Annaly Capital Management Inc (NLY) 2015 Q3 法說會逐字稿

Good morning and welcome to the Third Quarter 2015 Earnings Call for Annaly Capital Management Inc.

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 these 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 the earnings call. We do not undertake and specifically disclaim any obligation to update or revise this information. Please also note this event is being recorded.

Participants on this morning's call include Kevin Keyes, Chief Executive Officer and President; Glenn Votek, Chief Financial Officer; David Finkelstein, Head of Agency and Residential Credit; and Michael Quinn and Jeffrey Thompson, co-heads of Annaly Commercial Real Estate Group.

I'll now turn the conference over to Kevin Keyes.

Thank you, Cleo. Good morning and welcome to the Annaly third quarter earnings call. To begin, I'd like to revisit some of the basic market benchmarks we've talked about over the past few years, which continue to provide a clear picture on the state of the global macroeconomic environment as well as the broader markets. This same time last year, on our 2014 third quarter earnings call, we framed certain market comparisons over a two-year timeframe from the beginning of QE3 in September of 2012 until it ended in October of 2014. At that time, we pointed to numerous red lights flashing in the global markets, even as the Fed's balance sheet had grown to $4.5 trillion. Specifically, we described the historic low levels of US Treasury and European sovereign yields, commented on oil prices sitting at a three-year low, described Chinese GDP growth at a five-year low, and even dissected third quarter 2014 US GDP to illustrate how the 3.5% annual growth rate at the time was misleading and not sustainable on an annual basis.

In the past 12 months, since the Fed's balance sheet has remained flat, fiscal policy stagnant and revised tax policy nowhere to be found, these fundamental market and macroeconomic indicators not only continue to flash red but each measure has increased in volatility while deteriorating significantly. US and European yields have grinded anywhere from 15% to 40% lower, with 30% of European sovereign debt now having negative yields, around $1.9 trillion worth. Oil prices have continued to fall another 40% since this time last year. On a year-over-year basis, Chinese GDP growth is now below 7% for the first time since 1999. Last week's US GDP number was more than 30% lower than the revised level of the previously-mentioned third quarter 2014.

So these past 12 months have only served to reinforce our views of a year ago, which at the time were countered a certain market consensus, when we said global growth will be slow at best, rates lower for longer, and Fed policy measured over time. The current rally in the equity markets and certain point-in-time data may provide the Fed temporary air cover for liftoff sooner rather than later, which as we've said before would be fine with us. But challenged global and macroeconomic environment coupled with more normalized monetary policy will result in a marketplace where diversified stable yield investments will be highly sought after.

Given these consistent macro views and the heightened volatility in the rates markets we've anticipated, our decision to maintain low leverage, preserve liquidity, and increase capital allocation into diversified floating rate credit assets is now more apparent in this quarter's results. Our commercial real estate and residential credit portfolios have grown over 50% this year and now make up over approximately 18% of our total equity capital. As a result of this more diversified portfolio, our business model continues to deliver normalized core earnings which have proven to be on average 65% less volatile than the agency mortgage REIT sector over the past year. It's clear from our results that as volatility has increased, especially over the past four quarters, our large diversified and industry low levered portfolio is proving to be more durable over time.

In regards for our diversification and capital allocation strategy, I'd like to briefly provide additional commentary on two other related topics, share repurchases and financial disclosure. Regarding share repurchases, I'd like to remind people that Annaly, back in the fourth quarter of 2012, at the onset of QE3 authorized a $1.5 billion repurchase plan, the largest in mortgage REIT history and the first mortgage REIT program larger than $100 million. The company then repurchased approximately $400 million worth of shares in that quarter and soon thereafter 22 other mortgage REITs followed with their own buyback programs. So clearly we are not afraid to act boldly in the market at the prudent time for our shareholders. Also when analyzing issuance and repurchase trends since Annaly last issued equity in July of 2011, it's obvious that a supply/demand imbalance overhang is now affecting valuations in the sector.

