Annaly Capital Management Inc (NLY) 2014 Q2 法說會逐字稿

Good morning, and welcome to the Annaly Capital Management second-quarter 2014 earnings conference call.

(Operator Instructions)

Please note this event is being recorded.

I would now like to turn the conference over to Willa Sheridan. Ms. Sheridan, please go ahead.

Good morning, and welcome to the second-quarter 2014 earnings call for Annaly Capital Management.

Any forward-looking statements made during today's call are subject to risks and uncertainties, which are outlined in the risk factors section in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the forward-looking statement disclaimer in our earnings release, in addition to our quarterly and annual filings.

Additionally, the content of this conference call may contain time-sensitive information that is accurate only as of the date of this earnings call. We do not undertake, and specifically disclaim, any obligation to update or revise this information.

Participants on this morning's call include Wellington Denahan, Chairman and Chief Executive Officer; Kevin Keyes, President; Glenn Votek, Chief Financial Officer; David Finkelstein, Head of Agency Portfolio; and Bob Restrick, Head of Commercial Portfolio. I'll now turn the conference call over to Wellington Denahan.

Thank you, Willa, and thank you all for joining us on the call today. We will make a few brief remarks before we open the call for questions.

As the Federal Reserve's exit strategy moves beyond the end of asset purchases, communication has centered on the merits of raising the price of money versus adjusting its supply. As the debate goes on, I am reminded of a simple economic story. Back in 1989, the fall of communism was underway, and the early stages of capitalism had started to take root in eastern Europe. At the time, a well-respected Harvard economist marveled at the transition from a centrally planned economy to a market economy.

He described the transformation from the perspective of an egg booth at a newly established farmers' market in a small town in Russia. Having lived in a centrally planned economy for decades, the farmers did not understand what it meant to be in a market economy. So, on the first day, only one brave farmer showed up to sell his eggs. Not surprising, the limited supply resulted in the farmer getting a hefty price for his eggs. In fact, this market price far exceeded the price during the centrally planned economy, immediately fueling criticism from staunch communist supporters.

However, as news spread among the farmers about how much they could sell their eggs, more of them came to market, increasing supply and putting downward pressure on prices. The market price of eggs ultimately settled below the centrally planned price to a level that worked for both buyers and sellers. It is instructive to note that this small market economy took hold without the need for complex economic models to guide it.

Now, back to our own economic story. Having placed greater emphasis on communication as a policy tool, the Federal Reserve has both assured the markets it will maintain its extraordinary accommodation to protect against any downturn in the economy, yet has voiced concern about a number of market themes that are a direct result of their unconventional measures. They highlight areas of focus as low volatility, risk taking via a reach for yield, financial stability, and deflationary pressures.

It should not be a mystery or unexpected that after five years of huge increases in the supply of money, while simultaneously replacing the normal market disciplined scrutiny of data with the certainty of well-telegraphed forecasts by central planners, you will undoubtedly get low volatility, which leads to subsidized risk taking in a reach for yield that drives asset prices higher than they otherwise would be, along with increased debt levels to support it, ultimately fostering financial instability and future deflationary pressures, as the free market ultimately reprices assets to fit the new supply/demand dynamic. Just as the simple economic example in the farmers' market demonstrated, I think it is much better to adjust the supply of money, and then allow the market to begin to adjust the price of, not only money, but all the assets that have been supported by the printing presses.

We continue to position our Company to deal with the unintended outcomes of monetary policy wind down, and the opportunities that will go with it. We've maintained leverage at very conservative 5.3 to 1, while delivering solid core earnings of $0.30 per share, and we believe we can continue to support a competitive dividend going forward. The fundamentals of the mortgage market remain strong, notwithstanding the reduction in asset purchases by the Federal Reserve. And will continue to offer competitive relative returns, even as short rates move higher.

Before I hand the call over to Kevin Keyes, I want to thank the management team for doing an excellent job of defending book value while delivering an attractive risk-adjusted yield on average equity of 9.24%, in an environment that has seen so-called high yields plummet to an all-time low of 4.83%. And to put that into context, was well below the Fed funds target rate of 5.25% during the 2006/2007 periods, which was just prior to the onset of the great financial crisis.

