Annaly Capital Management Inc (NLY) 2015 Q2 法說會逐字稿

Good morning and welcome to the second quarter 2015 earnings call for Annaly Capital Management, Inc. All participates will be in a listen-only mode. (Operator Instructions). After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. Any forward-looking statements made during today's call are subject to risk and uncertainties which are outlined in the risk factor 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 statements 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 the 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, Chief Executive Officer and Incoming Executive Chairman, Kevin Keyes, President and Incoming Chief Executive Officer, Glenn Votek, Chief Financial Officer, David Finkelstein, Head of Agency Portfolio and Michael Quinn and Jeffery Thompson, co-heads of Annaly Commercial Real Estate Group. I will now turn the conference or to Wellington Denahan. Ms. Denahan, please go ahead.

Good morning and thank you, Anita. Welcome to the second quarter Annaly earnings call. Before I hand the call over to our Incoming CEO Kevin Keyes and other senior members of the team I would like to make a few brief remarks regarding the business and investment landscape, the Chimera management internalization and our buy back program. We remain optimistic that the long overdue change in the monetary policy landscape is in the offing.

We are encouraged by the strength in the labor market, recent stability and inflation indicators and the generally strong economic growth that in our opinion solidly support an adjustment off the zero bound by the Federal Reserve later in year. Our conservative leverage stance will allow us to better navigate the potential impacts of increased market volatility, the effects of reduced liquidity and the untested market functioning in a less accommodative monetary policy environment.

Our increased capital allocation options along with our lower leverage will allow us to remain a nimble and opportunistic player. We will continue to be an active voice in the dialogue on housing finance reform and are encouraged that the process of reform and redistribution of assets from government hands will provide investment opportunities for years to come. We will continue to engage with lawmakers to help ensure that the [Emery] sector remains a prominent private capital participant.

With a strong and liquid balance sheet, we are excited about our position in the capital markets. This quarter's results are a strong reminder that the higher market rates can and did have positive impacts on our earnings. I am incredibly proud of our management team and excited about the challenges and opportunities ahead. With respect to the Chimera announcement, it's important to note that when we're much smaller company, it was sufficient for us to gain our exposure to investment opportunities in mortgage and commercial credit through our stock holding in the public companies that we managed.

However, with the growth of our capital base over the years and the changing market landscape, it makes more sense for us to have the ability to more directly participate in the non-government agency mortgage markets on our own balance sheet. We will continue to invest in the agency sector as the core of our business and remain focused on producing strong risk adjusted returns for our shareholders. With respect to share buy-backs, I'll first start by saying that it's always important for a company's leadership to be willing to change their mind.

Our buy-back program will serve as another capital allocation option among the many we have. I think it's important for us to have all the tools we can to provide long-term durable value to our shareholders. Lastly, I like to say that I'm very proud to have been in a position to serve our Board of Directors and our many shareholders over the past 18 years. I have enjoyed navigating the endless challenges and opportunities that these markets always present. I look forward to working with Kevin and his team who are eager to capitalize on the market volatility while guiding the Company through the challenges it will undoubtedly face in the decades ahead.

I will now hand the call over to our Incoming CEO, Kevin Keyes.

Thanks, Wellington. Before I begin with my prepared quarterly comments I want to congratulate Wellington on her new positions as Executive Chairman and thank her for all that she's done for this Company, its employees, and most importantly, for our shareholders. Not enough can be said on this call or in a press release about how Wellington and Mike Farrell had the vision and leadership to create this phenomenal Company. I was lucky enough to advise and then work closely with each of them and have admired Wellington's resolve during the challenging and rewarding times over the past few years.

I'm especially grateful that in her roles as Executive Chairman, Wellington will continue to both create and challenge ideas as she has done so well for this Company. I also want to thank the Board of Directors and all the employees here at Annaly for all the support and confidence they've given me in my new role. I know the opportunities that lie ahead for us are enormous and I'm honored and energized to lead along with Wellington going forward.

As we mentioned on our earnings calls over time and as exemplified in our most recent strategic decisions we've been preparing for lift-off even well before the onset of QE3. While we've been in capital protection mode during this abnormal market cycle, we've been investing aggressively in all of our investment teams and corporate infrastructure and broaden our expertise across the entire Company all in anticipation of what is hopefully a return to normalcy in our market.

This has been done methodically over the past few years and yet executed with urgency every day to make sure we're ready to capitalize on all of our opportunities. Our Company has never been stronger and is prepared, as we are today, to remain a leader in our markets and continue to grow the yield generating machine that Annaly represents.

To further expand on Wellington's comments the most recent strategic announcement regarding the internalization of Chimera's management is further evidence of our preparation and expanded opportunity. Now that we have developed and acquired the expertise investing independently in the non-agency sector offers us the ability to more efficiently broaden our residential portfolio into assets that have complimentary risk and return characteristics to our core agency strategy.

