Annaly Capital Management Inc (NLY) 2016 Q2 法說會逐字稿

Good morning, and welcome to the Second Quarter 2016 Annaly Earnings Conference Call. All participants will be in listen-only mode today. (Operator Instructions)

After today's presentation, there will be an opportunity to ask questions. (Operator Instructions)

Please note this event is being recorded. I'd now like to turn the conference over to Jessica LaScala. Please go ahead.

Good morning, and welcome to the second quarter 2016 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 of 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 contents 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.

During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our earnings release. Please also note that this event is being recorded.

Participants on this morning's call include Kevin Keyes, Chief Executive Officer and President; David Finkelstein, Chief Investment Officer, Agency and RMBS; Michael Quinn and Jeffrey Thompson, Co-Heads of Annaly Commercial Real Estate Group; Glenn Votek, Chief Financial Officer; and Tim Coffey, Chief Credit Officer.

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

Good morning, everyone. Amidst the distraction of the constantly streaming financials, sociological and political news cycle of an election year, corporate earnings and the interrelated trends around these net cash flows are the most obvious and yet perhaps the least fundamentally analyzed product of our central bank and government influenced macro and micro economies. The continued outpouring of global accommodative policy continues to drive disparate correlations between market fundamentals and valuations, once a phenomenon which has now become the norm across equity and credit markets across the world.

With approximately two-thirds of the S&P 500 Index members having reported this quarter, earnings are down over 3% in the US, marking the fifth straight quarter of decline. Asia and Europe have fared much worse. Earnings have plummeted 19% for the largest companies in Asia and have dropped 14% so far for the European 600 Index members.

Operating profit margins for the S&P 500 fell below 12% for the first time since 2010. And yet against this backdrop, this widely accepted measure of Corporate America's value now trades at a historically high P/E ratio north of 20 times, an aggregate level not seen since 2004 when earnings were actually growing 20%, representing the standard and reasonable one-to-one P/E to growth ratio which certainly does not exist today. Given this continued meltdown in corporate earnings, it's no surprise that US GDP growth averaged only 1% in the first half of 2016. These falling dominoes obviously impact Fed policy. In order to reach the Fed's growth projection for the year, a level which may potentially justify an additional rate increase assuming the rest of the world economies are mistakenly ignored, growth in the second half of the year will need to accelerate to 2.9%, a level not seen in two years and almost two times the average growth rate over that same time frame.

In recent history, the mortgage REIT industry has been under pressure as the proxy for lift-off in higher rates. Now that there is a growing and broader acceptance of our longstanding thesis of the need for lower rates for longer, the paranoia that has surrounded the sector and other yield manufacturing industries has begun to dissipate, especially for the larger, more diversified participants. Another significant and recent development in our industry has been an appreciation for the positive impact of consolidation.

On July 12, we closed the acquisition of Hatteras, the largest mortgage REIT acquisition ever, which illustrates the advantages of our enhanced size, liquidity and diversification as well as the highly experienced management team that manages Annaly. In a shrinking world of declining profits and margins I just described, with this transaction, Annaly has actually uniquely grown its asset diversity, earnings book value and capital base by over $1.3 billion, while maintaining a leverage ratio of approximately 25% lower than our peer average.

Over the past 12 months, we'd anticipated the industry's need for strategic combinations and the rationalization of certain operating models in the sector. And now, since the announcement of our acquisition of Hatteras in April, the market has recognized the numerous benefits associated with this industry-leading transaction, with the sector rising in equity value by over $5 billion and Annaly shareholder value increasing by over $500 million in just three months time.

In addition, this past quarter in accordance with our strategic plan of both asset and funding diversification, we secured incremental term financing across all four of our businesses. Financing the 25 product strategies across our four main asset classes now includes a dozen funding options, adding to our capacity for growth while as importantly, insulating us from the obvious risks monoline strategies face today.