I will now hand the call over to Kevin Keyes.

Good morning, everyone. Before we get into the financial details of the quarter, I thought I'd briefly expand on a couple of the points Wellington mentioned regarding our relative performance and general outlook for the rest of the year.

Overall, we do not consider ourselves as operating merely in the technical vacuum of the mortgage REIT sector. We target long-term outperformance relative to the risk returns in the overall market, amidst all fixed-income classes and yield-oriented options for institutional and retail investors in the equity market.

Our common stock dividend yield of 10.7% is currently at a premium that has never been wider, in comparison to certain other asset classes. It is also important to note: Our premium yield is currently generated with 40% less leverage than our historical average dating back to the Company's inception.

So, one simple way to measure our yield premium and relative value is to look across the $35 trillion invested in the largest sectors and indices in the yield markets. Ranging from corporate treasury and municipal debt, the ABS and CMBS markets, and to certain equity indices, including the S&P financial index, MLPs, equity REITs, and utilities. The average annual yield of these sectors combined sits at 3% today, over 50% more expensive than the average since the year 2000. These alternative yield options are not only more expensive today, but also typically held in less liquid vehicles with less transparent exposures to rates and/or credit.

In terms of our overall outlook, we are confident in sustaining the $0.30 dividend for the remainder of the year, at a minimum. We have this confidence in a relatively tumultuous world due to a number of factors, including: the improved visibility in the agency MBS market; our complementary business mix of interest rate and credit risk, which is manifested in fixed and floating rate yield structures; our leverage level, which is markedly lower than the sector and the financial industry overall; the elimination of certain swap expenses Glenn will get into in more detail; and improved operational efficiencies we've achieved over the past 12 months.

In times of dislocation like this, our shareholders have always earned outside returns over the longer term. For instance, since the fourth quarter of 1998, when our share price was last valued below book for an extended period, our buy-and-hold investors have realized a total return of 799%, with 756% of that return coming in the form of cash dividends.

Now, I'll turn it over to Glenn who will summarize our financial results for the quarter.

Thank you, Kevin, and good morning. I'm going to take a brief moment to give you some key financial highlights for the quarter.

So, to begin, our core earnings per share available to common shareholders rose 30% in the quarter to $0.30, compared to $0.23 in Q1. Our core earnings excludes realized and unrealized gains and losses on swaps, and other derivatives, as well as asset sales, and was $300 million in the quarter, generating an annualized [core] ROE of 9.2%, and that compares to 7.7% for the prior quarter. From a GAAP standpoint, we reported a loss for the quarter of $336 million, or $0.37 a share, which, similar to last quarter, was driven largely by the interest rate swaps losses. Key factors driving the improvement in core performance for the quarter were, first of all, a 4% increase in interest income, primarily due to increased investment balances and relatively steady asset yields, along with a 10% reduction in economic interest expense.

Now, the interest expense decline was driven by about a $40-million drop in swaps expense, which translated to a 37-basis-point decline in our cost of funds, and a 36-basis-point improvement in net spread, and a 25-basis-point improvement in our net interest margin. Our net interest margin, which represents the economic net interest income earned relative to our average interest earning assets -- and I think it's a more meaningful performance indicator than net spread -- was 157 basis points, which compares to 132 basis points in the prior quarter.

I want to spend a moment on the swaps impact for the quarter. Now, you may recollect that on last quarter's earnings call, we mentioned a repositioning of our short-dated legacy hedge position that we were undertaking in the second quarter. This amounted to the net unwinding of about $26 billion notional of short-dated pay six swaps that, given the macro environment, we believe that they were providing very little hedge protection.

So, as we do not apply hedge accounting, our swaps are fair valued each quarter, with any changes recognized in earnings in the current period. So, gains and losses associated with the swap terminations are also recognized in our current-period earnings. So, for Q2, the terminations amounted to $772 million.

Now, bear in mind, much of this is shifting among the swap-related line items on the income statement as a result of the termination of the swap. So, specifically, unrealized gains and losses on swaps improved by just under $525 million, as the unwound swaps were moved out of the unrealized line and into the realized line of terminations.