Combined with our commercial credit businesses, this residential credit platform simply makes us better positioned to not only navigate various interest rate cycles but, as importantly, various market scenarios and events which will be the product of the growing uncertainty and complexity of regional, national and global economies. It shouldn't be a surprise to those in the marketplace or in Washington, D.C. that Annaly is prepared to be a significant part of the permanent capital solution for the redistribution of residential assets, both resulting from the Fed exit and from any type of GSE reform.

Assuming the Feds reinvestment program ends in the second half of 2016, we estimate supply from this fed run-off to be over $500 billion over the following few years. In addition, when factoring in the GSE mandates, transfer capital to the private sector, sales of agency, non-agency NBS and loans will total approximately $80 billion to $100 billion annually until 2018. David will describe our residential credit strategy in more detail but suffice it to say that we believe our size, structure, liquidity and expertise provides us with a significant advantages in capitalizing on the obvious future growth of the industry.

As I mentioned on our earnings call in February, amidst one of the most volatile quarters in the history of the fixed income markets, volatility equals opportunity for Annaly and the timing of the Feds lift-off really doesn't preoccupy us. Our belief is that with the normalization of monetary policy, which will likely be slow and pulsing no matter when it is initiated, normalization of asset pricing will result as well. But given that, we also need to remain prepared for periods of increased volatility as we hopefully move closer to shifting back to conventional monetary policy.

So at this point, the authorization of a share repurchase program is quite simply another capital allocation option, as Wellington mentioned, we've chosen to exercise. That allows us greater flexibility to manage the windows of uncertainty prevalent in this market. We don't view repurchasing shares as a one-time accretion of that. We simply do it in the context of the potential returns and risks of our other investment strategies over the longer term. Just as our agency interest rate strategies compliment our residential and commercial credit strategies, the buy-back program, when seen through this longer-term prism, can be a valuable capital markets insurance policy over time, especially as we approach a period of heightened market volatility.

So our strategy continues to evolve and it's further defined following this recent strategic developments. Annaly operates as not only the largest and most liquid mortgage REIT in the world, it is now built to be even stronger, more efficient and has more optionality than any other company in the industry. Our four main investment businesses, agency NBS, residential credit, commercial real estate and middle market corporate lending are all positioned to grow while providing diversified and durable earning sources for the company. Now I'll turn it over to David who will discuss our agency business and provide further detail on our outlook for the residential credit businesses.

Thank you, Kevin. As we have all witnessed, fixed income markets have exhibited significant volatility over the past quarter as interest rates increased and spreads widened across a wide spectrum of fixed income assets. Given this backdrop, our book value declined slightly which was consistent with our forecast given rate to spread moves experienced over the quarter. It should be noted that our portfolio was cushioned by proactive portfolio decisions made in prior quarters such as our low level of leverage, the asset adjustments we made at the beginning of this year, and the quality of our hedges which largely protected the portfolio from significant steepening of the yield curve that characterized the quarter.

Also notable, this rise in longer term yields benefited our earnings as reduced amortization expense contributed to the $0.41 in core income that we generated for the quarter. Specifically with respect to the agency portfolio, we entered into the quarter with what we considered to be a relatively defensive posture. As we discussed last quarter, we reduced the portion of our longer duration specified core holdings in favor of TBAs. While specialists in the TBA markets was less material than in quarters past, the TBA sector outperformed specified pools as rates increased and declining demand for call protection led to deterioration in specified full pay-ups, even after adjusting for the longer duration profile and pools relative to TBAs.

We also pre-emptively reduced spread and volatility exposure by making a modest rotation in the 15-year and 20-year sectors. And lastly, our hedges were more concentrated in the long end of the yield curve which experienced the largest increase in rates.

Regarding our market views going forward as Kevin mentioned, we have received greater clarity regarding Fed lift-off and we do expect the first rate hike to occur later this year. But as we have stated previously, we anticipate that the pace of Fed tightening will be very gradual given slow growth of (inaudible) backdrop. Agency NBS spreads are as attractive today as they have been since mid-2014 and we are less concerned about a significant rate sell-off now relative to earlier this year when the ten-year note was yielding inside of 2%.

In spite of market being in a better place today, we do expect to maintain our conservative leverage profile over the near term as we anticipate better entry points to emerge later in the policy home utilization process that would offer good opportunities for us to add to our agency portfolio. Turning to our residential credit efforts as Wellington and Kevin discussed, we are increasing our footprint in the sector beyond GSE credit risk transfer security.