In addition to focusing on the breadth of funding sources and capacity, we have concentrated on term and lengthened our maturities when prudent, a critical component of our financing strategy given the current market reality of the impact of money market reform on LIBOR. Specifically, within the agency, residential credit and commercial real estate businesses, we are actively managing our $3.6 billion financing line with the FHLB. This type of financing with its low cost, four-year weighted average maturity may be flexibly deployed across these multiple strategies, as our capital allocation strategy dictates. We have also increased capacity under an existing credit facility by 75% to $350 million for the commercial real estate group, and obtained a new $300 million line for our growing middle-market lending platform.

And in the Hatteras acquisition, with our underlying liquidity, broad financing access and RCap, our broker-dealer, we seamlessly on-boarded the largest industry acquisition ever, settling $11 billion of collateral in a single day, barely impacting the firm's overall balance sheet risk ratios.

Concurrent with achieving scale across our investment platforms, the plan has been to increase the dedicated financing for each strategy, resulting in a more optimal use of our equity across the firm. And it's expected to drive enhanced returns on this invested capital in the second half of this year and beyond.

As we entered the second half, while numerous other yield oriented monoline strategies are strapped with unsustainable fixed operating costs lack liquidity and struggle for access to funding, Annaly remains in growth mode. The liquidity of our balance sheet with unencumbered assets 11 times larger than the median market cap of all 34 mortgage REITs, coupled with the liquidity of our currency, our average daily trading volume of our common stock is greater than 70% of the sector combined, uniquely positions us to take advantage of both the internal and external growth opportunities we see on the horizon.

Our diversified investment model as a broader real estate finance company is capturing market share in the competition for asset selection, financing terms and finite balance sheet capacity. And relative to our various permanent capital competitors and peers, Annaly has evolved into a liquid alternative asset manager and equity yield investment option, noticeably distinct from the mortgage REIT universe in terms of our stability, diversity, liquidity and size.

Now I'll turn the call over to David Finkelstein who'll discuss our agency and residential credit results and outlook.

Thank you, Kevin. The second quarter saw the passing of a major risk event with Brexit representing a tremendous inflection point across all financial markets. After signs of renewed stability in markets and expectations of continued rate normalization earlier in the quarter, the results of the UK referendum drove a rally across the yield curve with the 10-year note finishing inside of 1.5%. In addition, the outcome of the vote created sizable political and economic uncertainty and increased expectations for Central bank accommodation around the world. As a consequence, fixed income investors were forced to re-examine the relative value equation as 10 developed market economies currently have negative yields on a meaningful share of their outstanding government debt.

Given agency MBS' attractive liquidity and relative yield advantage, the sector performed reasonably well in this global hunt for yield, despite volatility and prepayment concerns as overseas investors bought sizable amounts of agency MBS. In fact, in the first five months of this year, foreigners have purchased more of the agency sector than what most strategists expected for all of 2016 at the beginning of the year, a trend which we believe should persist in the second half of the year.

With respect to our portfolio strategy on the agency front this quarter, we adjusted the composition of the portfolio, primarily to accommodate the on-boarding of the Hatteras asset. Given the high concentration of [warrants] held by Hatteras, we reduced our holdings of shorter duration of 15 and 20 year MBS and rotated into longer duration 30-year MBS. This was also an extension of our continued strategy to enhance the durability of the portfolio, as over the past year and a half we've actively reduced the portion of the fixed rate portfolio without inherent call protection from roughly a third of the portfolio to under 10%. This gravitation into 30 years also fits with Hatteras' MSR portfolio were longer-dated securities provide the appropriate hedge for the negative duration of the MSR aspect.

Of additional note with respect to hedges, we also reduced our swap position and replaced a portion of those hedges with Eurodollar contracts. Combined with the existing Hatteras hedges, this equates to roughly $15 billion two-year equivalents in short Eurodollar contracts for our portfolio.

Turning to residential credit, spreads tightened over the quarter which served as a driver of the more modest growth in the portfolio. We did ship the composition of portfolio as we prepared to take on roughly $400 million of Hatteras' non-agency assets. The residential credit portion of our investment this past quarter was largely focused on the legacy RMBS sector, where secondary market supply was reasonably healthy and valuations appeared favorable to us. Furthermore, given that Hatteras assets are predominantly composed of new origination loans, the legacy sector provided us an opportunity to add seasoning to the portfolio. Of additional note, as anticipated, we have wound down Hatteras' jumble prime origination conduit, so we may still pursue home loan purchase opportunities from other third-party channels depending on the economics for the sector.

