Annaly Capital Management Inc (NLY) 2017 Q1 法說會逐字稿

Good day, and welcome to the Q1 2017 Annaly Capital Management Earnings Conference Call and Webcast. (Operator Instructions) Please note that this event is being recorded.

I would now like to turn the conference over to Jessica LaScala of Investor Relations. Please go ahead.

Good morning, and welcome to the First Quarter 2017 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 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.

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, this event is being recorded.

Participants on this morning's call include Kevin Keyes, Chief Executive Officer and President; David Finkelstein, Chief Investment Officer; Mike Quinn, Head 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. When my role transitioned as CEO in the summer of 2015, one of my first priorities was to expand and enhance our relationships and dialogue with our institutional and retail investors, research analysts and the broader investment community overall. Since that time, we have embarked on a comprehensive marketing campaign, holding over 200 investor meetings, including communications with over 90% of our largest institutional shareholders. Today, we are beginning to realize the benefits of our outreach. However, despite our outperformance and the improved market conditions of our diversified model, a wide relative valuation divide remains when comparing Annaly's operating and financial metrics against not only the mortgage REIT industry, but more importantly, versus the broader market and other yield-oriented companies in the equity market.

Since mid-2015, Annaly has achieved a total return of 60%, far outperforming all yield-oriented equity strategies and far exceeding the returns of the S&P 500 by 200%, and the Bloomberg Mortgage REIT Index by over 70%.

During our numerous investor meetings, 3 common issues are consistently a part of almost every discussion: first, what I'd call the persistent paranoia around Fed policy in the economy; second, questions around the resiliency of the mortgage REIT model, especially during times of volatility; and third, issues relating to the supply demand and balance in the sector. We have gained clarity and insight into the answers to all 3 of these questions with our views and performance leading the way, and thus, valuations have listed in the sector, especially over the last few months.

To simplify the response to the first question, the market consensus is now aligned with our views, views which we've expressed for a while. But, although rates may be moving higher, the Fed moves will be gradual and slow in a fragile global economy. The Fed has also begun to guide the market and the timing of the likely taper of its treasury and Agency MBS portfolio in order to support its interest rate normalization strategy.

The market now appreciates that the Fed is aware of not just the price of money, but also how the supply of money may impact asset prices, rates and influence market behaviors in the near and longer term.

The removal of certain aspects of this wind down uncertainty has, obviously, helped investors understand the reduced risk and increased opportunities for our sector, albeit without the commensurate valuation differentiation for those companies which have the optimal liquidity to take advantage of the new supply on the horizon.

Going a bit further back in time with the establishment of our current investment teams in 2014, Annaly alone has answered the questions regarding resiliency of book value and earnings during periods of extreme volatility. For the last 3.5 years of unprecedented interest rate volatility, Annaly's diversified model has protected book value 2x better than the average agency mortgage REIT, 3x better than the average commercial REIT and is on par with the hybrid REIT sector. And while 2/3 of the entire industry has cut dividends 51x, with 78% of the agency and hybrid REITs have cut at least once, Annaly has now paid the same dividend, the $0.30 dividend for 14 consecutive quarters. In our investor meetings, we reiterate that our outperformance will ultimately differentiate us in a sector that has historically not performed well during volatile market periods. The fourth quarter of 2016 is the most recent example of our unique durable model.

The market is currently afflicted with selective amnesia, as it relates to a lack of valuation distinction for certain underperformers. But suffice to say, we have done what we have said we do during times of stress, knowing that our platform has been designed for these challenging markets.

The third investor question we inevitably receive in almost every meeting relates to our market position relative to the numerous small mono-line companies in our sector. I have talked about the need for consolidation in an industry with such an obvious supply-demand imbalance. It is no coincidence that since we announced our acquisition of Hatteras a year ago and with a further 20% reduction in the number of companies through other combinations that followed, the sector has increased by over $11 billion in market value due in part to this rationalization. Consolidation, which was doubted by many to happen at all has been a win-win for all shareholders in the industry.