So, additionally, one more point, from a tax standpoint, since we had previously elected tax hedge elections for the swaps, any gains or losses on the unwinds are amortized over the original term of the unwound swaps. So, in other words, as if they had never been terminated in the first place.

Turning to the balance sheet, the agency portfolio increased $4.6 billion to $82.4 billion, that's a 6% increase for the quarter and 12% year to date, while the commercial portfolio was relatively flat, as pre-payments offset the current quarter's originations. Repo balances increased $5.8 billion, consistent with our asset growth; and book value grew 7.6% to $13.23 a share.

And then finally, our capital levels remain solid, both in terms of leverage and capital ratio. Our capital ratio remained at 15.4% at the quarter. So, in summary, a very solid quarter that we're very pleased with.

And with that, Teresa, we're ready to open it up for questions.

Will now begin the question-and-answer session.

(Operator Instructions)

Jason Weaver, Sterne Agee.

Good morning, thanks for taking my question and congratulations on the quarter. Just one question. What sort of changes in the economic environment that may be upcoming would make you more comfortable with increasing your leverage position?

I do get a feeling that there's a lot of dovishness at the Fed. And I don't think I'm alone in that feeling. And I do think they are looking for reasons to continue to, even in light of some stronger numbers, to continue to hold rates lower than I personally think they should and probably lower than some other market participants think they should.

So the quality of the data that they can no longer ignore, or you start to see downward movement in some of the economic data that has been supported by the tremendous amount of liquidity in the market. So you get a clear sense that they're going to have to reengage at some point.

Right now, I would like just to see a play out of the end of the asset purchases, start to see the dialogue really start to percolate around the first rate increase, which I don't think you're going to see until early next year, although there's a lot of back and forth about the timing of that. So I don't think there's any reason right now to say, you know, we're going to just take leverage up and we feel completely comfortable about that.

I do feel being in the agency arena, you are on the front lines of potential re-engagement by the Fed. And so, if things start to get a little out of control or volatility picks up or some of their fears start to surface in a bigger way, I think the mortgage market is going to be a beneficiary of that and we feel comfortable in that position.

Fair enough, thank you

Dan Altscher, FBR.

Thanks, appreciate you taking my call this morning and looks like a pretty good result overall. I'm referencing page 17 of the slide deck which shows the rates sensitivity. And I totally understand it's a hypothetical exercise.

Right.

But I'm surprised to not see the relative sensitivity increase considering the notional value of the swap or for that came up. Was that just maybe a function that that was all short-term swaps?

Yes. They were all very short-term swaps. The reduction in the notional amount probably added about a half-a-year duration to the portfolio. This is the reason we did reduce that position.

We did move some stuff out into the 10, 20, the 6 to 10 year bucket and greater. So you see the tenor of our swap position has moved out providing protection where we think we ultimately need it. The short book was really protecting against a fairly sizable move out of the Fed in the near term, which I don't think we or anyone else really expect.

Okay. That's helpful. And just maybe a quick question on probably what's the less focus part of the business, on the CRE side.

It looks like there was maybe an incremental $40 million or so of real estate equity that was brought on board. Is that result of the new partnership, if you will, with Inland?

Yes, this is Bob Restrick. That is a direct result of the partnership with them

Can you maybe just talk about what those asset or assets were that got brought on? Assuming they're all net lease, but a little bit more specific around that?

Right. It was two sort of evenly split triple-net lease retail transactions.

Anything like property types or geographies, anything like that?

They're both in the Southeast and retail.

In retail.

Yes, retail.

During the quarter, too, we did have about $100 million in paydowns --

Correct.

-- that we also redeploy during the quarter. As you can tell, there's a lot of markets that are getting a little bit frothy.

Yes.

