Annaly Capital Management Inc (NLY) 2014 Q3 法說會逐字稿

Good morning and welcome to the Annaly Capital Management, Incorporated third quarter 2014 earnings call. All participants will be in a listen only mode. (Operator Instructions). Please note this is event is being recorded. I would now like to turn the call over to Willa Sheridan.

Good morning, and welcome to the third quarter 2014 earnings call for Annaly Capital Management. Any forward-looking statements made during today's call are subject to risk 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. I encourage you to read the forward-looking statements 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 the date of the earnings call. We do not undertake, and specifically disclaim, any obligations to update or revise this information. Participants on this morning's call including Wellington Denahan, Chairman and Chief Executive Officer, Kevin Keyes, President, Glen Votek, Chief Financial Officer, David Finkelstein, Head of Agency Trading, and Bob Restrick, Head of Commercial Investments. I will now turn the conference over to Wellington Denahan.

Thank you, Willa. We have a few perhaps remarks, and then we'll open the call for questions. As I have said many times, we would welcome the day that market participants collectively determine the pricing of risk assets instead of the (inaudible) bankers. Based on the latest moves out of the bank of Japan, we may be waiting a bit longer. However, we're encouraged by our own central banks more balanced guidance with respect to inflation, the economy, and the end of QE3. Although it's important to note that as US monetary policy makers reduce their market presence, regulatory reforms will start to exert greater influence on market functioning going forward.

In order to put these expected influences in prospective, it's worth recapping some of the more notable impacts on markets and behaviors from past efforts to improve the regulatory framework and oversight. Thirteen years ago, the SEC ushered in the era of decimalization of prices in stock markets. Their admirable objective was two fold; reduce transaction costs, and better liquidity for the small investor. Michael Lewis, the famous story teller, can thank this subtle change for the success of his latest book, flash boys, which sensationalize the much maligned business of high frequency training that owes part of its success to decimalization of prices and still may be the only valid explanation for the 2010 flash crash in equity markets.

It is a fact generally acknowledged that well meaning post crisis regulation does little to prevent the next crisis. In the aftermath of the DOT com boom, which was partially fueled by the over exuberant analyst reports and commentary from the likes of Henry Blodget and Jack Rugman. Revised regulation of cell side analysts and investment banks resulted in new and various forms of Chinese walls, coupled with required pages of disclosures and disclaimers within each report that are often longer than the actual reports themselves. Moreover, with the comfort of new regulation in place, we quickly moved on to the next crisis.

We can thank the accounting scandals of both Enron and World Com in the early 2000s, for the Starbucks Act, an avalanche of audit and control assessments designed to hold top management and boards to an attestation that they know which activities they are involved in, but did nothing to ensure they understood those activities. Even with the rigors of Starbucks in place, Fanny and Freddie still manage to grab headlines with their own accounting missteps several years later. Again, these regulatory safeguards did little to alert investors, regulators, or even the very corporate management adhering to Starbucks to the dangers of the impending financial crisis.

We now have the behemoth Daud Frank legislation and the Basil committee engaged in a tremendous effort to reform the financial system. All this well meaning regulation is a natural out crop of crisis, but can actually have a hand in creating the next unintended market event. New regulations that target bank and broker/dealer liquidity, as well as new disclosure requirements are predictably drying up liquidity in favor of the noble pursuit of reducing system wide leverage. I fear that this lower leverage could be a mirage. A few weeks ago, we got a glimpse of the impacts on the changing liquidity landscape, when an on a seemingly uneventful day-to-day we experienced exaggerated rated moves in both equities and fixed incomes.

Could it be that regulatory reforms have addressed the sources of the last crisis only to give rise to new issues? As the fed moves away from the fixed income markets and regulatory reforms change the incentives for the remaining participants, we feel it warrants a healthy dose of concern. There is no question that the volumes of regulation and reform will slow the pace of economic growth and often times give rise to unintended and unwanted outcomes. Since 1997, we have operated through many challenging off-market environments and are respectful of the lessons learned and the opportunities they have presented. We have paid out $12 billion in cash dividends since then, delivering a total return to investors three times that of the S&P 500 during the same period. We continue to position the Company to be responsive to the unforeseen, while taking advantage of our liquidity and flexibility to capitalize on any market volatility going forward. We remain hopeful that the cumulative effects of all of this change will ultimately lead to a sounder financial system and marketplace, but we are paid to carry a healthy position in scepticism. I will now turn the call over to Kevin Keyes to discuss the economy.