Now, I would also like to expand on Kevin's comments with respect to our financing in the current environment, particularly as it relates to the on-boarding of the Hatteras assets. Prior to the close of the merger, Hatteras assets were funded on a short-term basis and on the closing date of the acquisition, we were able to seamlessly roll nearly $11 billion in Repo contracts with an average term of 180 days, predominantly on a fixed rate basis. The vast majority of those Repo agreements were conducted with primary dealer counterparties whom we view as high quality, consistent and stable financing partners, and we have also been able to optimize the use of our own broker-dealer through this transition.

More broadly with respect to our Repo strategy, our methodical approach to financing and the term structure of our Repo is extremely important in today's environment where money market reform and Brexit had pushed three-month LIBOR to its highest levels since May 2009. Over 15% of our Repo is termed out over one year, which helps to cushion the impact of fluctuation in the short-term rates. We do not expect a meaningful increase in financing costs over the very near term.

With respect to our views going forward, we do expect continued global uncertainty as political risks remain high and economic growth remains weak. We are cognizant of the risks within the broader European banking system and regulatory changes such as money market reform implementation in October, and the combination of all of these factors suggest that it will be difficult for the Fed to hike this year. While we do not anticipate a meaningful market rally from here, we do expect the reality of low yields to remain with us for the time being. This creates a reasonable environment for agency MBS as its valuations are fair and the global bond rally should continue the demand spill over into our sector.

We do not expect to actively increase leverage, however, as the Hatteras acquisition has achieved that for us and we are comfortable with our post-acquisition economic leverage of roughly 6.6 times. This still places us on the lower end of our historical leverage while allowing us to deliver what we expect to be attractive and consistent returns.

For non-agency assets, positive housing and consumer fundamentals in the current rate environment should provide a favorable landscape for continued investment in certain sectors. Even though credit spreads are tighter quarter-over-quarter, under longer term lends, we still view the asset class is attractive relative to historical levels, the spreads are still wider than mid-2014, despite equities being at post-crisis highs. Therefore, we do expect to continue to grow our residential portfolio over the remainder of the year.

And with that, I'll hand it over to Jeff to discuss the commercial portfolio.

Thanks, David. The fundamentals of the US commercial real estate market continued to demonstrate resilience for the last quarter, although some markets and property types are seeing deterioration. In addition, the publicly traded capital markets have continued to build on the improvement from last quarter. Equity REIT share prices are up 30% since early February lows and have reached new all-time highs, [5% pass] prior peak. CMBS spreads have continued the tightening trend that started last quarter. In the last 30 days, AAAs have rallied approximately 10 to 15 basis points or 10%, BBBs have rallied approximately 30 to 40 basis points or 5% improvement. The moods in the CMBS market have largely followed the broader rally in credit markets.

Turning into market transaction volume, second quarter 2016 acquisition activity was significantly below the comparable period in 2015. $105 billion of property traded hands in the second quarter, a year-over-year decline of 14%. Volumes did pick up toward the end of the quarter as the 25% decline in May was followed by only a 4% decline in June. CMBS volume was also significantly lower with $11 billion of issuance in the second quarter, a 59% decline from the same period last year.

As we observed in our last conference call, property pricing has leveled off, but not yet been impacted negatively by the slowing transaction activity. As of June 30, 2016, our commercial real estate portfolio stood at $2.4 billion. Net of leverage, our net economic capital invested in commercial real estate was approximately $1.5 billion and is producing a levered yield of 8.6% and excluding one senior loan held for sale, our levered yield of 9.4%.

The new business pipeline has picked up as we continue to be very patient in committing to new deals. We have begun to see an increase in opportunities coming out of the elevated maturity wave and increased regulation on other market participants.

In anticipation of realizing on these new opportunities, we increased our capacity for external financing during the past quarter. We will continue to focus on high quality borrowers with cash equity in new deals. Our priority remains the preservation of capital while providing our shareholders with longer-term primarily floating rate cash flows as a strategic complement to our agency portfolio.