As I stated last quarter, following the board's authorization of our plan, we view the buyback program as one of our numerous capital allocation options. We are not a monoline strategy, so we intend to the use the program when the risk and return calculus is superior to our four other businesses over the longer term. During this past quarter, Annaly had unique opportunities to invest in a large commercial real estate transaction with Blackstone and we also determined to grow our resi credit portfolio significantly over the last quarter as well. Both categories of investments are credit oriented, lower levered, floating rate with cash flows generating attract long-term returns. We are uniquely positioned because our diversification and complementary investment strategies. But if a share repurchase makes sense, our decision to execute on it is not clouded nor influenced by our platform's optionality.

Lastly, I'd like to state that not only do we believe in share repurchases for the company at the prudent time, we also strongly believe in share purchases by management and employees. As summarized in a recent filing, senior officers at Annaly have purchased about 1.4 million shares over the past few years, multiples more than any other management team in the industry or in the marketplace for that matter.

Finally, regarding financial disclosure, as depicted in this quarter's earnings release and supplement, we have provided more detailed portfolio information of our current investments and enhanced our definition of our core financial earnings. The decision to add more detail around our business and financial results at this time is simply to increase transparency and enable a deeper dialogue with the market and our investors at a time when our strategy continues to evolve and as market volatility continues to be pervasive.

Specifically, our growing commercial and non-agency asset portfolios are now of the size and breadth that merits this enhanced disclosure. With the heightened volatility and resultant sizable swings in our amortization expense, we feel defining normalized core earnings, which presents earnings excluding the effects of changes in long-term CPRs is representative how we evaluate our performance and establish our quarterly dividend payments.

Now, I'll turn the call over to David Finkelstein, who will discuss our agency and resi credit strategies and outlook.

Thank you, Kevin. As Kevin discussed, the volatility in fixed income markets continued in the third quarter as global economic pressures materially impacted virtually all financial markets and left the Federal Reserve on hold through September. Interest rates retraced much of the increase we saw in the second quarter. Credit spreads widened materially and agency MBS performance was only loosely aligned with swap hedges. While these factors did make for a challenging environment, our conservative positioning led to a roughly flat total economic return for the quarter. Additionally, the excess liquidity as a result of our low leverage allowed us to further diversify into residential credit given wider spreads.

With respect to agency MBS, while our positioning did not change materially over the quarter, we did modestly adjust the composition of our portfolio by reducing our 15-year pool exposure and adding to our TBA position. Dollar roll specialness continued to moderate this past quarter, but there still remains an advantage over repo in certain instances, which we expect to persist over the near term.

On the hedging side, as swap spreads tightened across the yield curve, we converted a small portion of our treasury futures into swaps while leaving the remainder of the futures position intact given the potential for further swap spread tightening. As we entered the fourth quarter, in spite of agency spreads at their widest levels of the year, we've not changed leverage materially as we still expect continued elevated volatility surrounding global markets as well as US monetary policy uncertainty.

Just one additional point regarding the agency portfolio, as it relates to our enhanced disclosure and specifically with respect to long-term CPR changes that result in variability in our amortization expense. The stability of our normalized core earnings should provide clarity to the market regarding the consistency of the earnings power of our portfolio.

Turning to residential credit, we continued our expansion into non-agency MBS by increasing our holdings of floating rate credit risk transfer securities as well as adding initial investments in legacy RMBS, conservatively structured shorter dated senior bonds in non-performing and re-performing loan securitizations and new issues senior prime jumbo securities. The spread widening that characterized the third quarter in spite of a fundamentally strong housing sector enabled us to proceed at a slightly faster pace than we initially anticipated. At the end of the quarter, we held just over $800 million in residential credit.

Looking forward, spreads are certainly more attractive today than they were earlier this year and we anticipate further expanding our residential portfolio but we intend to do so at a methodical pace and remain considerate of volatility and the risk of further spread widening. Over the near term, we expect to remain focused on the same sectors within residential credit that I previously mentioned and we will continue to evaluate the attractiveness of each of these sectors relative to one another including both fundamental credit characteristics as well as liquidity and financing considerations. Lastly, we will dynamically evaluate the size and characteristics of the residential credit book in the context of the firm's overall portfolio composition and liquidity profile with the goal of optimizing the asset mix that should help us deliver more stable returns across interest rate and credit cycles over time.