This is an initiative that we have methodically prepared for since our initial entrance into the risk transfer sector and it's a natural extension of our broader effort to diversify our balance sheet. Within residential credit, we intend to focus on a range of sectors that represent growth opportunities including new securitization backed by prime jumbo loans, legacy pre-crisis securitizations as well as shorter dated conservatively structured bonds backed by non-performing or re-performing mortgage loans.

These latter transactions are essentially funding vehicles for sponsors who purchase loans from government entities as well as bank portfolios with the goals of generating value through high touch low resolution strategies.

With respect to financing alternatives for residential credit, many of our positions will be funded through traditional street repo although we will utilize other forms of financing including the FHLB. Considering financing costs across residential credit, leverage returns are currently in the low double-digits to mid teens, depending on the product targeted and the leverage employed.

I've given the key for liquidity and higher training volumes is non-agency relative to GSE risk transfers. We anticipate building the rest of our residential credit portfolio at a quicker pace while at the same time maintaining the same rigorous discipline that characterizes all of our investment initiatives. As is the case across our investment spectrum, our allocation to the residential credit sector will depend on its relative value versus agency, commercial and middle market corporate lending. With that, I'll hand it over to Mike to discuss our commercial efforts.

Thanks, David. The fundamentals of the US commercial real estate market continue to improve in the second quarter of 2015. Compared to last year, investment sales volume was up 23% to $118 billion and values were higher across all property types. On a sequential basis, second quarter 2015 volume was actually lower than the first quarter. The first time we have seen volume drop in over a year. However, we don't see this as a signal that the market is slowing as there were a number of large transactions that were announced in the second quarter that will likely close later this year.

While there is increasing concern in the market about the future impact of tightening on real estate values, it has not yet shown up in pricing. Cap rates have either helped steady or decreased slightly in the second quarter and remain at historical lows. The MBS issuance was almost $25 billion compared to about $19 billion in the second quarter of last year, an increase of almost 30%. Spreads have widened across the board this summer with AAAs is now at about 100 basis points, 12 basis points wider than at the beginning of the year and 25 basis points wider than this time last year.

In addition, BBBs are almost 100 basis points wider than this time last year. At Annaly as at the end of the second quarter, our commercial real estate portfolio stood at approximately $1.8 billion. On an economic leveraged bases, our commercial real estate portfolio was $1.3 billion and produced a leverage deal of approximately 10%. Our book is slightly smaller compared to the end of the first quarter primarily as a result of over $286 million of pay downs including the pay-off of the largest loan on our balance sheet. In addition, as we previously announced earlier in the second quarter, we added a significant amount of talent to the commercial team to help continue to grow the business.

Specifically, we hired Jeff Thompson as the leader in our group and added five members of his investment team from GE capital. While the market remains very competitive for new business, we are enthusiastic about our current pipeline and the increase in opportunities that we are seeing as a result of adding Jeff and his team. In addition, we continue to pick our spots on a risk return basis across our various investment products which include first mortgages, mezzanine loans, preferred equity investments, JV equity and securities. With the goal of providing our shareholders with longer term primarily floating rate cash flows as a strategic complement to our agency portfolio. We continue to aggressively manage our credit risk as we invest new capital prudently and profitably for our shareholders.

And with that I would like to turn it over to Glenn to discuss our financial results.

Thanks, Mike and good morning, everyone. I'll provide a brief overview of the key financial highlights before we then open the call up for your questions.

Beginning with our GAAP results, we recorded net income of $900 million, or $0.93 a share. That compares against a first quarter loss of $476 million. The Q2 improvement was largely attributable to favorable mark-to-market adjustments in our interest rates swaps portfolio. Our core earnings which include among other things realized and unrealized gains and loss on derivatives, increased sequentially to $411 million, or $0.41 a share.

This compares to $0.25 in the prior quarter and our annualized core ROE to 12.8% versus 7.7% in the prior quarter. Factors that contributed to the quarterly results were increased net interest income which was up about $122 million, or $0.13 in the quarter, which was driven by both lower amortization expense and lower interest expense. Beginning with amortization, under GAAP we're required to update our cash flow projections for differences between expected and actual pre-payments and incorporate current and forward-looking market assumptions. We perform this analysis using third party models. Pre-payments speeds during the quarter are less likely to influence our results as often times actual speeds may be the result of events or circumstances or market conditions from a prior quarter.

So while average CPR is over our current quarter were faster, our projected CPRs declined as both interest rates as well as the yield curve steepened. And interest rates rose. The effect of the slower long-term projected CPR is relative to Q1 projection with a favorable $0.07 a share. In terms of interest expense, the decline was due to the maturity of convertible senior notes as well as lower repo balances. Additionally, dollar roll income was a factor in the quarter. It was up $36 million, or about $0.04 a share in the quarter as we recognized the full quarter impact of this addition versus the partial quarter impact in Q1.