To put it mildly. And so, we don't feel the nice thing about having the commercial position paired with the agency position on our balance sheet is it gives us a lot of flexibility, and I don't want our team to ever have a gun to their head. In light of deterioration in some of the credit metrics out there that they need to go ahead and add to position without feeling completely comfortable with it

Right. Just as a follow up to that, we, despite the $100 million in, $100 million out, our pipeline continues to be consistent. We've looked at, in the second quarter, almost $8 billion of debt opportunities, of which we passed on 75% of them because of pricing and credit, and then put quote sheets on about $0.5 billion.

And the same thing is true on the equity side. Since the beginning of the year, we've looked at about $1 billion of transactions through both Inland and on our own, kind of 50/50 on our own real estate opportunity. But also passed on two large portfolios that were five dome. We didn't do them, but we look at those as real opportunities that we could do.

So when we do those transactions that we think makes sense from a credit perspective, whether it's debt or equity, and from a pricing perspective. We're not sort of a one monoline, have to do it shop.

Yes. No, that's great. I thought they were really thoughtful responses, so thank you. I appreciate it.

Joel Houck, Wells Fargo.

Thanks and good morning. I'm just curious as to what you think it will take for interest rate volatility to move higher? It seems like everyone's been waiting on the taper to kind of run its course, and hearing now, we're almost at the end and we still see low val.

If that doesn't trigger it by the end of the year, what will, and I guess if we continue to see lower val, do you run a low leverage strategy as you point out the returns relative any comparable indice, the yield, if you will, is still very attractive. So therefore, why even take a chance in the face of low val for moving leverage higher?

Again, there's no precedent for this transition that the market ultimately is going to have to go through. And my prepared remarks deal with what I think is the key question. You can change the price of something out there, and I characterize the liquidity in the market pre-crisis was synthetic.

It was driven through ratings, financial engineering, and when you had downgrades or some of that stuff coming into question, liquidity quickly went away. And this kind of liquidity, it's far different. It is printed, it is out there, it is real, and the only one who can take it away is the Fed and the central banks.

And they have this idea that they are going to just change the price of it and leave all of that liquidity sloshing around out there. And, of course, it becomes problematic for the cost of carry, holding risk asset. But ultimately, I think you see a change, a serious change, in the underlying fabric and makeup of the market when they start to reduce the size of that balance sheet, where it is a permanent drain when they stop reinvesting on the MBS portfolio.

When they do reverses with the market, they can temporarily take that liquidity out, and if all things go to hell, they can add that money right back in the next day. Whereas them reducing the size of their balance sheet, in my mind, is going to be the real question.

Now, they are currently behind the scenes trying to make sure that when they do that, they don't create this incredible financial instability. The thing I think they're overlooking is they have reduced, and all of the regulatory pressures have reduced, the liquidity ability of the market. You don't have the dealers in a position where they can actually absorb some of that unwind.

And so, it will be interesting as they stop adding. I mean, they're still adding, I have to remind people they are still adding money to the market. And once they stop that, I think you start to see, and as we get closer to, all right, now they're not going to take it away, they're just going to change the price of it, it should start to impact volatility.

Although, I have to remind people that in 2004, we went from 1% on fed funds to 5.25% just before everything blew up. And Bernanke, when he took the reins, was still raising interest rates in light of the fragility that we saw in this synthetically fueled liquidity world pre-crisis. So they may continue to encourage all the things that they're concerned about, and people will just do a lower relative return because the cost of carry has moved up.

Now, we have the ability to look across the pretty broad spectrum of investments, and I have to say that the mortgage market, the agency, government agency mortgage market, is still the best risk reward profile and has the best liquidity, which I think will become paramount at some point.

Yes, no, when you sit here and you look at the relative attractiveness of mortgage assets on a relative basis to other yield products, there's no question that it's there. But it does seem like everyone's kind of waiting for this great unwind, and if it starts to happen, as you point out, the Fed can just in a day or literally hours change that dynamic by injecting more liquidity. There's nothing that says that they have to, they can't resume asset purchases.

That's true, but there can be a lot of pain in between all that.

Yes.

The key is making sure you can withstand that. I do think though that sitting on the forefront in the mortgage market and the direct impact that they have on that, we feel comfortable with our exposure there.

I wouldn't necessarily feel comfortable in, and as our commercial position has demonstrated, we don't necessarily feel comfortable in other parts of the risk spectrum. I like to remind people, we do take interest rate risks. That is the business we are in.