Now with that, I'll hand it over to Jeff to discuss the commercial business.

Thank you, David. The third quarter saw continued improvement in US commercial real estate fundamentals with healthy demand across all property types. Vacancy rates across all asset types declined compared to last quarter with office and industrial continuing a trend of 22 consecutive quarters of positive demand. Commercial real estate markets overall are maintaining a healthy equilibrium with supply held in check, solid demand, and positive rent growth. Investment sales volume was up 3% to $115 billion compared to this quarter last year and up 25% on a year-to-date basis, with values following fundamentals higher.

While the pace of sales has more recently begun to slow, down 10% in September, we don't see this as a weakening trend as large take private transactions continue to be announced with private equity taking advantage of the discount between listed markets and asset values. CMBS issuance was approximately $27 billion compared to about $23 billion in the third quarter of last year, an increase of 15%. Year-to-date volume is just over $77 billion, 12.6% increase over the $69 billion in 2014. Spreads, however, have continued the widening that started this summer with AAAs now at about 120 basis points, 32 basis points wider than at the beginning of the year and 34 basis points wider than this time last year. In addition, BBBs are almost 200 basis points wider than this time last year. While this type of rate expansion is significant, we have not yet seen cap rates move higher. The move up in CMBS financing costs does, however, create opportunities for us as a balance sheet lender. CMBS is no longer the least costly financing vehicle for buyers of commercial real estate, increasing opportunities for us.

As of the third quarter, the Annaly commercial real estate portfolio stood at approximately $2.4 billion, net of leverage and giving effect to our anticipated syndication of the Blackstone loan. Our commercial real estate portfolio is expected to be close to $1.4 billion with a levered return of approximately 9.4%. Our book is approximately 7% larger than the prior quarter primarily as a result of the Blackstone New York City apartment portfolio loan of $572 million, of which we expect to retain a mezzanine position of at least $90 million at an attractive levered return. Our balance sheet enables us to originate whole loans and create junior positions with better returns compared to buying mezzanine positions from other originators.

In summary, we are analyzing our opportunities with a measured approach, given the meaningful spread widening in the CMBS market. Given the strength of our capital position and the depth of our institutional relationships, we believe we are uniquely positioned to take advantage of current and future volatility. We are focused on attractive, risk-adjusted returns on our investments and are able to participate across the capital [side], further enhancing our portfolio flexibility. Preservation of capital is our priority while we provide our shareholders with longer term, primarily floating rate cash flows as a strategic complement to our agency portfolio.

With that, I would like to turn it over to Glenn to discuss our financial results.

Thank you, Jeff. As Kevin mentioned earlier, in order to provide greater transparency we've enhanced our financial disclosure this quarter beginning with further granularity on our growing credit portfolio. You can find that information in our quarterly supplement that we filed.

In addition, we've expanded our discussion of financial performance to include the concept of normalized core results while also disclosing the estimates of long-term CPRs. These results are adjusted for the component of premium amortization that relates to period-over-period changes in estimates for long-term CPRs. The market volatility experienced this year has caused quite a bit of movement in our long-term CPR estimates which has also resulted in significant volatility in premium amortization going from period to period. We understand that this has made it quite difficult to analyze and estimate our financial results. One need only look at the latest few quarters to witness this. So providing the normalized core results we're looking to isolate the effects of those changes in the long-term CPRs so that you can better understand the results of the company. I will point out that both core and normalized core results, while not a replacement for GAAP results, are intended to provide very useful supplemental information to assist you in better understanding the overall performance of the business going forward.