Also contributing to the core earnings growth was an expansion of revenues from our commercial businesses. The net interest expense income expansion drove both improved net interest margin as well as improvements in our spread. Turning to the balance sheet, the agency portfolio was down $2.2 billion to $68.2 billion and includes $214 million of agency CRT securities which grew just over $100 million in the quarter. Excluding the effects of consolidated VIEs to commercial portfolio which includes corporate debt was up slightly as new investments were offset by pay downs.

New commercial investments approached $400 million in the quarter and I should point out that our balance sheet depicts a greater increase in commercial investments. That's largely the result of our purchase of the Jr. class of a Freddy Mac securitization that we are required to consolidate and that consists of about $1.2 billion of assets and $1.1 billion of liability. Book value declined to $12.32 a share. Leveraged as traditionally reported was flat at 4.8 times. Economic leverage which captures the effect of the TBA contract was 5.9 times at quarter end which was up slightly from 5.7 times the prior quarter. And finally, our capital ratio was up slightly at 14.2%. So with that, Anita, we're ready to open it up for questions.

Thank you. We'll now begin the question and answer session. The first questions comes from Douglas Harter with Credit Suisse. Please go ahead.

Thanks. Could you talk about where you are in terms of building out the team for the non-agency investments in light of the Chimera spin-off or split out?

Sure, Doug. This is David Finkeltein. We did make an announcement a couple of months ago about some strategic hires and we have added significant resources not only to the front office trading and portfolio management but also technology and other infrastructure. So from where we're operating in the space today, we're pretty complete with that effort.

Great. And then on the buy-back, is there anything you can share with, kind of your appetite and likeliness to use to use that to help us kind of get a sense for the pacing of that?

Yes, hi, Doug. The way that we look at it is it needs to be a prominent contributor to long-term, more durable accretive profile relative to the other options that we have. And where we are in the interest rate cycle, you know, hopefully we are in a transitional period that will potentially offer opportunities on a number of fronts. I always hope that it's not in our stock but if it is, we would want to make sure that the stock has a significant amount of weakness relative to our forward projections on book value that we would have the opportunity to go ahead and close some of that valuation gap and I would say we would probably be fairly aggressive on that.

I think, Doug what I would add following our last call, Wellington, throughout the analogy really purposefully I think to add some realistic commentary around a potential repurchase program. I think what's changed since that call is a few things. First, we're obviously closer to September whether you think it's lift-off or not. We're closer to that time period than we were then. For us, more specifically, our stock technicals haven't gotten any better. So we're well aware of that relative value equation. And then, lastly, this independence with Chimera, we have proceeds with that company repurchasing our position there so we freed up $125 million or so and everything is fundable but you can argue that if you have a position in one other company, why note have a position with your own? So, those three kind of reasons are recent developments since our last commentary on the potential for a share repurchase authorization.

Great. Thank you for that color.

Thank you. The next question comes from Mike Widner with KBW. Please go ahead.

Good morning, guys.

Hi, Mike.

You added some comments in the opening remarks about the premium amortization adjustment and I just want to make sure I understand the math there. I think you said $0.07 a share would be attributable to what a lot of others would refer to premium amortization catch-up and I just wanted to make sure that I was interpreting that comment correctly?

Yes, that's correct, Mike

So to be clear about that then, that translates to roughly $56 million. Would it be fair to say that if we strip that out, that your run rate premium amortization, you would expect all else to equal, nothing changes, market stays as it was in terms of rates? You're somewhere around $150 million a quarter and I'm getting there just by adding the $56 million to the $94 million that you reported. And is that math right or I imagine there's a number of ways I could do that but I just want to make sure that I'm thinking of it right as we model it going forward.

One thing I'll ask of you Mike is that you strip it out when it's to the downside too.

I mean, you know.

I just want to be clear that we've been doing in this way now for over a year now.

About a year now. And Mike, for example, last quarter when we (inaudible) $0.25 a quarter, there was about $0.05 or $0.06 of detriment that came through. So if you look over the last few quarters, our amortization expense averaged about $190 million.

Yes. And I mean that's really at the end of the day what I'm getting at. I mean, not that you read our research on competitors, but, your point, Wellington, is fair and we wrestle with this every quarter, it's not fair to consider on the downside and not the upside or whatever. But, you know, what we're really trying to get to and what investors care about obviously is what's the ongoing earnings power. That's what the core should represent.

Right.

Is $190 million, is that a decent sort of number?

You know, it really will depend on the level of interest rates.