All right. Well, thanks for the comments, Wellington.

You're welcome

Mike Widner, KBW.

Hey, good morning, guys. I'm just going to follow up on a couple of the themes you just touched on.

First, just a broad big picture question. You said, if I heard you correctly, that you like the risk-adjusted returns on agencies. It's one of the best places to be right now. And I guess --

Yes.

-- putting that together with the commercial balances overall haven't really moved much in the past couple quarters. You're pretty close in add where you were.

I guess where I'm puzzled is if I look at overall ROE, just for a simple metric for the portfolio as a whole, you guys are sitting in the low mid-9% ROE. And on your commercial assets, you're in that same range unlevered. And it seems like there's a lot of interest rate risk out.

The table on page 17 shows the rate risk by your own true calculations. And so, I guess I'm just trying to reconcile those two points of view?

Yes. I would say the commercial yield that we have on our books right now are generated at a different time period.

Yes.

Once you, when you commit new capital, you're committing it at a different level, and so you may get less quality at a lower return in the current market. And be pushing on metrics that make you a little uncomfortable.

There's no question that low-yield subsidized price, and we've got them all over the place and that basis is permanent. It doesn't change with the market moving around, and the cash flows generated on that basis is also permanent on your balance sheet.

So given the profile of, we talk about new money yield in the agency market, and we're being conservative, you're looking at 10% to 13% relative to sub debt that, to get the kind of quality you want, you might be pushing 7%, 8%. And you're dealing with a market that I always struggle with listening to people tell me, well, there is not all this supply that there was the last time the commercial market had a problem.

Well, there seems to be a hell of a lot of cranes in the air all over the place, and when the supply comes on and how it starts to impact pricing remains to be seen. So given that profile, and considering the fact that we are on the front lines of their policy tool, they still do have the ability, unlike they don't have the ability to tell us anymore. If that comes into question in the future, they don't have that ability but they do have the ability to buy MBS.

Right. So that makes perfect sense, I appreciate that. Let me just follow up on one piece of that. You talked about incremental ROEs or incremental spreads and everything on agency investments today.

I guess what I'm struggling with a little bit is in your general commentary and your tone, it just seems like you're concerned about the unpredictability of rates and bond prices and so on as things move forward. The economy gets better and we can see the curve steepen a lot, or if the economy or the global situation stays crappy, we can see things stay where they are, maybe even move lower. But it's very hard to predict and there's a lot of uncertainty.

Sure.

At the same time, you talk about mid-teens ROEs on incremental investments. I mean, you have to take a lot of rate risk to get there. As I do the math on your portfolio, it looks like you've got a duration gap somewhere in the two-and-a-half year range.

The sensitivity table on page 17 points us at roughly the same thing. So I guess I'm just struggling a little bit with reconciling this to the cautious tone, but what appears to be embracing of a fair amount of rate risk in the portfolio?

I would say the rate risk in the portfolio is not unlike the rate risk in the portfolio that we've had for years. We, again, we are in the business of taking rate risk, and you have to weigh a lot of the uncertainty, we are always in a world of uncertainty, and I don't think we're unique in that.

But just looking at across the risk spectrum, that I feel that you are getting paid for the risks that you are taking in the agency arena, whereas if you look to some of the corporate high-grade debt and high yield, I don't know if you are getting compensated for the relative risk that you're taking. And you don't necessarily have the same liquidity profile, which I can't stress enough that it's a very valuable asset that is not necessarily quantifiable.

So we're always going to be dealing with periods of uncertainty and having to deliver what I call our product, which is our dividends. Which, as Kevin mentioned, represents the majority of the return that we have generated for investors over the years, and we can't lose sight of producing that product. But we do it and we have to look to do it in a way that we feel comfortable, given what the landscape looks like.

I'll have David just expound on the duration a little bit further and how we manage the change there.

Sure. Thank you, Wellington. With respect to the duration, our duration is actually lower than two-and-a-half years, it's actually below two years.