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

Thanks, Jeff and good morning, everyone. I am going to provide a brief overview of some of the key financial highlights in the quarter before opening the call up for your questions. But first as we mentioned on the previous calls, we continue to enhance our financial disclosure to provide investors and analysts key information that we as a management team rely upon as to both manage and assess the performance of our business while also taking into consideration regulatory guidance and interpreted releases.

So for example, as I'm sure you all know, the use of non-GAAP financial measures has been an area of increasing focus for the SEC. Beginning with this quarter's results, we've reduced the number of non-GAAP metrics to those relevant to management. We've eliminated the normalized core metrics from our disclosures but is still quantifying and disclosing the impact of quarter-over-quarter changes in CPRs, that being what we refer to as premium amortization adjustment as part of core earnings, which has now been redefined to remove the effect of the premium amortization adjustment. And of course, it goes without saying that non-GAAP measures should not be viewed in isolation. They are not a substitute for financial measures that are computed in accordance with GAAP.

So with that, turning to the results for the quarter beginning with our GAAP results. We reported a net loss of $278.5 million in the quarter or $0.32 per common share, which compares to Q1 net loss of $868.1 million or $0.96 a share. Both quarters were significantly impacted by unrealized losses on our interest rate swaps hedge portfolio. The quarterly improvement was largely attributable to a favorable movement in the hedge portfolio mark-to-market value.

Our core earnings, which excludes the premium amortization adjustment, were $282.2 million in the quarter or $0.29 a share that compares to $0.30 a share in the prior quarter. Our core ROEs were relatively stable at 9.7% versus 9.9% in the prior quarter. Some of the key factors contributing to the quarterly results were a decline in interest income for the commercial real estate portfolio along with some additional amortization and depreciation expense, which related to some final purchase price allocations that were required for a commercial real estate investment, which in combination of those two items represented about $0.02 a share.

Our average Repo rate was up about 5 basis points while swap expenses were down on higher receive rates as well as lower notional balances, all of which represented a lower economic interest cost in the quarter by about $0.01.

Our projected CPR at period end was 13% that was up from last quarter's 11.8%. Q2 reported premium amortization expense was $265 million versus $356 million for Q1, and this resulted in a premium amortization adjustment in the quarter of $0.10 versus $0.19 in Q1. Both core net interest margins and net interest spreads were flat on a sequential basis. And G&A expense, although being up about $1.2 million, actually included about $2.2 million of transaction-related expenses associated with the Hatteras acquisition. So our efficiency metrics remained strong, with annualized operating expenses to assets excluding the Hatteras acquisition costs being about 24 basis points and that's actually down slightly on a sequential basis.

Turning to the balance sheet. Residential investment securities portfolio was relatively flat, with a slight increase in the resi credit portfolio. The sale of approximately $115 million held-for-sale loans contributed to a decline in the commercial investment portfolio and our middle market lending business was up slightly in the quarter as well. The combined portfolio of credit investments, which includes resi credit, commercial real estate and middle market corporate lending assets represent 24% at the end of the quarter. And finally, book value declined slightly to $11.50 a share. Leverage, as traditionally reported, was flat at 5.3 times and our economic leverage which captures the effects of TBA contracts declined slightly to 6.1 times.

So with that, [Nam], we're ready to open it up for questions.

Thank you. We will now begin the question-and-answer session. (Operator Instructions)

Douglas Harter, Credit Suisse.

This is actually Josh Bolton filling in for Doug. Amortization expense is down in the quarter. I'm just curious any updates on how residential prepayments are trending as far in 3Q, and also how you are guys thinking about CPRs going forward given the current low rate environment?

Sure, Josh. This is David. With respect to prepayments over the near term, they have trended a little bit higher this past month relative to last quarter, probably one CPR higher in this past month. We do expect a slight decrease the current month, which we'll find out tonight actually just given day count issues and then we'll pick back up again in the following month.