Yes. there's so many factors. It's based on the way GAAP works and what we're required to calculate. There's so many factors that come into play that are going to impact that number. If you looked over say the prior four quarters, the prior two quarters is about $190 million. If you go back four quarters before that it averaged about $170 million so it's going to vary quite a bit and fluctuate. We would hope that you would be looking at over a longer term period of time to get a sense of as to what the true core is because even the concept of catch-up, presumes that your initial assumption day one is an accurate assumption which we probably can conclude is not the case. So you're always trying to compare against an assumption that may or may not be right in the first place.

Which, you know, this is part of the opportunity that being a mortgage investor presents and it's unfortunate that it's not as presents as certain a picture on a quarterly basis as everybody would like. But, you know, it is what it is.

Yes, I appreciate that. And, you know, I get all that and that's why I phrased the question was, if your current assumptions that are baked into your numbers don't change, right, if the interest rate environment remains statics or whatever happens to be baked into the assumptions, is 190 the number?Is 160 the number?And, I mean, the reason I emphasize it is obviously as you said yourself, last quarter was $0.05 to the downside and this quarter it's some number of cents to the upside. There's no way from the outside that we can know what your base line assumptions are unless you actually tell us and that's why I kind of belabor the point a little bit.

And that further amplify the point. If we were to re-strike Q2 based on where rates are today, that impact would be about $0.03 to the detriment instead of $0.41, it would be $0.38 to give you a further perspective on how that changes from point to point.

Yes. Do we expect $0.41 to be our core run rate? No.

Yes. I mean in case the question is not obvious, what I'm asking is last quarter the premium amortization was $284 million. This quarter it's $94 million. You know, that's a huge difference, $0.20 of earnings difference. And I'm just trying to figure out if the run rate there is, the $190 million which you said is kind of the two quarter average, or if it's $160 million which is I could get the math that way or I could get the math that says 220. And I'm not asking you to promise me what it's going to be next quarter, I'm just going to say, given your current assumptions that are baked into that June 30 number, what would assuming no change in rates, what would a normal quarter given the CPRs that we saw last quarter, what would that number be?

In other words, very precisely, what is the amount that you backed out of a run rate premium amortization to get to $94 million?And maybe you're not going to give me. Any better answer than that, I don't know.

I think Mike, what I would say, I think I talked about it in the last call. I don't have all of the numbers in front of me but the last 12 quarters since the onset of QE3 when the Feds stepped into our market and bought our assets. I think 10 of those 12 quarters are poor. We manage the business. We don't take extra risk without knowing we're going to have incremental returns. I think our core range from 25 to 35, 10 out of those 12 quarters and those are very model interest rate cycles and trends. I think we are managing for stability and I think components of the equation, that's always a function of not just interest rates but where our leverage is and what we're doing within other parts of our floating rate portfolio. So we manage it, and I'm looking at Glenn. We manage for stability and 10 out of the last 12 quarters we've been a much tighter range than anyone else in the sector.

Yes. In fact, over the last six quarters we've averaged $0.30 a share (inaudible).

So I'm just going to take a simple, $0.30 is all else equal kind of what you're sort of suggesting. Because it seems I'm not going to get a better answer than that. And I appreciate, as always, and I'll let someone else ask questions.

Thank you, Mike. We understand.

We know you can model with the best of them.

Thank you. The next question comes from Jason Weaver with CR Capital. Please go ahead.

This is Pedro Saboia on for Jason Weaver. Thanks for taking the call. Our call is if there was any amortization true up adjustments in the quarter?

Yes. I think we just covered that. If you look at what our long-term assumptions were in Q1 verses Q2, the impact would be $0.07.

all right. Okay. Got it. So sorry, I missed that. All right, thanks then.

Thank you. The next question comes from Rick Shane with JPMorgan. Please with ahead.

Hey, guys, thanks for taking my questions.

Hi, Rick.

Look, you know, it's interesting. We're all investors and one of the important things as an investor is always reevaluating your own hypothesis and I think you guys have done that in terms of the share repurchase and frankly, I think you see the evolution of Annaly over time moving from basically a sold product to the a pretty diverse, and an increasingly diverse platform. So I think it's, you know, an indication of the entity both in the short term and the long term. And I did want to say I wish both of you guys well in your new roles.

Thank you.

I had a couple questions. One of things that we're looking at here and I like the strategy over view slide and it's really interesting to compare it quarter over quarter. What you're showing here is that you see the opportunity and the agency MBS improving slightly versus where you were even a quarter ago and actually the opportunity in commercial first in the near term a little bit down from what you saw previously. Will you ship the portfolio growth in the near term to adjust for that? And the other element of that is that last quarter you provided a pretty good update on where you stood in terms of your TBA position and frankly, you probably didn't pay enough attention to that. It's not in the strategy overview this quarter. I'm curious where the TBA position is today.

sure, Rick. Hi, this is David. First of all, are respect to our potential to shift the preference from commercial to agency, the reason why agency returns look for a period to be somewhat higher is attributable to the fact that the curve seasoned out longer term rates increased and as a result the yield non-agency MBS are higher relative to current or near term funding costs. The one thing that's different that we like about commercial relative to agency is that a lot of that sector is floating rate and since we do anticipate that the Feds will ultimately be raising rates this year and subsequently more hikes thereafter, that floating rate feature is very appealing to us.