But that being said, you have to put in the context of our overall leverage. A duration gap on a 5.3 times levered portfolio is very different than a duration gap on a higher levered portfolio. So what we do is we look at the risks and returns that are available in the market and we try and select the best that has the longest, or the best long-term potential to provide return to the shareholder.

Over the near term, with respect to Fed policy, et cetera, there's a couple of points to note. Differentiating the near-term view from the longer term. The Fed has made every effort to convey to the market that they're going to take a very cautious and predictable approach to increasing interest rates, which has comforted market participants and kept rates low, not to mention other factors like global yields, high yield, et cetera, that have kept lower risk assets in demand given their relative value.

Another point to note is that the Fed has also, through their actions, in addition to just their language, has had a calming effect on markets. Number one, is through QE, they've obviously taken roughly a third of the agency MBS out of the market, which has reduced the negative convexity of the overall market. Much of the volatility we've seen in years past in fixed income markets has been attributable to mortgage negative convexity, and by removing that portion of negative convexity, that will lower volatility well beyond QE, which is also comforting to markets.

Secondarily, they've also, throughout the last quarter, conveyed that they're going to continue to reinvest the runoff from their agency MBS portfolio. So they're going to continue to provide support. And as they indicated in the last minutes' release, that will last likely through liftoff of Fed funds.

So over the near term, in terms of rate risk, there is certainly rate risk and we're always cautious, especially when you consider the technicals of the market. But there's been a lot of effort made on the part of policymakers to suggest a pretty smooth approach to normalization of rates.

Well thanks, I appreciate the very thorough answers. And I guess if I could just summarize maybe, tell me if I'm wrong in what I'm hearing here. But you know, Wellie, it sounds like you're saying what a lot of folks are saying, there's if you look out in bond land, there's really nothing that's cheap anymore, except maybe MREITs.

Yes.

To deliver your product, which is a dividend, you have to take risk somewhere. And out of all the risks out there, you're not saying there isn't any rate risk, but that's the one that you like better than really the other options?

Yes. Even given the fact that we fully expect short-term rates to move higher. It's still, from our perspective in the analysis that we do, it's still the better option.

And, Mike, I would just, it's Kevin, I would just summarize it I think you're balancing our portfolio in terms of interest rate and credit risk. I mean, at the end of the day, the commercial business, the longer term is how we looked at it. There's two things.

First, since we bought that business on balance sheet, the business has doubled, and it has added durable earnings to our dividend. And right now, we just don't see a lot of buy signals that are flashing out there. So the business has doubled, but the design of the strategies when we put that 25% of capital ratio out there, we didn't put a time horizon on it because we, as Bob said, we don't feel like we have to have a gun to our head.

So we recognize. It's flat, but longer term, it has doubled and we can choose to be more opportunistic when we think the value is there.

And then on the core portfolio, for better or for worse, it's kind of ironic that our $0.30 core of this quarter matches the $0.30 core that we had in the third quarter of 2012, which was the onset of QE3. So from two years ago, eight quarters 'til now, we've been roughly be between $0.28, $0.35, and we think that that's been a pretty stable return in the marketplace that financial repression is evident in a lot of other asset classes.

Yes. Well, certainly agree with that, and definitely like the book value gain this quarter. Hope you guys can do some more of that.

Thank you.

Arren Cyganovich, Evercore.

Thanks. Hello. I just wanted to talk a little bit more about the swap reduction. Clearly make sense for me from a longer duration standpoint on that you're not really impacting your book value protection that much.

But on the short end, just really basic thoughts of having $70 billion of repo and $31 billion of swaps, you're leaving yourself open on $39 billion. So I just it seems like the short rate risk is up pretty substantially, and how to you combat that if, for whatever reason, short rates rise faster than your anticipate?

Yes, one thing I would say, we have about $23 billion an our repo bucket that's greater than 120 days. And in the swap position, you would have needed fairly sizable move out of the Fed to justify or to have those really kick in as near-term protection.

And so, we deem them not as helpful to the overall portfolio as otherwise would have been had they been put on brand new. A lot of those are legacy positions, obviously, that have rolled down the curve. I'll let David talk a little bit more about it.