However, due to the continued appreciation and valuations, 2 new entry-related market realities are unfortunately now apparent: first, although this sector is still made up of too many small, illiquid and more risky, single-strategy participants, there is a reluctance by management teams and boards to consider strategic combinations to maximize shareholder value; second, as it relates to recovery and values, equity sales of personal holdings by management teams have shockingly become the norm. In fact, in the past 3 quarters alone, while the agency's REIT sector, excluding Annaly, lost an average of 5.5% of book value and have cut dividends 40% of the time, executive officers in 80% of these companies have sold stock with over 60% of these sales coming from CEOs. And it's important to note, a very high percentage of these CEO sales, if not all of them, are for granted, not purchased shares. By stark contrast, Annaly has instituted employee stock purchase guidelines, whereby over 40% of our employees have been asked to purchase stock with their after-tax dollars over the next 5 years, including me.

Primarily because of these 2 emerging factors, coupled with serious doubt around proper incentives and governance, any assumptions of M&A premiums in this sector should no longer be made. Valuations and required liquidity and capital for dividend maintenance, much less dividend growth should be revisited now for every company.

Regarding relative valuations in the market, there is much that can be said, as we seemingly break records every day in 2017 with new highs. Although Annaly has widely outperformed the market and the sector overall on a total return basis, given the dramatic increase in market multiples, our relative valuation discount remains steep, no matter how it is measured. Here are a few metrics, which illustrate our very conservative valuation.

First, our current price-to-book multiple of approximately 1.03x trades at a 15% discount to the company's average valuation since inception and remains at the same level to the average micro-cap mortgage REIT since 2000. Second, despite the fact that since 2000 our average annual total return is 16.8% and is over 2.5x higher than that of the S&P 500, our current price-to-book multiple is now at a 66% discount to the S&P 500 Index. The widest this comparison has been since 2001. Third, to go even deeper into the comparative set, relative to the 190 companies that make up the yield-oriented sectors in the market, our evaluation now trades at a 50% discount to those peers. Importantly, these yield producers, which include $3.4 trillion of market cap in the utilities, MLP, asset management and banking sectors have also produced returns 58% less than Annaly since 2000, have also cut dividends a 156x since 2014, and now treated an average forward P/E ratio of 29.8x or 54% higher than the historical average. In addition, leverage ratios producing these lower comparable returns for these 4 yield sectors combined now average 6.8x, the highest level since 2008 and higher than Annaly's economic leverage of 6.1x as of this quarter-end.

These valuation discrepancies suggest that there is room not only for further interpretation, but also a need for additional valuation methodologies besides simply analyzing relative book value levels and dividend yields for industry-leading companies, like Annaly. As we continue our ongoing dialogue with current and prospective shareholders, we stress that our shared capital model, obviously, stands apart. We have built diversified scale and demonstrated market leading earnings and book value stability at reduced leverage levels for over 3 years now. We are an operating ownership model, not a trading shop, driven by short-term incentives. We've proven to not just to be nimble or scalable, we have a powerful unmatched liquidity engine, which can drive both -- which can both drive earnings power or insulate our equity capital depending on the environment.

Our proprietary model is producing higher cash flow margins than most any other financial services company and should be valued not solely as a leverage-spread player, but as a yield manufacturating operating business that is built to last.

Finally, our valuation today also does not factor in the largest growth opportunities we have now in front of us. Essentially, our largest competitor is soon to exit our largest market with the Fed using its balance sheet to tighten money supply, instead of solely raising rates. This return to normalcy in the Agency MBS market, coupled with our proprietary credit-origination platforms, which can further scale and add floating-rate lower-level double-digit returns, amounts to a menu of investment options we haven't seen in the market for a long time.

Now I'll turn the call over to David Finkelstein, our Chief Investment Officer.

Thank you, Kevin. The first quarter provided a considerably more favorable investment environment in that which we experienced at the end of last year. While Agency MBS spreads widened modestly, volatility diminished somewhat and prepayments were subdued. Credit markets experienced an acceleration in the spread tightening that followed the November election, as fundamentals remain on solid footing, and we saw further strengthening in the technical landscape for credit assets that persist today. As a result of these factors, we were able to deliver another solid quarter in which we generated a modest earnings improvement as well as growth in book value.

As Kevin discussed relative values in the broader market, I would like to address valuations across the markets that we operate in as well as our views on the current environment.

Continued economic strength and renewed optimism surrounding fiscal policy have created a tailwind for risk assets that has generated significant appreciation in credit-sensitive sectors. At the same time, monetary policymakers have been successful in raising short-term rates in each of the last 2 quarters and have signaled their intention to begin balance sheet normalization either later this year or early in 2018.