Good morning. Before we address the positioning of the portfolio and our quarterly performance, I thought I'd take a few minutes and expand upon Wellington's theme of increased regulation and, specifically, its impact on economic growth by framing some of our own broader, macro economic views now that QE3 has ended. Ironically, after all of the money printing in recent years, QE ends with the market now focusing on the prospect of deflation, rather than inflation, and slowing growth versus a global economic expansion.

Although the tone of the committee statements sounded a bit hawkish, the language was simply met to substantiate the end of QE3. Having said that, following three purchase programs that have brought the feds balance sheet to $4.5 trillion, there's numerous red lights flashing in the global markets, including the 10-year US treasury that are flat to four years ago, European yields at the lowest they've been in hundreds of years. Oil prices at a 3-year low, Chinese GDP growth at a 5-year low, and the latest year quarterly GDP number, which on the face exceeded expectations, can easily be dissected as evidence of an under performing business sector.

Taking a closer look at last week's GDP number, even though the initial print showed growth at a three and a half percentage rate, compared to an expected 3%, the source of increase was primarily the net result of two temporary growth drivers that tend to stick out in challenging times. Net exports and government spending, combined to add two-thirds of the total growth in GDP. Obviously, an increase in exports is not expected to continue giving the strength of the US dollar, and the relatively weak global economies. In fact, this week's trade deficit number just released scaled back exports dramatically and as a result, GDP growth is reduced to no more than 3%. And likewise, the government's share of GDP was way above normal with defense spending at a level not seen since the second quarter of 2009, the teeth of the last recession. The three other main components of GDP when you break it apart, business investment, residential investment, and consumption, all performed well below historical averages and slowed considerably from the second quarter.

When you compare the relative growth quarter over quarter, all three categories declined by an average of 30% to 80% with residential investment performing the worst. So, our view continues to be that global growth will be slow at best, rates will be lower for longer, and fed policy measured over time. Continuing to look beyond the headlines of the latest economic data as the market transitions from the unprecedented error of QE, we've seen numerous structural challenges to sustain growth and indicators for little or no inflation. Increased debt levels reduce corporate and residential investments, demographic realities weighing on the housing sector, and the broad effects of increased regulation that Wellington mentioned, all contribute to a market backdrop which is favorable for our type of investment strategies. Our yield generating profile in a yield starve world, combined with our portfolio of dollar denominated liquid assets, typically out perform during times of muted economic growth and heightened market risk and volatility. Now, I'll turn it over to David who will summarize our agency portfolio performance.

Thank you, Kevin, and good morning. Regarding agency MBS specifically, while we had an active third quarter we were not inclined to add to our agency portfolio. We felt that MBS faced some headwinds following the strong performance in Q2, in addition, the technical landscaped looked less favorable with the continued wind down of QE3, as well as an increase of MBS supply over the summer. As the quarter unfolded, MBS did in fact underperform has we saw some normalization of spreads and supply and demand imbalances that characterized the first half of the year, moderated somewhat as well. In terms of specific trading activity in the quarter, we purchased $7.5 billion in securities and sold $4.2 billion with the difference primarily reflecting reinvestment of portfolio run off.

While the subject of today's call is on the third quarter, more recent concerns over the global economic climate and other factors that have led to a meaningful increase in volatility since the end off third quarter certainly merits discussion today as well. As interest rates rallied substantially in early October, fixed income volatility measures spiked and nominal MBS spreads widened. While the market did retrace some of the rate rally and spread widening, investors were certainly left with a sense that MBS may be some what vulnerable in a lower rate environment. Directionality of rates aside, this higher volatility environment translates to less predictability of MBS cash flows as negative convexity has crept in the mortgage market. One point to note regarding recent agency MBS performance is that higher quality specified pools have exhibited very strong, relative performance as investors have priced in a renewed demand for pre-payment protection and cash flow stability in the event that recent volatility proves persistent.

While call protective pool pay-ups have appreciated all year, given the trend down in rates and given the fact they started 2014 at very depressed levels, the specified sector still looks quite fair, particularly when you consider the possibility that lower rates may persist for some time as Kevin alluded to. Nonetheless, careful security selection is increasingly important at these valuations. With respect to our outlook on the agency MBS sector going forward in spite of recent market turbulence, valuations still look reasonable. We do think that volatility will remain elevated over the near term as the market continues to deliberate over cyclical recovery in the US will be derailed by global economic weakness, but our view is that MBS spreads provide sufficient compensation in this environment.