Yes, Arren, I would just say with respect to the swap unwind, when we did that, there was a pretty significant increase in short rates that were priced into those swaps. So from a relative value standpoint, we felt that taking them off at a higher forward rates was advantageous.

And the way that works is if short rates are below the forward rates, which were about 80 basis points higher on the two-year note, than we would have been better off. And that's appears to be working out for us.

In terms of the overall portfolio repo versus our swap position, there are other pockets of the portfolio that we do believe provide protection for increases in short rates. And it's also important to note that higher short rates are well priced into MBS spreads and yields, but as Wellington mentioned, our term repo, $23 billion over 120 days, of that, $9 billion is actually longer than one year, it's fixed rate. So that effectively provides protection a little further out the curve with respect to higher short-term rates.

And on the asset side, as short rates do ultimately increase, amortization expense should go down because prepayments will likely be modestly lower. So lower in amortization expense should help defray some of the cost associated with higher short rates.

Also on the asset side, we do have a fair amount of both arms, which will adjust higher with short rates increasing. And commercial and middle market also has a fair amount of their portfolio that is flowing rate.

And then, lastly, our leverage plays into that quite a bit, too. I mean, we're obviously at the low end of our leverage and at the low end of leverage with respect to the sector. So that just implies that will be less reliant on repo expenses in the future with the lower leverage.

And to the extent, again, with respect to opportunities, to the extent opportunities materialize, we will increase leverage. And at that point, higher short rates will be priced into the assets we buy.

Thanks, that's really helpful. The one comment that I guess you made when you talk about the tax treatment of unwinding the hedges being more on an amortized basis, is that going to essentially help keep the core type of EPS pretty close to what you would expect tax basis to be, just in terms of treatment of taxable income for the dividend?

No, that's where you will have a bit of disconnect in that the expense related to the swap unwinds was recognized immediately. Whereas, from a tax standpoint, it will continue to be amortized over the original term of the swap. So there will be a bit of a disconnect as a result of that between GAAP and tax.

Yes. I caught the GAAP disconnect, but I guess we back that stuff out for core anyways, so it seems to be pretty close to what the core would be?

Well, we're still going to have expense going through from a tax standpoint each quarter that would not be going through core.

Okay, got you. And then just lastly on prepayment expectations, everything seems to be pretty benign there. Any expectations for increases ahead?

Specifically, with respect to prepayment. Summer, obviously, you get a lot of -- a fair amount more housing turnover, so prepayments are slightly higher this summer, although I think given housing markets lost a little bit of its footing, they're lower than what we would have expected at the beginning of the year.

Going forward, if you do believe the forward rates, then rates should be a touch higher and prepayments will be lower. But along those lines, specifically with respect to our portfolio, we're virtually a 100% of our agency MBS portfolio is in actual physical securities and pools.

And of those, we do invest in high-quality specified pools, which do have better prepayment characteristics. That's been a conscious decision of ours for a very long time.

As Wellington said early on in the call, or actually I'm sorry, as Kevin mentioned, we're about long-term investing. So when we look at assets and we differentiate between the TBA market and the specified pool market, we look at valuations, we look at the technicals of the market and specialness in the TBA market. And we have to determine where the better risk return trade off lies.

In the TBA market, obviously, for much of the year, it has traded quite special in terms of the ability to finance them through the dollar roll market. But that being said, when we started our increasing our portfolio, we had to make the determination as to what we thought the better value was. Was it the TBA market where there's more specialness, or by, what we like to call, or what we think of as high-quality specified pools, which are going to have better prepayment characteristics.

And given the Fed's ultimate departure from QE, we felt that these technicals, which were well priced into the TBA market, were not going to persist for the length of time that the valuations in TBAs suggested. So we went the route of buying high-quality, better convexity, lower prepayment specified pools, and we think over the long term, that's going to benefit us.

Great, thanks a lot.

Steve DeLaney, JMP Securities.

Thanks. And good morning, everyone, and let me add my congratulations on a very nice quarter.

Thanks, Steve.

Thanks. In your first quarter, your March 10-Q, you guys disclosed that you had gained membership into the Federal Home Loan Bank of Des Moines.