So I don't think we're going to, you know, draw back on our effort to reduce the emphasis on commercial portfolio. One other note with respect to our entrance into the residential sector. That is very appealing to us relative to both of these sectors for a couple of reasons. It's primarily rooted in diversification but purely from a risk return standpoint, the sector is very appealing. When you consider the housing fundamentals that are currently characterizing the economy today, HVA growth of around 6.5% according to core logic. Existing home sales relatively low so supply is somewhat light and also there's less shadow inventory out there. Home affordability and factors like that are beneficial.

Just broad economic growth in the recovering economy and also credit standards are loosening to some extent. We compare that with the returns available in the sector and as I discussed in the initial comments, you know, low double digits to mid teens and given the housing fundamentals relative to returns, that certainly merits a place in our portfolio. But nonetheless it also has to compete with the commercial sector as well as the agency sector for capital allocation and we look at it holistically. And there's certainly room for all three of those sectors as well as middle market lending and we take a top down approach in looking at all of these markets and then we decide not only what are the most attractive sectors, but also, how should the portfolio look from a diversification standpoint to sort of maximize the risk adjustment return the portfolio with the long term.

That's a great answer actually. It helps us think about this outside of the context of just what is the short term ROE in terms of how you think about balancing the portfolio, so, thank you.

Rick, it's Kevin. What I would add, you're well I aware of our strategic evolution here since you've been around the block as long as we have. Its just to put it into two simple terms. What we've done now with the credit businesses both residential and commercial, similar to when we bought (inaudible) in a couple years ago, we just feel the liquidity of our agency business is a real strategic weapon for us in terms of really two things. First, competitively by definition since we're large, we can move more quickly and be opportunistic. And secondly, and it ties to our move with Chimera, we can do these businesses and we have built these businesses for not just the last couple years but for a decade or so. We can do it much more efficiently. We have a scalability that really not many other money managers or institutions have. So it's really a continuation of that and really liquidity has always been our weapon. And you've seen our lower leverage through the years and I think it just allows us to be opportunistic and we have the expertise in-house, as David mentioned, and now it's just a matter of making sure we're disciplined enough aligning our priorities and measuring the risks and returns of each strategy which we're doing every day here.

Rick, to your second question, TBAs and our strategy overview, we do discuss it not to the extent we did last quarter but we still think the sector's relatively attractive. We think it actually offers better value in the current environment relative to specified pools given the fact that financing rates are still special. Last quarter even though they were modestly less special than in quarters past based on our conservative assumptions regarding pre-payments, etc, we do believe we have financed that position at negative rates and we expect that to continue going forward as long as the Fed remains a large part of the NBS TBA market through their reinvestment. We anticipated that it will remain meaningful portions of the portfolio. We don't anticipate increasing it substantially but we think it's going to be here for the near term.

okay, got it. Hey, and last comment. My job is not to provide any advice to you guys and we don't see it that way. But Kevin, if you don't allow Wellington to have some influence in your opening comments, going forward, our lives will be a little bit less interesting going forward.

You know, I kept my sarcasm to a minimum on this call. I thought people had enough of it.

Again, I'm not here to advise but I found that interesting today. Thank you, guys.

Thank you, Rick.

Thank you. The next question comes from Joel Houck with Wells Fargo. Please go ahead.

Thanks. Kevin, congratulations on the new CEO role and Wellington, more sarcasm is preferred.

Thanks, Joel

Thanks, Joel.

So on the Chimera, obviously you took a different approach than Crexus here. You're kind of divesting yourself. I'm just curious, was it because there was a difference in price to book connection that you didn't want to bring it in? Why was it decision made this way when you went the other way with Crexus a few years back?

You know, Joel, we certainly looked at a number of potential options including possible M&A scenarios. And, you know, we believe the conclusion that we came with the separation was the best value for both companies. We looked at both situations under the same light and tried to make a determination what was in the best interests of our shareholders given where the market was for the underlying assets.

I also think just with any strategic move, I mean we're always planning. You're always strategizing but then there's the time for execution. And I think in this situation, it's more efficient for us to really to build and we've done that over the past couple years with the expertise we have in house. You know, there's public company expenses and other cost savings and things like that which makes this a prudent move. But overall I think we look at all of our alternatives all the time and when you have to pick a point in time to execute, this was really I think most efficient for both companies for both Boards and really it couldn't have gone, there was a lot of work that went into it, right, in terms of structuring.