With respect to prepayments. With rates at current levels, we anticipate a modest pickup in prepayment speeds but a meaningful further rally would be required to experience prepays consistent with that what we saw in 2012 and early 2013. Regarding our portfolio, we have taken a conservative but opportunistic approach to both leverage and asset selection in 2014 and this has served us well and puts us in a good position going forward. Again, spreads currently look fair, but if they do widen in a fashion that we do not feel is justified by the fundamentals, we will look to add to our holdings. With that said, I'll now hand it over to Glen Votek to discuss the financials.

Thanks, David, and good morning everyone. I'll provide a very brief overview of the key financial highlights of the quarter before we open the call up for questions. To begin, our core earnings, excluding realized gains and losses on derivatives, asset sales and other non-recurring items was up about 3% sequentially to approximately $309 million. Core earnings per share was $0.31 which compares to $0.30 in the prior quarter and our an annualized core ROE was 9.3%, up versus 9.2% for the prior quarter.

From a GAAP standpoint, we reported earnings of $355 million, versus a loss in the prior quarter of $336 million. The prior quarter loss being driven by the terminations of certain interest rate swaps that we had previously discussed with you on last quarters call. We generally had two offsetting factors that contributed to the current quarter results. To begin, our interest income declined due to a $48 million increase in premium amortization, as CPRs increased. This resulted in our asset yields declining to just under 3%, and conversely we experienced about a 15% reduction in economic interest expense.

The interest expense benefit being driven by about $52 million decline in swaps expense, following the prior quarter's unwinds that I just alluded to. Our net interest margin, which represents the economic net interest income earned relative to our interest earning assets, and I believe to be a more meaningful performance measure relative to net spread, was 161 basis points, which was up from 157 basis points the prior quarter. Net interest spread was also up for the quarter. And turning to our balance sheet, our asset portfolio was relatively flat as David alluded to a moment ago.

Likewise, our repo balances were also relatively flat. Our book value declined in the quarter to 12.87 per share which compares against 13.23 in the prior quarter, largely driven by unrealized losses on agency securities. Finally, our capital position remains sold with leverage at 5.4 times, relatively flat from the prior quarter, and our capital ratio at 15%. With that, Operator, we're ready to open it up for questions.

(Operator Instructions). We have a question from Jason Weaver from Sterne, Agee. Please go ahead.

Good morning, thanks for taking my call.

Good morning, Jason.

I wonder if you could briefly discuss the FHFA proposal for (inaudible) for the (inaudible) warranty release efforts and what affects that may have on both terms of available supply and pre-payment activity within your current portfolio.

Jason, this is David. I have to tell you it's a little bit early to really understand what the impact will be in terms of the actual supply available in the market. Our hope, however, is that we do get a meaningful increase in net supply so we do have more product, particularly in an environment where the fed does own a third of the securities, so we're not concerned about an abundance of supply in the market, and we anticipate initiatives like this on the part of FHFA to support housing to continue and this is one example of that.

Would you characterize the change as more of a marginal impact?

Marginal, is correct.

Okay. Good to clear that up. Second, last quarter you reduced the size of the hedge portfolio quite substantially, as you mentioned. What are your thoughts today about hedging and the amount of curve and duration risk you're comfortable with?

That's a good question, Jason. In terms of hedging, we take a view that we have two broad types of risks. One is obviously mortgage basis risk, as well as interest rate risk. When it comes to the tradeoff between the two, we look at the relative value between them. In terms of hedging, we're not concerned about the move-in rates necessarily today. It's relative to what's priced into the forwards. When we think that the rate move that's priced into the forward market is too aggressive, we'll hedge less, and when we think it's not pricing at enough of a rate move, we'll hedge more and that tends to factor into our discussion.

In the current environment, obviously, we've rallied quite a bit this year and we rallied pretty substantially in early October and after retracing a lot of that move. We're comfortable with the current level of rates. We do think there are a lot of concerns with respect to the global economy, which we are going to impact the US economy, and when we think about the longer term headwinds that Kevin spoke about with respect to our own economy, we think that longer term rates are not not likely to increase very dramatically, so we're relatively comfortable with the rate environment. Although, we expect the fed to increase rates like the rest of the market in the latter part of next year.

Fair enough. Thank you for answering that. I'll say congratulations on the quarter and wait to hear more.

Thank you, Jason.

Our next question is from Brock Vanderlick from Nomura. Please go ahead.

Hey, thanks for taking my question. Just to follow-up on Jason's question regarding the swaps position and how you're thinking about the world. So the major recarving you did was obviously last quarter in the 0-3 year category or bucket. I see you added back some of those positions. You're pretty calm about the rate outlook in terms of the probability of actual rate moves. If that outlook changed, I'm assuming you would bulk up in that area again or no?