That's correct.

I'm just looking at the 6/30 balance sheet, there didn't appear to be any balances, unless they were somehow just included with repo, which I wouldn't expect. Just curious if the fact that were not seeing any advances on the books, if this is a voluntary decision on your guys' part? Or did, by any chance, you get caught up with this FHFA moratorium that was taking place -- ?

No. Thanks for the question, Steve. Actually, we have about $5 million, I think, in balances. It really comes down to competitive pricing.

Where we would place some of our liabilities and we actually have a fairly sizable line with the FHLB of Des Moines. We just have chosen not to fill it.

Okay. And did you say $5 billion or $5 million

$5 million, actually. Just $5 million, yes.

$5 million, okay. Yes, I was going to say, billion would catch would stand out.

Yes. No, it's $5 million. And we would most likely use it, it's just that's most competitive in the commercial arena.

Yes. No question, with the whole loans, yes.

Hey, Steve, I would also add that --

Hello, Bob.

-- it's a new arrangement that we have, it's a new relationship. So we're still working through how that relationship will manifest over time. So to Wellington's point, the $5 million was really just a first step to begin testing the funding, how the mechanical operation of that will work, et cetera.

Great, okay. And Wellington, related to that, if you'll just allow me one big picture question?

Sure.

The FHFA moratorium references lack of regulation. We've heard the FSOC and other folks in Washington, around the world just also site this lack of regulation of mortgage REITs.

And I just wonder big picture, long term whether [sunareit] or anything, is there some concept of form or regulation, in quotes, such as an SRO, or maybe through an arm of the FHFA, that over the long term might actually benefit the mortgage REIT industry in terms of its view and is positioned in the marketplace and its acceptance into situations like broader acceptance into the FHRB system?

Well, I would first off say that I think the FHLB system probably needs the mortgage REITs more than the mortgage REITs need them.

Would agree.

The mortgage REITs are a part of the mortgage finance spectrum. And I think all of us are plugged into highly regulated entities. We do a tremendous amount of public disclosure, public reporting. We do have a number of tests that continue to qualify us as REITs, so I wouldn't say that the information is difficult to find or aggregate.

Now, we and others via NAREIT and other areas have tried to elevate the dialogue and help in the understanding of our participation in the mortgage market and housing finance market. And that's an ongoing effort.

So anything, as you know, all of us have increased our disclosure, our reporting, to try and help facilitate a better understanding out of the regulators on how we participate in various markets. And that will be an ongoing effort.

As far as coming under certain bank regulators or whatever way they want to do it, via someone like F Stock can regulate certain activities. And again, getting away from SIFE designation and just saying we are going to regulate repo activity or short-term funding activity. And if you're a participant there, these are the kinds of reporting requirements to help us.

And I can see that kind of evolution happening on a number of fronts. And we welcome it. It's not like I think that any of it is going to be more onerous than our own self-enclosed discipline. So I wouldn't look at it as a bad thing for the market or the industry.

That's helpful, and I agree. I don't know what any regulator might ask of the industry in the way of disclosure transparency that's already provided in the improved disclosure that we've seen over the last one to two years.

Right.

And I guess the last just thought, I think part of this is the opaqueness of gaining membership through a captive insurance. Frankly, I don't know what the legal process is, but it seems like, to me, if the government wants -- if government policy is to attract private capital into the mortgage industry over the long term, why not just allow mortgage REITs de facto right to membership --

Sure

-- rather than the captive, which I think it looks like smoke and mirrors and maybe that's what got Mel Watt's attention in the first place?

Yes. I agree.

Thanks.

I think of the opaqueness of Warren Buffett being able pay 17% tax. (laughter)

Let's just put it all up front and call it was it is.

If the rules are up there, people will use them.

There you go. Thanks for the comments, Wellington

Thanks, Steve

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

Again, I just want to thank everybody for joining us on the call today. I know it's early August and most of you would rather be at the beach. But we are excited about the prospects of returning to a more normalized rate market and welcome the opportunities that it will provide, and we will speak to you on the third quarter. Take care.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.