So with that, beginning with our GAAP results, we reported a net loss of $627.5 million or $0.68 a share in the quarter, which compares against $900 million of earnings or $0.93 a share in Q2. Unfavorable mark to market changes on interest rate swaps were the primary cause of the quarterly change. Our core earnings declined sequentially to $217.6 million or $0.21 a share versus $0.41 the prior quarter. Changes in estimated long-term CPRs were the obvious factor that impacted the quarter-over-quarter changes, most notably changes in amortization expense for each of those periods. For example, in Q3, we reported premium amortization of $255 million versus $94 million in the prior quarter. This again was due to changes in projected estimates of long-term CPRs, which in Q3 were 9.2% versus 7.7% in the prior quarter.

The component of premium amortization due to the change in estimates of long-term CPRs in Q3 was a cost of $83 million versus a benefit of a similar size in Q2. So our normalized core earnings, which were adjusted for this component of premium amortization, is $300 million in the quarter or $0.30 a share versus a normalized core earnings of $0.33 a share in the prior quarter. The primary factors contributing to the sequential decline in normalized core were higher swap expense and a reduction of income following the Chimera separation. I will point out that normalized core EPS over the last five quarters has averaged about $0.33 a share and has been in a very tight band with three of the five quarters being at $0.33 a share.

Both normalized net interest margin and normalized net interest spread declined slightly, which was due to higher funding costs and our normalized core ROE was 9.7% versus 10.3% in the prior quarter.

Turning to our balance sheet, investment securities were down $1.2 billion to $67 billion but included $821 million of agency CRT securities and non-agency MBS, which grew over $600 million in the quarter. We also saw growth in our commercial portfolio with the combined credit portfolio now representing 18% of equity, which is up from 14% in the prior quarter.

Finally, book value declined to a penny under $12 a share. Leverage as traditionally reported was flat at 4.8 times. Our economic leverage was up slightly to 5.8 times.

So with that, Cleo, we'd like to open it up to questions.

Thank you. We'll now begin the question and answer session. (Operator Instructions) Steve DeLaney, JMP Securities.

Thanks. Good morning, everyone, and congratulations on a solid quarter in a tough market. I think I'd like -- Hey, good morning, Kevin. I think I'd like to start with the expanded CRE strategy, especially since you got the leadership of the team there. You know in the past the investments have been I would say maybe a little eclectic, a little bit of everything from mezz loans, preferred equity, etc. Just based on what we've seen in this recent large Blackstone loan, would it be reasonable for us to think that the largest growth opportunity, say over the next 12 to 24 months would be in these senior floating rate loans on institutional quality real estate?

Steve, it's Kevin. I'll just quickly give you an overview and then Jeff will respond with more detail. Overall you're exactly right. I mean I think our strategy has morphed over time and I think the biggest, frankly, fundamental reason for the shift is we want to make the business more scalable. So by definition we're going to move to a -- we've moved to a more institutional strategy. So, this past transaction with Blackstone is the type of business to your point that not only are we going to be doing but we're going to hopefully replicate that with other sponsors.

I think the other thing I would say is we have a very strong team and it got stronger. I think it's not like we're discarding the old strategy. I think it's a complementary group of people that we're able to hire from GE that the marketplace was after. I think the way -- the reason we were able to attract and to bring them here is because of the platform. I think our size, liquidity and I really call it when we speak to the marketplace, as I think you know, we almost act like Switzerland in the world of commercial real estate, which is highly competitive. But we don't have the agenda of a lot of the sponsors out there. So I think we can partner with firms like Blackstone and not necessarily, because we're not necessarily a competitive threat in the other parts of their businesses.

But I'll turn it to Jeff to add more detail.

Yes, Steve, not only focused on institutional real estate, more importantly even institutional sponsors. That's really -- we're going to turn up the notch and focus on that group of private equity players that are out there, similar to this transaction here. Our pipeline already reflects that field of players that we're going after.

Jeff, your comment -- I was interested in your comment that there -- CMBS is -- the CMBS market is not the competition for balance sheet lenders that it may have been before the spread widening. Do you think you will see more demand for I guess what I would call mini perm type loans where sponsors are simply going to say, you know what, I'm just going to sit. Get a two-year floating rate loan and then I'll lock up my ten-year financing when CMBS tightens back. So, do you think that adds opportunity for you in the near term beyond just transitional properties?