As a consequence of this eventuality, Agency MBS has not participated in the spread rally that has impacted virtually all other fixed income sectors, creating an attractive valuation disparity between Agency MBS and credit. Agency option adjusted spreads are at their widest levels in 3 years, while credit spreads are at the tightest levels postcrisis across many sectors and credit curves continue to flatten. For example, current coupon 30-year Agency MBS have widened on an OAS basis over the past 2 quarters, while high-yield and second loss CRT spreads are 100 basis points tighter and CMBS BBB- spreads have rallied nearly 200 basis points since the election.

Now we're certainly mindful of the impact of reduced Fed sponsorship in the Agency MBS market, but the market appears overly focused on the direct implication to the Fed's balance sheet reduction on the agency sector without paying sufficient attention to the indirect consequences on other asset classes through the portfolio balance channel, as the unwinding of QE ultimately gets underway. This is not to suggest that we expect meaningful widening in credit spreads, as we view current economic performance and fundamental support of the credit. However, we do anticipate that the performance gap between agency and credit will normalize somewhat. As a result, our capital allocation has recently shifted in favor of the agency sector, although we will add to specific areas in credit where we feel that we have a distinct advantage or other discrete opportunities that arise from our proprietary origination engine.

Turning to portfolio activity and beginning with the agency sector. We did reduce agency leverage in the first quarter, which was largely a tactical decision achieved through selling TBAs and moderating our arms position, both through run-off as well as outright selling of arms after the sector exhibited significant outperformance relative to fixed-rate securities as a result of strong bank demand. We then subsequently took advantage of wider spreads in the second quarter, which has taken overall portfolio leverage back closer to 6.5x, roughly where we ended 2016.

Our re-levering was executed almost exclusively through the TBA market, as dollar roll specialness has been marginally more attractive than the carry-on pools. While assets were added on a hedged basis, we are reasonably comfortable with the current interest rate environment, as the risk of a 3% 10-year note appears more remote today than it has been throughout much of the postelection period, given the new administration's difficulty in enacting its various pro-growth policies.

Shifting to residential credit. We further added to our home loan portfolio through our partnerships with originators and aggregators, as we discussed last quarter. Although we have seen an increase in the pace of loan securitizations and the home loan sector has become somewhat more competitive, our FHLB financing remains an advantage that allows us to execute at attractive risk-adjusted returns.

As I mentioned earlier, GSE credit risk transfer securities have continued to tighten into 2017, which explains our modest reduction in CRT in the first quarter. To put this into perspective, entering the year, our mezzanine CRT portfolio was purchased at an average spread to LIBOR of well over 400 basis points, while the mezzanine tranche offered the most recently issued CRT deal is currently trading at LIBOR plus 290. And at current spreads, we expect to remain a marginal seller of the sector.

Our NPL portfolio experienced some refinancing activity in Q1 and with the yields on senior NPLs in the context of 3.5%, we're not motivated to reinvest in the sector.

Lastly, with respect to legacy RMBS, we continued to reduce our spread duration by rotating out of longer-duration, locked-up subprime mezzanine structures in favor of shorter-duration conservatively structured resecuritization. Looking forward, we're still positive on the fundamentals underlying housing, but finding attractive value in residential credit has proven more difficult and the determination with which other participants seek to invest in the sector at these inflated levels is somewhat surprising to us.

Consequently, we expect our growth in residential credit to come largely through home loan acquisitions, which may come at the expense of reducing our securities portfolio, considering how spread evolves at current levels.

Turning to our commercial business. While we continued to see numerous attractive opportunities in the sector, and we remained active in the industry, we are willing to forgo many of the investment prospects, as risk-adjusted returns are often more appealing in our other businesses, which explains our modest net decline in the portfolio.

In the market, slower new acquisition activity is forcing increased competition for loan refinancing and this competitive dynamic has led to both spread tightening as well as increasing LTVs.

And finally, with respect to our middle-market corporate lending platform, we were able to add assets in the first quarter, and we remain optimistic about the growth of the business going forward. Our barriers to entry surrounding the direct origination platform and a reduced transparency of the sector have kept spreads from contracting to the same degree as in other credit sectors. We believe that significant advantages exist to those who have been long-standing and durable participants in the arena, which we have accomplished through Annaly's commitment to this business since 2010 as well as our strong and liquid balance sheet. Amid this commitment, we have developed deep relationships with a number of private equity sponsors that has solidified our position in the industry and leaves us confident that we can grow this portfolio with accretive returns going forward.