That's absolutely correct, but just to go over the swaps from Q3. What you saw in terms of those front buckets changing was actually roll down from longer dated swaps as they simply rolled down the curve. We didn't add to the shorter duration swaps bucket, we did add a small amount of swaps out to curve. To your question, for the extent our view changes, we will absolutely reflect that in our hedge portfolio.

Got it, okay. And a question for Wellington, I guess. You spoke about regulation. It would seem like, you look at the mortgage market now versus pre-crisis, the government is stepping back, the mortgage REITs as an industry are one of the few buyers that are poised to potentially grow even further. It would seem like it would be a ripe environment for a collective knock on the door of the industry by regulators. Do you sense any shifts in the wind there of any kind?

No. You know, I think a lot of the dialogue with respect to concern over the industry as a whole really took place when they saw an incredible amount of equity growth and asset growth along with it. I think regulators were keen to keep an eye on how the industry performed in the 2013 period where you had a fairly substantial sell-off in the market. I think the industry as a whole has done a good job of maintaining a constructive dialogue with regulators and policy makers to help them better understand the risks that we all take and I don't get a sense that there's any impending increase in regulation above and beyond what has happened in the counter parties that we're all plugged into. So by default, we're also, where that regulation reaches beyond those balance sheets and financials into people like us that are dependent on them for our business operations. We do have that knock on effect and I think it's pretty well understood by the regulatory community.

Brock, it's Kevin. I would just add we spend a lot of time in D.C. and I think at the end of the day, the last couple of years, the educational curve and appreciation for our sector has appreciated and the need for private capital, to your question, there's a definite realization that our sector cannot only participate, but be a big component of the redistribution of ownership. I think we feel, you see the latest risk sharing deals that are getting done or starting to get done, we just think that's going to grow and our ability to participate in that I think there's a big opportunity for that, for us in our industry.

Got it. Thanks for taking my question.

Thanks, Brock.

Our next question is from Joel Hawk from Wells Fargo. Please, go ahead.

My question has to do with mid-October. Massive rallying of rates in mid October, spike in valve, fairly short-lived. Maybe talk about what in terms of portfolio management without giving away the secret sauce, what exactly does a large firm like Annaly do in that type of environment? Are you shorting duration? What are you doing with hedges? Give us some sense of how you're both protecting value and how you're taking advantage of an outsized move in rates?

Certainly in light of where we are in the policy cycle, my first reactions obviously and I kid with the desk, is sell everything at 187, but that's not always the right response given the bigger, broader picture, but I'll let David expand on how you react to situations like that.

Sure. Thanks, Wellington. Hello, Joel.

Hey, David.

Talking about that example specifically in the beginning of October. As you might have heard over the recent past, MBS have exhibited very directional performance. As the market sells off, there's yield buyers that come in, they tend to out-perform very well, and pre-payment risk reduces. As the market rallies, there's not a lot of demand, pre-payments are expected to increase, and mortgages underperform. So, when you have a move like we saw in early October with that level of volatility, MBS obviously suffered quite a bit in that rally. We do have a positive duration gap and a lot of the reason why we carry a positive duration gap is because of this performance profile in this current environment.

For a rate rally, you actually do have to have positive duration to be able to keep up with the market effectively, and then you have some protection, although you're in the market as a sell off given the fact that mortgages tend to out-perform in that environment. So, with respect to specifically what we did, as Wellington pointed out, we would have loved to have sold the entire portfolio at 187, but that's not possible. We don't chase the market. We didn't delve to hedge, as our duration gap did shorten, we certainly weren't buying the market. In fact, we took advantage of the higher dollar prices to actually sell assets, but certainly not in the magnitude that you would like after the fact, but nonetheless, we do take those opportunities to reduce exposure, and then with the anticipation of adding it back in more favorable local rate environments. Does that answer your question?

Yes. Maybe, David, if you could comment on what, if anything, you're doing on the hedge side?

We actually did a couple of things and these are all local trades. We did one trade where we sold a fair amount of pools in lower coupon MBS which had been the best performers as higher coupons were a little bit stuck. But that being said, in higher coupons, we actually bought higher coupons given how cheap the basis did get and used futures contracts to actually hedge those. We do a lot of things when markets become dislocated, but in terms of the overall hedge, I would say we reduced assets as opposed to added hedges.

Okay, great, thank you very much.

Our next question is from Steve DeLaney from JMP Securities. Please go ahead.

Thanks, good morning, everyone.

Good morning, Steve.

I noticed in the third quarter that there was minimal activity in the CRE portfolio and certainly understanding the sort of the macro position you're taking as far as waiting to see how markets evolve, I understand that totally with respect to agency, and maybe naively on my part, but a little surprised that you're not being more proactive in the CRE area. I'm wondering, does this also reflect a macro view and a concern that credit spreads may blow out in some sort of a market disruption, or more closer to the actual loan and equity products that you would be investing in?

