if we wanted to. Again, it's not our intention to utilize recourse liabilities against those assets. You know we do originate the entire debt stack and we will securitize and retain the bottom part.

Understood. Thank you.

Joel Houck of Wells Fargo.

Thanks and good morning. Appreciate the disclosures, again, this quarter they're very helpful.

Sure.

Can you talk about July -- did you guys take any further action in terms of defensively positioning your portfolio? Obviously July 5 was very disruptive in terms of price discovery and now things have kind of, at least relative June 30, are kind of back to where we were, so there's been no change during the month but there's been a lot of volatility. Can you talk about what you guys actually did in the month of July?

One thing, just a blanket statement I'll say is we are actively trying to continue to reduce the overall levered duration of the portfolio and the levered risk of the portfolio. And with that, there are shifts and I show that simple 30-year and 15-year price volatility chart and so their shifts that we have done within those asset buckets and coupled with that is leverage. And as we continue to bring credit onto the books with commercial assets, you have to strike a balance between the mortgage position, which is- provides tremendous amount of liquidity that other commercial players don't necessarily have. It allows us to be an incredibly quick mover and responsive on transactions. So keeping all of that in mind and balancing the two risks, we continue to try and strengthen the durability of the book value that's allocated to the agency position. So just bringing lower duration assets on, trying to reduce some of the spread duration, lengthening some of our swap positions -- you see we do have a large zero- to three-year bucket that is at above market rates that we extinguish some of that stuff and move it out on the curve and so hopefully that answers your question.

Yes, maybe -- that's good. Maybe, [lot of times]you wouldn't mind talking about, give us some historical context in terms of the mortgage spread, obviously basis risk is something investors have to live within these -- particularly the agency reads and also your perspective on the risk to spread widening between now and kind of when we get a new Fed Chairperson, whoever that is.

Yes, historically the relationship has been interest rates rise, spreads tighten to the curve. With the distortion, I'll call it, that the Fed has introduced into the market by their asset purchases, you have a tremendous amount of negative convexity in the market that is atypical but the recent activity has rendered the market, I think, a bit more normalized, yet they haven't left yet. So I don't want to throw a blanket --- when it was just Fannie and Freddie as the big participants, it was a different kind of relationship with the market. They were economically driven and so you did have a response to spread widening as rates rose. It was a fairly quick response, whereas this time -- and we still have to deal with the potential policy impact from a new FHFA Chairman, so I would say there's potentially more spread widening to take place, although I think we've seen a fair amount of it.

Daniel Furtado of Jefferies.

I just had a couple kind of maybe slightly outside the strike zone some questions here. The first is I'm kind of surprised that with the diversification plan, we haven't seen any non-agency RMBS come on the balance sheet. Can you just talk around your strategies there in terms of, I mean, you're just not finding this and attractive market, waiting for prices to settle, or just kind of a higher level strategy there.

We have an interesting situation where we do have a large public company that does participate directly in that market and they've been active participants in that market. If there are things outside of what they can do, we certainly have the wherewithal to go ahead and take advantage of that -- and I'll leave it at that.

Understood, thank you, and then my favorite conspiracy theory surrounding FDIC is [Shannon Funding] and I'm just curious, are you originating whole loans out of Shannon during the second quarter?

We have not, but we have the ability to.

And is eventually it your plan to do so? Is that how to think about that opportunity?

Yes.

Okay and then if I may, just one more on that. Would this be predominantly a conforming or a jumbo type of strategy?

It would probably -- primarily a jumbo strategy.

Rick Shane of JPMorgan.

I'd love to sort of talk through two things here, following up on Joel's question but also relating it to capital allocation. You guys have basically made the comment that OAS has normalized, but I think implicit in your comment is that even though basically that reflects rational expectations, as the taper begins that's already reflected in pricing -- you think that you could see some additional spread widening. Is your decision to shrink the balance sheet but not to buy back stock during the quarter basically positioning you for a view that spreads are going to widen over the next three to six months and you're going to have the opportunity to put that capital to work?

Yes.

Okay, and so that's really why you guys -- because if I look at it on a pure, where you are trading versus book, where you are in terms of leverage, what the near-term ROE is, it would've made a lot of sense to buy back stock this quarter.

It would make some. I mean I think it's a delicate issue, not only with liquidity but also with -- the original program that we put out there is we wanted to reduce our exposure to the impacts of Fed policy and not having the commercial option on the balance sheet and not having great options in the agency space, the best thing to do at that time was to reduce our overall exposure to the market. With the market becoming much more attractive at the prospects of not only the Fed exiting, potentially exiting the scene, but also with the commercial coming on and having seen the impacts of the flexibility of our balance sheet in its ability to deliver for borrowers that the best option is not necessarily to buy back stock.

Okay. There's actually something really interesting occurred to me as you were saying that, which is that is it fair to say that your expectation of how long QE3 was going to last has compressed significantly since you announce the buyback?