And with that, I will hand it over to Glenn to discuss the financials.

Thanks, David. We had good start to the year with solid first quarter financial results as evidenced by improvement in earnings quality and increased book value. Getting with our GAAP results, we reported net income of $440 million at $0.41 a share versus Q4 net income of $1.8 billion or $1.79 a share. 2 factors served the sequential change: first of all, net gains and interest rate swaps were $1.2 billion lower this quarter, reflecting a more modest increase in rates in the period compared to the higher rates that rose in Q4; additionally, premium amortization expense increased by approximately $220 million.

As I mentioned on last quarter's call, based upon SEC interpretive guidance on the use of non-GAAP financial measures, the fourth quarter was our final period to report core earnings metrics that exclude the premium amortization adjustment, or PAA. Beginning this quarter, core earnings and related core metrics include the PAA, however, given its value and analyzing the company's financial performance, we'll continue to separately disclose the PAA and its impact on other key metrics, which will allow you to calculate the core earnings metrics as previously defined as well as permitting you to compare to both historical metrics as well as that of other industry peers. And, of course, non-GAAP measures should not be viewed in isolation and are not a substitute for financial metrics computed in accordance with GAAP.

So with that, our core earnings were $318 million for the quarter or $0.29 a share, that included a PAA cost of approximately $18 million or $0.02 a share.

The comparable fourth quarter core earnings were $0.53 a share, included a PAA benefit of about $239 million or $0.23 a share.

Some key factors contributing to this quarter's results were: higher coupon income, including higher interest income from commercial and corporate debt investments, offset by lower dollar role income that combined represented about an increase of $0.01; interest expense was up; modestly higher repo rates; while swap expense was relatively flat, despite higher notional balances, and together represented higher economic interest costs of about a $0.01; and then finally, MSR amortization expense declined approximately $0.01 on a core basis.

Our projected long-term CPR at period-end declined modestly to 10%, that compares from last quarter's 10.1% and resulted in GAAP premium amortization of $204 million, including the PAA cost of $18 million that I mentioned a moment ago, and compares against last quarter's accretion of $20 million, including the $239 million PAA benefit which was driven by sharp declines in long-term CPR projections at the end of Q4 versus Q3.

Overall, our financial metrics are solid, despite the higher GAAP amortization expense in the period, which showed improvement when considering the impact of the PAA, which, again, for Q1 was a cost and had a suppressing effect on certain metrics versus Q4, which had a significant benefit and thereby expanded those metrics. Core ROE for example, while a healthy 10.1%, was impacted as for yields, net spreads and net margins. We've added disclosure in both our press release and financial summary to illustrate and quantify these effect for you. Turning to the balance sheet. As a result of clearing organization rulebook changes that took effective at the beginning of the year, you will notice that our cash balances were lower. We are now reducing the value of essentially cleared interest rate swaps by the variation margin that we post, which at the end of the period was $673 million.

Previously, the valuation margin was reported as part of cash and cash equivalents. And this change will explain both the reduction in cash as well as the reduction in swaps at share value from the prior period, as those prior period balances were not adjusted.

In terms of the portfolio, David mentioned the decline in Agency MBS largely coming from the ARM's portfolio is down about $2.8 billion. The residential credit portfolio grew 13% to about $2.8 billion with the growth largely coming through newly acquired home loans that, as David mentioned, can be attractively financed through FHLB financing. Commercial portfolio declined in the period and included the sale of $115 million of loan that we had in held-for-sale. And middle market lending portfolio increased about 9%, all of which resulted in credit portfolio comprising 21% of allocated capital as opposed to 20% at year-end.

And finally, book value increased to $11.23 and economic leverage declined to 6.1x.

And so with that, Merdo, we'd like to open it up for questions.

(Operator Instructions) The first question comes from Bose George with KBW.

First, one on the agency arm holdings. It looks like that was down a couple of billion. Can you just talk about relative value there versus other agencies?

Sure, Bose. This is David. So as the quarter progressed and bank started to looking at higher interest rates and they often are attracted to arms, given their cash flows. As a consequence, there was a lot of demand for that sector and they actually tightened pretty significantly, trading at very negative Z spreads. And so we took the opportunity itself. About a $1.3 billion I want to say of arms and the rest came through runoff. Subsequent to that, this sector did cheapen back up, and so right now we're sort of in a holding pattern. We don't anticipate selling right now.