So over the near term, we'll probably be one to two CPR higher. We're getting out of the summer seasonal, so we do think the peak will occur in probably September based on these rate levels and we'll see where rates go from there. Current 30-year mortgage rate at about 3.625%, so they're about -- there's still a lot of loans that are in the money and prepayments should remain elevated, but the late summer months are probably going to see the peak.

And second question, talking about lower leverage, you guys have slightly lower leverage than your peers. It looks like leverage is going to be up after with the on-boarding of the Hatteras assets, how should we think leverage going forward and is the 6.5 or 6.6 times that you mentioned with the Hatteras assets a good level and finally, what are you guys seeing in order to take leverage up from these levels?

Josh, it's Kevin. I'll start and I will let, David, fill in the gaps. We were asked this question, as you asked, by others quarter-after-quarter, month-after-month in terms of leverage. The simplest way that we think about it is, it's really opportunity cost, really and risk. And the way we look at it is we're backing into risk-weighted returns for all four of our businesses tied to the underlying liquidity. So leverages, it's partly equation but it's not the determining factor.

The Hatteras acquisition is a perfect example. If we would have been more aggressive or if we would have been less liquid, we wouldn't have been able to move like we did in that transaction.

So the way I look at it is, we weigh all our opportunities in terms of where we can put our capital and we layer on leverage, the right type of leverage, maintaining frankly the biggest focus around here is liquidity. So with Hatteras, we picked up about $165 million of core earnings and a nice relatively sizable discount to the value of those earnings. And frankly, we were able to do that in less than three months and on-boarded in a day and extend the maturities of the collateral five or six times out further, because we were conservatively positioned.

The other part of it, I'll let David speak probably in more detail about the businesses specifically, but the credit businesses, the three credit businesses that we have, they are obviously less levered in nature. We can capture the same amount of returns without the type of leverage in their floating rate and they are complementary to the interest rate strategy. So by definition, since we have those businesses and their sizable, we can generate the same type of return with less leverage, which points as to why we're at 25% to 33% less levered than a monoline out there.

So it's a combination of factors. We don't think that this is the type of market we should torque leverage to generate incremental return, because frankly at a 10% or 11% dividend in this world of no yield, we don't think that's a prudent strategy based on what value we get from the market for it.

And I would just expand on Kevin's comments regarding liquidity that's in the current environment, the most significant factor that drives our portfolio decisions as I spoke about going forward, political risk and economic risks remain high. We have a lot of events that need to pass whether it's money market reform, our own election here that could create some volatility and other factors and that do keep us somewhat conservative. In the current valuations, we feel like we can generate the return necessary to make investors appreciate the business and to the extent there are changes in the market that create opportunities, we will have dry powder to do deploy.

Bose George, KBW.

I've got a couple of questions. I was on some other call, so this might have been asked earlier but just the press on your credit, the capital that's in the credit area, just have you talked about how large that could go over time, is there kind of an upper bound for that?

We didn't miss it, we didn't address that specifically. So we have - [it's all related to the market], I think we want to be fair in managing our expectations in terms of what this platform can generate on the credit side among the three credit businesses. Right now, we stand at about a quarter of the capital in those businesses. I'd like to remind people that that's up from this time last year, that's up from 14% to 24%, that's 70% increase. So we think we've grown the business as nicely.

Going forward, I think the easiest way to think about it is to calibrate, we told the market up to a third of our capital could be moved into the three credit businesses in the next six to nine months, but that's kind of the beauty of our model. It's all relative value driven and as we've talked before, we view -- that's -- we don't have a gun to our head in any sector. It's tough to find value at the risk level of risk that we want to take. But we're thankful that we have 25 different options in terms of products among these four businesses, because we obviously have the optionality that no other company does in the sector.

So we have the options, we can move with the same business platforms and business plans in and out with our liquidity. It's really the ending -- the end driver is really how we weight the risk of the return among all the strategies. And as I mentioned before, you might have joined just liquidity underneath those investments. We need to maintain that to make sure we're flexible when something opportunistic comes along like a Hatteras transaction or a large commercial deal that we did a few quarters ago. But it's 25% now, it could go up to a third, but if it doesn't, it's just because there is relative value somewhere else.