Are you seeing sloppy underwriting or irrational pricing if you could comment on where you are.

Before Bob answers your question with more detail, one thing I want to emphasize is the commercial team here has a tremendous amount of flexibility in that they do not have a gun to their head that they just have to be in the business constantly, irrespective of the fundamentals or the pricing, so these guys have a tremendous amount of opportunity with the kind of portfolio, the kind of balance sheet they are a part of, but I will let Bob really expand on the change in the composition of the portfolio an the size of the portfolio from quarter-to-quarter.

Thanks, Wellington.

Hi, Steve, it's Bob Restrick.

Good morning, Bob.

How are you?

Good.

I think it's important to put into prospective and as Wellington said, if you look at our change quarter-over-quarter, it's relatively flat, but hides the fact that since the beginning of the year, we've had $240 million in deals paid off and 13 transactions, in the mean time we've put out $295 million against that. There's activity going on constantly. It just doesn't show up necessarily, so we've maintained sort of the level of the portfolio. And then, also I'd say, third quarter historically is always kind of the lightest and the fourth quarter is generally the highest and we're seeing that, too, in our forward pipeline. To the bigger picture about the comments about why aren't we increasing at a faster pace, I do think valuations across the board are at or above peak levels and on top of that you have more investors in every component of the commercial real estate spec whether it's a first mortgage or whether it's equity, than I've ever seen before. You need to pick your spots and we have that flexibility, and so we've been just much more selective.

Got, it that's helpful. The 11% equity allocation currently, I think I've heard you all say in the past that could go as high as 15%. Am I correct there?

Sure, absolutely. Technically it could go as high as 25%.

Okay.

As per our perspectives, obviously, could go a lot more, but we've committed to keep it relative to our equity base of about 25%.

Right.

We're in a fantastic position to start to have the market experience a world without such direct impact from policy, and I don't think there's any rush to get involved when the fed has only just begun stopping to add the amount of liquidity that it was. I think there will be periods where you get a change in the composition of the risk profile of the market and the demands and influences that will be on pricing and spreads and things like that, I think there will be opportunities.

Totally understand, and I do appreciate your comment that with this team and this portfolio embedded in the larger Annaly complex, there's less quarter-to-quarter pressure to put capital to work, so thank you for the comments.

Thanks, Steve.

Thanks.

Our next question is from Aaron Cyganovich from Evercore. Please go ahead.

Thanks. Getting your crystal ball out, do you think there will be any GSE reform into the next Congress and what do you think the odds are of that happening?

If they want to do something, you know, housing is probably something that they can get done, there will be compromises now that the republicans control both the house and the Senate. I think a big wild card out there is whether either of the agencies would require some kind of capital injection that would force the issue much further. Right now, I don't think there's an incredible amount of urgency to it and I think there's a lot that the FHFA itself is doing to set up for the ultimate resolution of the GSE. I don't put it at a high priority, but if they have something that they have can point to that they've gotten done, I think there's a possibility, but there would be compromises that need to take place from the bridges between path act and Johnson (inaudible).

It's a decent size bridges, I think.

Yes.

On the other side of that, have you looked much at the credit risk sharing deals that the GSEs have been doing? I think they're looking to increase those fairly substantially and what are your thoughts about participating in some of those transactions?

Historically, those assets we have not considered them good REIT assets because the cash flow is not derived from the real estate asset. That being said, a very recent initiative to make this program REIT eligible, effectively, has been undertaken and in fact, last week, the first of such deals was done, so now it's on the radar. We certainly would view it as something that could be attractive. It offers diversification benefit away from the core agency strategy, or it does require a different look at the securities. We'd evaluate it in context of credit across the credit spectrum, but also in terms of liquidity. Agency liquidity is obviously very good. The generic credit risk structures, the liquidity has improved somewhat, but these unique one off structures created for REITs, we will have to see how that liquidity develops. It's certainly something we would consider as that market develops.

One thing I will say is it was nice to see that all of the dialogue, that not only ourselves but others in the space have been having with the GSEs about making these assets more REIT friendly, is starting to take hold.

Makes sense. Thanks, appreciate it.

Thanks, Aaron.

And ladies and gentlemen, this will conclude our question and answer session. I would like to turn the conference back over to management for any closing remarks.

I just want to thank everybody for participate in our call today. I want to thank my management team for doing a tremendous job navigating through these markets and we look forward to speaking to you for the fourth quarter call.

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