But it couldn't have gone more smoothly and more amicably and I think it speaks to the relationship we have not only with management but with Paul Donnellan and his board. And I think it's as clean as it can be which just really allows us to be independent and to grow, just to grow more quickly for both of us.

Okay.

And we certainly congratulate the Chimera team on this transaction.

Yes. I think it will help investors. This move will provide more clarity in terms of strategy to both companies, no question about it. Just to switch gears on you a little bit. If we go to the slide 20, the interest rate sensitivity and the MBS spread sensitivity table, these are always interesting, particularly the interest rates sensitivity everyone sees a parallel shift. I think there's a growing notion, perhaps sentiment that if the Fed raises, like they're signaling they're going to perhaps 25, 50 basis points, who knows, that it could because of the underlying weakness we're announcing, it could long rates down. And if that's the case, and by long rates let's just use the ten-year as an example so that we can crystallize the discussion. If the 10-year comes down 25, 50 basis points, is that roughly representative of a negative rate change here where you're showing an increase in Nav at 2.5 or negative 25 and up 3.8 for negative 50?

Joel, this is David. I would say it all depends what the rest of the curve does. To your point, already this quarter, the curve has flattened pretty materially. The front end's up 7 or 8 basis points with the 10-year node down about that same amount. With respect to how we hedge as we talked about, we did have a steepening bias on in the second quarter and we spoke pretty extensively about that. Actually in our Q4 call in February and we felt like the risk associated with potential for MBS extension was high and we needed hedges out the curb. And also with respect to our view, we felt that the flattening that was priced in the curve up the horizon was a little too much, particularly when you consider the slow pace we anticipated the Feds to raise rates at. But to your question, in terms of how would we perform, it's important to note that we did slightly adjust those hedges down the curve in the second quarter. So as you can see from our futures position, we added a couple billion in front and Euro dollar positions and took some of that long short exposure off. Also, in the interests of disclosure the month of July, we actually further added to our front end hedges.

We're up to about $8 billion in Euro dollars contracts in the front end so we have moved some of our hedges down the curve but how we would perform in the environment you're talking about, let's say we get back to a 165 10-year note, or thereabouts, where we bottomed out in late January. (inaudible) did not perform very well in that environment as we witnessed so that would be the dominant factor in terms of our performance I would imagine. We do carry duration on a balance sheet but this spread component of it would be the larger impact I think. We'll benefit from the duration, or the change in rates.

I would imagine that if the front end of the curve doesn't follow suit, which it really can't under that environment, that you would take the average, of the rate shift since we are reasonably well hedged across the curve now and use that to determine what the impact associated with rates would be. So just to give you an example for this quarter, you know, rates were up 43 basis points in the long end and only about 9 or 10 basis points in the front end. The average for the quarter was about 25 basis points between 2, 5 and 10. So if you look to this past quarter, the rate impact associated with our portfolio is about 1.7%. The opposite would be occurring in a rally and that's how I would look at it, taking the average of the (inaudible) change.

Yes. You guys did, on a relative basis, quite well this quarter. Most of the companies have reported so congratulations on that. Just on the MBS spread sensitivity in that bottom chart, I mean can you, you're looking at the most egregious example is out 25. Maybe taking through some history here and I know the GSEs are not as influential as they used to be when spreads had widened but after the demise of the GSEs can you talk about how often we see a 25 basis point spread widening in MBS on a quarterly basis?

Sure. 1998, 2003, 2008, and 2013.

Okay.

So it's about a once in four or five years I would say.

Okay. That's helpful. Thank you very much and again, Kevin and Wellington, congratulations on your new roles.

Thank you, Joel.

Thanks, Joel.

Thank you. The next question comes from Brock Vandervliet with please goes ahead

Thank you for taking the question. To follow up on that. (inaudible) right now are about 155 basis points. Your position in Q1 for a steepening from here on out, staring closer now at the Fed, it sounded like you're more positioned for a moderate flattening, but I just wanted to confirm.

Hi, Brock, this is David. Yes. I wouldn't say we're positioned for a moderate flattening. I would say our duration exposure is more even across the curve. How we look at it is and evaluate our heads isn't where the curve is today but what is priced over the curve over the horizon. And if you look at the forward rates over the course of the next year, two 10s are expected or priced to flatten almost 50 basis points. So to have a flat line, to break even on that trade, you would have to experience a flattening of the curve about 4 basis points a month.