The last thing I would say, which in my prepared comments, if you missed them, we have a structured finance, we have term financing now in this quarter that we've captured for the middle market lending business and the incremental capacity for the commercial real estate business. So by definition, we don't need to put as much capital to work. We can use that financing to preserve our capital and still capture the return. So that percentage may stay the same even if we have more assets on, in terms of the percentage of capital because we have more financing today than we did a couple of months ago.

And then have you talked about where you see the best incremental value?

This is David, Bose. In my comments, as well as Jeff's, I think we did talk about increasing our investments in the credit sector. I think that on the residential part of the equation, there are some sectors that have outperformed like non-performing loans, securitizations we have outperformed as well as jumble prime securities, AAAs off the jumbo primes but CRT still represents reasonable value, there is credit risk transfer as well as the legacy sector where there is an upward of $600 billion in bonds still outstanding and we have seen some secondary market trading in that sector over the past quarter and we expect that to continue. So those are two areas where we can find values in the resi space. And Jeff, can add in commercial.

Yes, sure. So whether it's regulatory or CMBS structure that's facing liquidity issues out there in the lending space, of course our pipeline is robust and we expect it to be so for the next couple of years. So we're seeing great value out there with respect to the lending environment. We're being selective, too. We look at our investments, relative value across the firm, but we are positive on what we see coming up.

Joel Houck, Wells Fargo.

I'm wondering if you can maybe talk about the geography, the book value composition or change in the second quarter? It wasn't huge, but it was slightly down, which is somewhat not what we were modeling. Can you talk about the composition of agency, net of hedges and then resi credit, how much either one of those contributed or took away from book value in the second quarter?

Sure, Joel, this is David. With respect to the asset side of the equation, as I said, the portfolio, we didn't change much. We did shift out of 15s into 30s, but it was largely unchanged. This should have been somewhat consistent with your model. And resi credit actually did appreciate to some extent where we did suffer, I guess, it was $0.11 in book value deterioration or just inside of 1% was primarily on the hedge side. I think going into Brexit, which obviously was a binary event, book was trending higher. We did take a conservative posture heading into that when we all know how the outcome of that materialized.

So we were little defensive heading into Brexit and also our hedges were further out the curve and the curve obviously flattened quite a bit last quarter, 16 to 18 basis points depending on -- and the $0.02 depending on whether you're looking at swaps or treasuries. And half of that flattening occurred post-Brexit. So that's essentially it, it was primarily on the hedging side where we are more conservative than you might have modelled.

And prospectively, if obviously -- you guys bought Hatteras for a much lower price to book than where the assets are trading. I'm assuming there was no valuation adjustment as the overall sector improved. You closed in July. Is there maybe a range of book value contribution we can think of from the Hatteras deal that we'll see in Q3?

Yes, Joel, yes you're right in pointing out that there was no effect in Q2. The transaction actually closed in July. So you'll see that in Q3. I would say that the portfolio has been performing consistently with our assumptions, so we would expect there to be some accretion in book value, albeit quite modest.

Jessica Levi-Ribner, FBR Company.

Ted Beachley here for Jessica. So first off, do you guys think the CRE origination will continue to slow?

Yes, so it's Jeff here. I think it would continue to slow for some of the parties that we mentioned earlier. Just enhanced regulation in CMBS owner structure, you've already seen a pretty significant drop-off in CMBS. I think though the market will adapt, I think the drop-off is significant this year. For a couple of years, nobody knows exactly what it would look like that structure, and you're seeing some of your first pool come to market under the new structure.

So I could see CMBS picking up. At their peak, I think they were $220 billion, they might do 50 this year, I will throw out a guess for the next year, but there is no way they're going to get back to the peak. So add the refi way that's coming over the next -- currently coming, we're seeing deals now that were originated 10 years ago looking for refinancing. You combine those two factors, then it creates a great opportunity for a flexible balance sheet like we have, with floating rate debt.

It sounds good. And secondly, can we expect any more acquisitions? Is there a possibility going forward?