Okay. And then actually just on the prepays. Do you think prepays have largely troughed it? Can you give us your outlook for prepays?

Yes, certainly. So the portfolio paid 11.5 CPR in the first quarter and that was actually somewhat inflated by pull-through that occurred at the end of the year, which was reflected in January speeds and -- so we don't anticipate prepays to increase that much this quarter. We -- the portfolio last month paid at 11.5 CPR as well. This month, we get speeds tonight. We expect them to be largely unchanged with possible increase next month. So for the quarter, we don't expect much of an increase and as we get into the later part of summer, we could see higher speeds and it depends on what the rate environment does. But these rate levels, we don't expect a significant increase in spite of the seasonals that are coming forward.

Okay. Actually just one more. Just in terms of incremental levered ROEs on the Agency MBS, where is that sort of coming out of that?

Yes, currently it's roughly just north of 12%, which is the highest we've seen. We're pretty conservative about how we look at agency leverage relative to others and some are saying mid-teens or in upwards of mid-teens, but we think it's just above 12%.

The next question comes from Rich Shane with JPMorgan.

First of all, I want to say appreciate the somewhat passioned tone this morning from Kevin. And I think that there's a lot going on here and one of the other observations I would make is that I think if we think about the Annaly over very long horizon, this has always been a very strategically driven company, sort of big changes to the business model as opposed to more tactical. And what we're hearing today is in terms of how you are handling the portfolio is much more tactical level decisions. And I'm curious if this is a change in tone or actually a change in how you're approaching the market. And I'm also wondering if the diversity -- if the diversification of the model allows you to be more tactical, because you're not so concentrated in any particular segment?

Rick, well, thanks for the compliment. So I think I'm not the only passionate person around here. I think we have big group of passionate people driving this company. Look, I think you have been tracking the history of this company probably longer than most, so I think you can appreciate the evolution. I could answer that question taking another 30 minutes to do it. But I think the short version or the Reader's Digest version, I would just tell you is that, I'd like to think they're both continuing to be strategic big picture wise and tactical. I think it's a combination. I think the latter part of your commentary, I think is the driving factor here. We have built this platform with 4 complementary businesses that now have 30 different investment options. And I just think in a market like this, the mortgage REIT of the -- of history is history. I think there is so many opportunities that are complementary for our shareholders. We built this platform over the past couple of years really consolidating all our strategies on to 1 balance sheet. And at the end of the day, I hear commentary about people talking about nimble strategies or scalable strategies. To me, it's all about liquidity and diversity. There is no optimal -- the optimal metric is liquidity, whether you are $1 billion or $500 million or $5 billion, the biggest thing that we have that no one else has is liquidity. And the second thing we have that no one else has is the diversified options. So I think you and I have talked before, and we've talked to the market before about risk management and the nature of this model. And when you have a shared capital model where you have investment heads competing for capital in complementary markets, the best risk-adjusted return wins and with that debate, that debate is inherently risk management. For these other strategies that are mono-line, they have no other choice. They have to put money to work in one sector at one period of time in one asset class. So by definition, that is a much more risky proposition. And you've seen that in terms of volatility, right? So the fourth quarter, the tide went out and you saw the impact, just like the first quarter last year. So look, I think I could go on and on and on. But I think the answer to your question, I think it's our diversification, it's our liquidity. I mentioned in my quote, in the release, I don't know if anyone reads these things, but we have $7.5 billion of unencumbered assets. That's the size of half of the industry's market cap. So when people talk about scalability and being nimble, there were -- those scalability and nimble models in the fourth quarter with no other option lost 10%, 12%, 15% of book value. That to me is not being nimble. That to me is losing. So I think we're just out there balancing our bets. We're not swinging for the fences, and I think our shareholders own us, especially in this 24/7 market for stability. And I think that's what we've put out there.