So we're not inclined to, you know, put a full flattener on but we realize the curve going to be whipping around a little bit as we debate between September, December, what the hikes look like thereafter. So, our position currently is try to be as well hedged across the curves as possible but if I had to say, do we think the curves are going to flatten 50 basis points over the next year? I would bet not. We know it's going to flatten but we would take the under on that meaning that the ten year note we expect to under perform the forwards and we expect the front end to outperform.

Got it. That's very helpful. And just going back to TBA a moment and you've been kind of late to the party there but you seem pretty confidence that specialness is going to be remain investable here. Do you have any sort of a longer term perspective on that based on how long you think the Fed will continue to invest or some other thing, or is that really a tactical month-to-month strategy?

Sure. First, I think I will say the firm has been involved in the TBA market for a very long time. It's just that it wasn't meaningful enough position to break out and put on the balance sheet. In terms of specialness, when we talk about specialness, I would say that it's not nearly as prevalent as it was when the Fed was actually adding to their portfolio relative to now when they're simply reinvesting the run-off. That being said, financing rates in production coupon TBAs which is largely where we are invested in, are close to zero whereas short-term repo rates around 30 basis points or thereabouts.

That financing advantage, even with very little specialness is still meaningful when it comes to the return on the portfolio. It's there for two reasons. Obviously the Fed is still reinvesting the run-off from pay downs which creates demand. No. 2 is it that the Fed buys exclusively TBAs and as a result, the work to deliver bonds go to the Fed and then the higher quality bonds, which tend to trade at a slight pay-up or be regarded as more precious, are sold in the secondary market or sold on a pay-up basis even if they are a simply, TBA deliverable, they're new production or some characteristic as beneficial. So the market sort of has a lot of demand for the TBA sector and as a result there's a premium on roles to cover short positions that are used to hedge those specified pools, etc. And that will remain the case as long as the worst to deliver goes to the Feds and we expect that to continue at least through the next year.

The market's expecting Fed to stop reinvesting sometime in the latter part of 2016 as Kevin talked about and, you know, we're kind of in that view. We'll get through a couple, two to three tightenings and that will probably be something for discussion beyond that.

Brock, what I would just add, separate from the micro economics of David's description of our TBA strategy or just the overall agency portfolio, just to step back, the reason we have these other businesses isn't just to have them around. It's to have a capital allocation discussion tied to some of these uncertainties you're talking about and in the world of interest rates and curves is the fact that we have these three credit businesses that are on one balance sheet that compliment. The arguments that David tries to make on behalf of the agency business. So the beauty is that we have a number of options here and whether it's moderate flattening or a minor flattening, we really are more focused on frankly the relative risk returns of the strategies. And I think we just have a different, a bigger macro view when we look at each of them in isolation. So there's a strong risk culture here of checks and balances that we feel is a strategic weapon as it relates to approaching this hopefully this lift-off and beyond.

Great. Thanks very much for the color.

Thanks, Brock.

Thanks, Brock.

Thank you. The next question comes from Steve DeLaney with JMP Securities. Please go ahead.

Thanks. Good morning everyone and Wellington, thank you very much for all you've done to help build our mortgage REIT industry that we enjoy working in every day.

thank you, Steve

It's been a long call. Just one quick question at the end and it probably won't surprise you I'm interested in credit. In your vision for the credit platform, I'm just curious if you ever see yourself buying or building an origination platform?

It's not in the offing. But I'll let David talk a little bit more about that.

Got it.

Hi, Steve, this is David.

Hi, David.

We wouldn't rule anything out. For the time being, our focus is as I said, new issue prime jumbo, legacy primarily prime, and (inaudible), as well as non-performing loans and reperforming loans. That's the focus that we have today. We have scales for those businesses or for those sectors and we have expertise in it. That's not to say we couldn't expand beyond that in a pretty efficient fashion or engage in strategic partnerships or relationships within the sectors I talked about or beyond. But for the time being, those are the sectors we're focused on and we'll take it from there.

Steve, we're really well positioned to grow organically and I think external growth we're looking at all the time. We get a lot of people pitching us on opportunities and things for sale. A lot of people are trying to talk tick this market in different asset classes and strategies but I think the triple answers to David's partnership, we can grow organically and frankly through JV's and partnerships, both in the residential businesses and we're doing it in the analytic commercial real estate group right now. That's just a way for us to scale this platform more efficiently than to take on big infrastructures and people and all the risks around that.

I understand. Because those infrastructures certainly have a cyclicality and as we've seen, can be painful as people try to build those. We'll look forward to seeing how it all plays out. I'm excited about the new diversity into the overall strategy. Thank you all. Have a great day.

Thank you, Steve

Thanks, Steve.

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

Thank you, Anita. And thank you everybody for participating in our Q2 earnings call. I wanted again to thank our entire management team and specifically thank Kevin Keyes for all he has done for this Company and I look forward to his leadership in the years ahead. Thank you.

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