That's a question we've asked a lot now that we've done one. Look, we don't need to do acquisitions to meet our return targets and meet the financial metrics that the market expects. I view our prospects is -- we have four scalable businesses that can grow internally. External growth, that's what I would call an acquisition is kind of the cherry on top. So you have seen a lot of people doubted, I think, some of the activity, but I think it's been healthy for the sector obviously. I think we've gone from 41 mortgage REITs to -- there's been five that have been taken out and a couple of that have been restructured, which I think are healthy for the industry, but that's not to say I would project that we would -- we're not banking on doing a specific number over a specific time period, because we don't need to.

Ken Bruce, Bank of America

I think you're back to your old cheery self. My question, I guess, kind of stepping back and looking at the longer term or I guess over the last year, the ROE has kind of migrated a little bit lower. A couple of various kind of moving pieces within that. It looks like near TBA dollar roll income has become a little bit less. It's been offset by little bit less swap expense and a little bit less premium amortization. My question is, do you think you can get back to a point where yields can grow from here or is this a situation where what you see in terms of the return profile is probably as good as it gets and frankly with a flatter curve, maybe it even grinds lower from here or is there something that you can do aside from maybe just gearing up the Company to increase the yield in the portfolio?

We are cheery about our business prospects. I think your question about returns I mean, that's what I'm focused on if you're in front of the call. I just focused on the market economy as it is. We are talking about the dearth of yield out there given what's going on with the central banks, but irony is that there's a dearth of earnings power in this economy.

So all this all this money supplies, it wasn't by design that we'd shrinking everything. So for us, look, if we can maintain our returns in this environment, that are at the widest, frankly arbitrage spreads of the yield in the history of the Company and we do have history that most others don't, I think that's pretty good and I think as you and I've talked and debated, as long as we build a model that's diversified, liquid and frankly a little bit more or hopefully even more predictable in terms of cash flows then I think if the returns stay the same, we should at least be somewhat rewarded in some form of a premium. You started to see the values, as you know, not just let the bifurcate for those models that are larger, more liquid and are more durable and that's just not my elevator in the speech. I really think it's relative to the marketplace and we're not -- we'd love to have incremental returns and I think Hatteras was a deal that provided that. We bought discounted assets that were basically in a primary market. We didn't buy them in a secondary market. So that's a unique opportunity, but we're not going to have those every quarter.

But I think we really weigh our returns relative to not just the sector, but to the market overall. And I think we're planning cash-on-cash returns that are double-digits in this world, you look at the any sector ROEs and leverage, especially in the financial part of the world that you know, I think that's pretty competitive and I'll leave it to the market to value it. I don't think we're going to reach, nor should we, we haven't been. We've been overly conservative and probably less cheery than others for I think good reason. We're in this for a long time and I think that shareholders own us, because we're really good part of their risk taking portfolio they don't really have to worry about that much.

And Ken, this is David. I'll just add to your observation about the trend in dollar roll income and that's correct. Dollar rolls have not provided as much value in it, because the market hasn't been provided as much value given the fact that the curve is flatten quite a bit and the carry has deteriorated somewhat.

With respect to going forward, we'll take what the market gives us. We've seen quite a bit of flattening in the yield curve, two stems and swaps inside of 50 basis points and about 85 basis points in treasuries, which is interesting to know is that if you look what the market is priced in two years out, there is no more flattening expected when you look at the swaps curve, and there's about 20 basis points of flattening still left when you look at the treasury curve.

So if the market's right, then we can continue to hopefully generate a reasonable return in this rate environment with the 10-year note around 1.5%. But at the end of the day, we'll see how the market evolves and that's going to determine more returns. And it's also important to note that we have evolved, as Kevin addressed, and we've moved a lot of our portfolio into shorter duration floating rate assets on the credit side and that's helped us maintain stable earnings over the recent past.

Yes, well, I would agree. The Annaly today is very different than the Annaly from many years ago and I think the risk is considerably lower given kind of the nature of leverage and kind of the portfolio position. It is what it is, it just feels like the reality is that we're kind of living in this slow rate environment, you guys are producing a very high return. I would agree that the market's got to figure out where it wants the price -- a yield of this nature, the wide ranging we've kind of looked at in, maybe that changes over time. I just wanted to get a sense as to where you think it can -- incrementally, you can't squeeze anymore out of it without taking more risk. I'm guessing, the answer is no. It's really just about maintaining a very healthy return profile that you've got today.