Not necessarily. No, not necessarily. I think the buyback was -- we hadn't had the Crexus transaction on the table and the long-term impacts of adding assets at the levels that were in the market and the risks associated with it warranted reducing the size of the company. I would say it's nice to see that the market understands that it's not just the one way market anymore. And the Fed, you know I remind you, the Fed hasn't done anything yet. Yet we've had a significant re-pricing from the lows in yield. That's not to say we won't go back there, but it's nice to see that you can get a more disciplined approach by mortgage investors in the market.

Okay, great. Thank you very much.

Oh no, did I answer your question, Rick?

It did and I guess in some ways what I think I am concluding is -- and I know that you guys were concerned how the exit would, how long it would take to see an exit and how that would play out. I think the conclusion is that it is better than feared.

Yes, I mean I agree. I do think, though, if you just take the economic data, for example, it wouldn't necessarily -- and there are thresholds in particular, whether it's unemployment or inflation --- it wouldn't necessarily warrant a hasty exit from policy. I think with them laying it out as a dial and not a lever would suggest that they understand and want to communicate, but they are also concerned about the relative position on the normal functioning of the market. And I think they've been fairly verbal and clear about that and I agree with them. Yet even as they taper, their impacts will still be fairly large, so I know I invoke the '80s here, but I don't think you're going to see anything like that.

Fair enough. I'm sadly old enough to remember the '80s, as well.

(Operator Instructions). Mike Widner of KBW.

Most of my questions have been answered already, but I guess just the broad question, you know the environment of volatility is probably here for a while and I guess the two questions are -- one of the reasons you guys had kind of run fairly defensively and low leverage kind of all along was your anticipation that the market was sort of in an unnatural place because of the Fed, so when kind of some of that started to unwind, I guess some of us had sort of hoped that your defensiveness would result in the performance of book value holding up somewhat better and so I guess maybe the broad question is where you surprised by not only what happened but how difficult that was to sort of protect against both from a combination of hedges, which he took up as well as leverage, which he took down? And how much confidence do you have that given what we just went through, it was a little bit of a learning experience, but it was unpleasant for book but do you have any more confidence that you can hedge better if things -- or protect book better, I should say -- if things continue along this path, which is maybe rates go up another 100 basis points or maybe they come down 100 basis points?

No, I mean as a mortgage investor for a long time, I'm not surprised by any of this and I've said year in and year out to, on these calls, and to investors, individually that mortgages are somewhat of a pain in the ass to deal with and quite frankly that's the way it is. One thing I will say, if I just look at our book value move over the last two quarters, relative to moves of everyone else in the space, our move comes in lower than the average of the space. So leverage does matter and the flexibility that it provides you from a number of fronts, whether it's, from regulators looking at it just -- there is a number of things that have to go into trying to protect book.

The other thing I'll say is there is no perfect mix of protection and if you overly protect but, you don't have any earnings and so trying to strike a balance between the two is really the ongoing challenge of mortgage investors. So I look back on the earnings of the company and what we've delivered to shareholders and if you put the chart, you see most of it, if not all of it has generally come from spread income and so if you protect book or you actually have a gain in book, as a REIT you pay it out.

And so your biggest long-term commitment to shareholders is that dividend and trying to make sure that the book doesn't deteriorate to the point where you can't provide that dividend going forward but also you have to allow for a certain amount of flexibility and volatility in book as a mortgage investor.

No, that certainly makes sense, both as an analyst, and I'm sure as a portfolio manager, I think a lot of people would agree with the fact that mortgages can be a pain in the ass, as you put it. I guess my other question related to that, so I go to the table on page 19 in your presentation. You show the interest rate sensitivities and I know all the caveats and I'm sure we all know all the caveats and that parallel shift and all that, but as I look at the 75, you know, the bottom line in the table, the 75 basis point move, it suggests that book value is, I don't know, I mean roughly about the same exposure as we had before. So I guess I'm just struggling with, you know we've heard different comments from different REITs over the past month or so. Some are really taking it more defensive and kind of getting negative or zero duration gaps and certainly from this it would imply that that's not where you're heading.

Well, the thing is one thing I'll say is you don't get anywhere without giving up something. And so we are actively trying -- this is a snapshot as of June 30. There's no question were actively trying to reduce our exposure to further volatility, keeping in mind the technicals and the fundamentals backdrop that were dealing with. I think the market was contending with this idea that they're not going to have this long-term participant and the Fed's going to get serious irrespective of economic data about introducing a tapering. So you saw a lot of the impacts of that. We will actively try and reduce this risk as we continue to rebalance the portfolio. There's no question that this is a snapshot at period end and this is what we're showing the market, but we are actively trying to bring these exposures down while balancing your ability to earn a dividend.

Thanks, I definitely appreciate the comments and absolutely, a difficult market with historically high volatility and trying to hedge out mortgages.

Yes, I mean like I say, there's so many of them and every market is different, so it's not like you can say this is like '94 or this is like 2003. They're all different.

Yes, it's like 2013 and ten years from now will be talking about that.

Exactly.

if there's no further questions, Andrew, we'll wrap up the call and I just want to say thanks to the team here at Annaly, who've done a tremendous job during a very volatile time and we look forward to speaking to you on the third-quarter earnings call. Thank you.