And Rick, this is David. I would just also add that, as markets change, we're going to reassess the portfolio. And markets have changed quite a bit. Oftentimes, dislocations materialize, when there is an abrupt movement in market or we happen to have a view that's inconsistent. I'd say reducing leverage early on was a function of the fact that the Fed started talking about reducing the balance sheet. We thought it was more conservative approach and then we took a look at valuations in this quarter and simply added back. We think it was a good decision. The agency portfolio, as we parse the data, did add to our book value appreciation. Resi credit was a dominant driver. But when you look at our performance relative to other fixed rate agency REITs, we had a increase in book value and some of that was driven by the agency portfolio. And so we think it was a sound decision. And also, I want to -- I do want to say with respect to tactical versus long term, when we make decisions, it's always about the cash flows over the life of both the assets and liabilities. We look at things not just over the near term, but over quarters and years out and that always drives the way we think about the longer-term positioning of the portfolio. But to the extent, we have the resources, and we have invested quite a bit in the trading teams here. We're going to take advantage of near-term opportunities as they present themselves.

Got it. One follow-up question, one comment. Kevin, you talked about the $7.5 billion of unencumbered assets. One question we've received a number of times over the last month related to Annaly is what is your appetite given the current multiple for additional equity capital? And I think I know the answer, but I want to hear it.

How far do you want me to hit that soft ball? We're not -- we have no need or desired requirement for capital, which is why I put that in my statement in terms of our liquidity. I would say just a couple of things to that, because I can't resist. I just think the market needs to pay attention, especially in our sector just like other sectors, and start to differentiate what's going on beyond the headlines, right? And I think, I would ask the market to dig in a little bit and the most recent capital raises, I would argue, are something that I used to do this for a living for 20 years before I showed up here, they are not advisable. The most recent examples. There's a -- it's not just capital raising, it's the combination of the decision-making and what happened. There's scenarios where a company loses in the past couple of quarters with the -- even with the stock prices appreciating, the scenario is you lose, I don't know, 10%, 12%, 15% of book value in a couple of quarters. You cut your dividend couple of times, 2 out of the last 3 quarters. Management sells stock during that time period, and when you come back to the market and ask institutions to buy new issue that dilutes your current shareholders after all that. To me, that is the opposite of how you manage capital. So I've outspoken before about other things. This is the most recent example. We talked about stock buyback. I won't talk about buybacks. There's $40 million issued in 3 years and $4 billion bought back, and we did $1 billion of the buyback and no issue. There has been talk about the FHLB and there's been business models built around that, while 22 companies added and then 17 companies lost it. Right on that line, management is selling stock. 80% of the companies, there's management selling in the middle of this run-up. So I just think, I don't want to be compared in our industry necessarily. I want to stand apart from it, and I think that's what we're trying to do. And capital raising is just one part of the equation. I really think it's -- to your point on strategy and tactics. In strategy, we did the biggest acquisition in history a year ago. And tactically, we have invested in the intellectual capital around here in the last 3 years to be more tactical, to complement our strategy. So no, we are not raising capital. Unfortunately, as I have anticipated, it doesn't surprise me that his company has kind of raised their eyes above the water level north of book value, you have seen 15 different deals come in the form of converts, preps, common deals, ATMs, all different types of flavors of delusion -- shareholder delusion. We're just not going to do that.

The next question comes from Doug Harter with Crédit Suisse.

This is actually Sam Choe filling in for Doug. I mean, you guys answered most of my questions. But, I mean, in terms of the relative attractiveness of the 4 business lines, I mean, I was wondering if you could provide some color on how the return profiles are kind of going to trend during the coming year. I know you kind of touched on this in the prior questions, but just wanted more color on this.

No problem, Sam. I'll start and then David can provide more detailed metrics. I think if you just look at the mix in the capital allocation for the last couple of quarters, I mean, that kind of illustrates relative value in our opinion and the best risk-adjusted returns. So really in the order -- it's in the order of resi credit in terms of our highest growth business right now. Middle market lending #2. The agency portfolio as the liquidity portfolio, but actually such as liquidity given these CPRs, it's really good cash flow, as David mentioned, at the highest rates of return we've seen in a while. That is the default return. And then the commercial business, Mike Quinn is here, you can talk about it. But it's really -- it's short about 10% last quarter. It's not because we don't like commercial real estate, and we don't like the business. We like the business. We like the stability of the cash flows and the lower-levered floating-rate returns. We just -- when you stack up the 4 options, commercial real estate right now -- and it can change, commercial real estate right now is kind of fourth in line. But there lies the beauty of our model. We can pick and choose opportunities across the platform. We don't have a gun to our head every 30 days, forced to put money to work in a market that is highly valued. I made comments on the equity market valuations. Well, every asset and every fixed income market is relatively, relatively expensive. But we have the convenience, and I think the foresight to build the platform. We're not taking excessive risk in any one of these markets.