The baseline is healthy. I don't want to get overly excited about some sort of opportunity that outsized. As you know, we're in financial repression and that being said, we do have a platform, we've scaled it now. So things come up that are -- I would view it basically as we can be opportunistic with larger situations that most others cannot. So our liquidity and our financing capacity among four businesses torques everybody else, so by definition, if something bigger comes up that's typically less competitive and higher return.

Well, it's good have options. So thank you for the enhanced disclosure and good luck with everything. Thanks.

Rick Shane, JP Morgan.

I will echo Ken's comment in terms of -- and perhaps in some ways it's a little bit harder to observe having followed the Company for a long time, but there is a very significant evolution that's going on here, both in terms of business model and in terms of disclosure.

I'd love to sort of talk a little bit about rate sensitivity. Obviously, your outlook is -- the world's coming in your way in terms of lower for longer, the hedge ratio has come down a little bit over time and I think that's consistent with that outlook. I am curious given as the world sort of shifts to your view and cost on things like swaption coming in a little bit, does it make sense at this point to protect yourself a little bit against that tail rest?

Hi, Rick, this is David. That's very good question. With respect to first of all, our hedge ratio, you're, I assume, referring to coverage over Repo, one point to note is that baseline number just consists of swaps. When you consider the futures and our long-term Repo, which is hedged effectively, that number is much higher. So, considering in the post-Hatteras acquisition pro formas, where we show nearly $47 billion in overall hedges, we're roughly at 68% I believe of our Repo balance, with the Hatteras Repo and then you factor in 15% of our Repo being one year or longer and we get to a 75% coverage or thereabouts, so we still do have a relatively conservative posture with respect to managing risk of the portfolio and it does show up, I think, in our supplement on page 17 where we showed the rate shock that's actually the lowest sensitivity it's been in quite some time.

So we do have a lot of protection but that being said, we're opportunistic with respect to hedges. We do believe that the rates are going to remain at the low end of the range. We're opportunistic with our hedges and should rates drift higher, we'll probably find opportunities to take some of those hedges off.

Rick, I'd extrapolate from there. Let's just -- there's presumption on whatever rate chart or table you want to look at, if the curve is going to stay where it is and short-term financing cost was going on with money market reform and the impact on LIBOR to our commentary earlier, if you only have one business and the ceiling is coming down and the floor is rising, protecting book is one thing but generating earnings is another. And I think the market's going to start -- it started to figure out the bifurcation of playing defense, protecting book and also having the call options to generate return. And I think in every sector, not just ours, but especially ours, we have a number of participants that are in one or two businesses at the most and I think in this environment, which is what we've kind of anticipated and you're starting to see it, earnings generation versus book value protection, I think there is going to be more of a binary comparison over the next couple quarters assuming things stay the way they are.

And Rick, this is David again. One more point with respect to your question about swaptions, it's something we look at all of the time. We have not had a meaningful swaptions position in our portfolio since 2013 and what we found is that it's easier and less expensive to dynamically hedge the portfolio as rates evolve. If you just look at the cost of swaptions, for example, the breakeven on a one-year 10-year swaptions, so one-year option on 10-year rates is about -- it's about a 40 basis points breakeven.

So the move you have to see in the market to even breakeven on that is relatively high and we found over the past 2.5 years that it is much more efficient for us to manage the duration dynamically and I think that bears out in our performance over the past 2.5 years as well. But that being said, if we do really feel like we need that type of exposure, we will enter into the swaptions market.

Got it. It's a good observation to that as the asset mix has changed, it changes the overall hedging profile across the Company. So just looking at it as a percentage of Repo probably is a gross oversimplification given the changes in the asset mix.

Yes, exactly. That's why we're doing what we're doing.

This concludes our question-and-answer session. I would like to turn the conference back to Kevin Keyes for closing remarks.

Thanks everyone for participating on the call and we look forward to speaking and meeting with a lot of you in the fall. Thanks very much.

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