Yes, Steve, as a matter of fact, in our pipeline right now we have two deals that are exactly that. They would have gone CMBS in the past. They're currently talking to us about floating rate. With the tighter cap that might -- replicated a fix rate product, but you know that's over $200 million, those two deals themselves that showed up in the last 30 days that would have been CM -- so yes we do expect to see more of that. So you know volatility in that space is good for us.

Well I appreciate the comments. Thank you.

Steve, I think one thing I would add just on the business, the size of it and it leads to our decision to disclose more on the credit businesses, commercial and non-agency resi credit is if you carved out these credit businesses as standalone companies in the marketplace. I mean our commercial business I think we'd be the fourth largest commercial mortgage REIT out there, just based on our equity capital base in the business. You know similar to this resi credit platform that we've launched this year, if you carve that out the 20 or so hybrids that you follow or 15 of, however you want to define them, we're in the top 10 with the equity capital base of around $500 million or so. So I think this platform, we've been branding it. I think the Blackstone deal is a good example of the brand now, not just catching on in the marketplace but we're executing with these sponsors that we hadn't previously. These businesses are sizable, which is again why we chose to disclose more about the portfolios.

Yes, no question. I mean the -- page 25, the detail laying out the CRE portfolio is fantastic. So we appreciate that. Thank you.

Joel Houck, Wells Fargo.

Thanks and good morning. Again, I just wanted to reiterate that I think the last two quarters you guys have shown remarkable resilience. Now that we're at the end of kind of earning season, it's clear that you guys outperformed on a relative basis. So kudos for that.

The question and not so much a question but it's more something that is really interesting is you guys have done probably the most in terms of share buybacks. A constant theme we've heard during this earning season and really for several is that the agencies complex doesn't look all that attractive. Certainly the hedging proved to be more difficult this quarter. You got the potential for further dislocation from Fed rate hikes or not. What prevents Annaly from saying look, we're going to just buy back a lot of stock and de-levering the agency business to the point where you're still 40 at compliant and you get a massive accretion in book value, which then further differentiates your valuation and puts you in a position of strength so that when the agency business does normalize, (A) you can take advantage of it and, (B) you can potentially acquire others that are at huge discounts to book. So I'm really kind of curious as to what's the logic or the rationale behind not accelerating buybacks in a massive way? Again, all on the guise of being 40 at compliant and realizing you have to have some agency exposure. Thank you.

So maybe management should take private transactions is what you're saying. You know Joel and we've talked about it, you and I individually, and the market is really focused on the issue. I think to your question, you know look over the history of this company, I think shareholders own us. They have us in their portfolio as a nice dividend-paying, stable, property you know as either a hedge or a complement to the other parts of their portfolio. So I think first of all you don't return 600% over the life of a company really without doing something right. What we've done is paid dividends in the form of a REIT structure.

So in our minds, we're a yield manufacturer in a world of no yield. So you're asking more of a corporate finance question. I think for us it's a strategic question really more so than a corporate finance question. So what I would tell you is look this past quarter is a very good example of the platform that we have now. So to your point of shrink the agencies and increase value, I mean that's essentially what we did this quarter in the form of $1 billion of equity capital underlying resi credit and commercial investments that frankly are north of our cost of capital and they're half as levered. So we can produce that yield with more durable earnings, more predictable earnings. We can sustain hopefully this level of a distribution in a marketplace to your point the last couple quarters you can see the performance is bifurcated. I think a monoline strategy without our liquidity with leverage that's 30% higher than ours and no other option, then buying back stock probably makes sense. But for us if we want to continue to be a yield manufacturer and continue to be owned by the ones that own us for that yield, we think this diversification strategy is the -- that's the reason we've done it over the last three or four years.

I hear you on shrinking down and the whole corporate finance restructuring. Look if it comes to that, I think we -- you know the world will look a lot different than it is today. I would say before it comes to that, we just think we have a lot of room to run with in these four business platforms. I think, frankly, there's going to be opportunities for us to take advantage of dislocation in the sector in different ways. We've talked a little bit about that where we can -- I think we can perhaps pick off some assets at well below book value. That's how we can continue to grow our earnings base and our company.

Okay. Very good answer.

Joel, this is David. How are you? Just to talk briefly about agency leverage. As I mentioned in my comments, we're not inclined to increase leverage certainly because there are some near-term risks, which we need to get through. But as you well know, agency spreads are certainly at the cheapest levels of the year. Our view is that we're not inclined to take the portfolio down and meaningfully given how inexpensive mortgages are relative to our hedges, which are swaps. So it's not the time to de-lever the agency book unless there's better opportunities in some of the other complementary sectors, is how we feel.

Okay, if I could just ask you a follow-up, Dave. I mean that's a good point. I mean it does seem like agencies are cheap relative to swaps. How are you viewing the swap spread narrowing? Is this more transitory or is this something that we could live with for quite a while? Or is it just hard to really know?

Well there is -- I mean it is difficult to know, but we think that it will persist over the -- certainly for the rest of the year. But generally speaking, it's transitory. It doesn't reflect the structural change in the swaps market. The way we view it is what we're trying to do is hedge our long-term funding and our long-term funding is obviously LIBOR based and that's the root of swaps. So we're not inclined to shift our hedges, given the -- what we think is a temporary dislocation in the swap, agency swaps basis. Now we'll see how it plays out. If it persists for a very long time, which we think is a low probability event and you get other relative value participants beginning to view the agency mortgage versus swaps trade as not a tight fit. They look for other hedges and then you do have that more longer-term structural shift we can adjust hedges at that point. But we don't see the need to consider that over the near term certainly.

Okay, great. Thanks, guys.

Thanks, Joel.

Brock Vandervliet, Nomura.

I thought I'd get a chance to lead off on the swap spread issue, but anyway I'll ask a follow-up. There certainly seems to be a seasonal aspect of this and I guess 30-year swap spreads have been negative for a very long period of time, but what we saw as 10-year going negative in September and continuing to tighten almost daily since then. Can you talk about what your perspective is on some of the specific drivers for this, whether it's just seasonality or big corporate CMBS calendar that's leading to aberrations in this market?

Yes, Brock. Hi, this is David, again. So, yes, seasonality does come into play. We're late in the year. A lot of the macro funds are somewhat -- are very quiet. So when you do get you know sort of significant moves in what we think of to be dislocations, you're not going to have the relative value folks come into play that you might at other times.

But generally speaking, I think we've all heard about the drivers of this trade. It's predominantly attributable to overseas selling of treasuries, which are loading the balance sheets of US dealers and creating upward pressure on treasury rates. Additionally, as you alluded to, there is corporate issuance, which is compounding the problem, primarily financials are -- will drive swap spreads tighter as they tend to issue and swap that into floating rate. Then there are some regulatory issues. It's much more efficient to have swaps on the balance sheet given liquidity coverage, etc. then treasury. So there's a lot of factors at play. The primary driver is the technicals associated with overseas selling. We don't know how long that'll persist, but it doesn't appear to be letting up. We think it's going to continue for the remainder of the year.

To your point about ten-year swap spreads, yes it's been -- you know this has been a major flow. Swap spreads at 10-year point of the curve are 25 basis points tighter than they were at the end of the second quarter. I think 30-year swaps this morning were somewhere in the neighborhood of negative 47, 48 basis points. So, it's unusual and it's something we're certainly watching very closely.

I hear you on the foreign selling now. Typically the calendar kind of peaks in October and begins to tail off November, December. Maybe we see that this year. Do you -- I guess I'm asking a very tactical question, but do you think we're kind of close to the maximum pain point here?

I'd like to hope so, but in terms of the calendar I think we had $12 billion, $13 billion in announced issuance from corporates this morning, Halliburton, Shell, etc. So, you know there's still a little ways to go this year.

Got it. Okay, thank you.

This is Cleo. This concludes our question and answer session. I'd like to turn the conference back over to Kevin Keyes for any closing remarks.

Thanks everyone for joining and we will speak to you next quarter.

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