And Sam, I would just add that when we look at capital allocation, having a core in credit in spite of the valuation discrepancies I spoke about, having that core does lead to a more efficient portfolio overall from a risk-adjusted return standpoint. So while agency does look to be -- have the highest risk-adjusted returns right now, we are anticipating and hoping that we're able to maintain the size of the credit positions and potentially grow those books. But we're not going to chase returns in the sector. We're going to rely on what we think are unique options for us, including our middle market lending business as well as our residential credit platform, where we can do things that others simply can't do, given our financing advantages.

The next question comes from Ken Bruce with Bank of America Merrill Lynch.

I guess, firstly, some of you have been following the stock for a long time, I really think the changes that you've made over the last few years has been positive and really do kind of play into the safety and stability that you're talking about in terms of the business. So firstly, congratulations on executing quite well. I'm also guilty at being persistently paranoid, so I do apologize for that. Your comments about trying to differentiate Annaly, not only in terms of performance, but, ultimately, in terms of the way that the market views the company and the valuation. It's been kind of an issue for long time, I know, Kevin, you and I've had this discussion over the years as to what it -- what may -- what ultimately may kind of drive that. I guess, I'm interested in terms of, as you think about the way that the market has evolved, you've got a lot more passive money that's in the market. Generally, it's pretty large, it's almost 20% of the ownership of Annaly. Obviously, it's not very sensitive to the valuation, that's only sensitive to flows. The mortgage REITs not being part of the equity REIT universe. It's somewhat have been orphaned in terms of having any kind of dedicated investor base. What do you think it takes for the market to start to think about Annaly not as just a mortgage REIT, something that is not just a yield producer, but ultimately will kind of get that better valuation that you're aspiring to?

Well, I think that's the same old question we think about every day. And my previous comments on our strategic view and the tactics around it. At the end of the day, for our shareholders, we got to do our best to get recognition for the cash flow generation out of this place. So I guess, I would say couple of things. First, there is reason we've been out on the road, and you've been sponsoring a number of trips for us in the past 1.5 years. There is a reason we're doing it. We do it very efficiently. There is, as I mentioned in 200 meetings. Look, we don't have all the answers. So we're talking to our shareholders and talking to the smartest institutions in the world. I think we have developed a better answer to the question longer term. So that's the first thing. And I'll get to the answer. Second thing is, this platform -- we have this time period really since 2014 to current, that's really the team that's in place now and that's when the diversification really started to kick in. So these cash flows are complementary on the credit side to the agency business. And granted agency, it's 80% of the capital, but we could flex to 70% -- we could flex it down to 70%, 60%, 50% of the capital, if credit whatever -- when credit ever becomes less expensive. So -- without adding a body or a computer, as I've said before. So we have the flexibility with all this liquidity and diversity to grow the lower-levered cash flows that complement the interest rate strategy. So the diversification gives us -- now gives us, we didn't have before, prior to 2013, now gives us the chance to talk about it. The track record in these credit businesses have been foreseen. There hasn't been one credit loss in our middle market lending portfolio. Not one credit loss in the commercial real estate portfolio. You could argue we haven't gone through a major downturn, but both of these businesses, we either owned on balance sheet or managed for the last 10 years. So I think we've done pretty well. So the track record speak for themselves. And at the end of the day, the reason I made the comment today, even though we talked about it separately on valuation methodology, is just by nature of our liquidity and diversity, we're not taking the type of risk that the rest of the sector is. So just flashing book value, we're looking at book value of one day or one point in time and what the cash on cash return of that yield is at one point in time. We don't look at it that way. We don't look at it every 30 days. We look at balancing our return and the risk, and what we managed to do in the last 14 quarters is produce $290 million to $340 million of earnings. That's a tightest range of not only any mortgage REIT, but any of these yield industries. So that's what we're trying to do. How we get value equation credit forward? Longest story short, I think we're going to start to lay out some parameters for the market. Now we haven't done that in detail, but I think it's time we can do it because of everything I just said. I think we are a business. If you just do back of the envelope and on revenue basis, produces $2.5 billion in revenue over the last 3 years, with cash flow or operating margins, whatever you want to -- whatever you want to call our cash flow, operating margins that have ranged from 45% to 51% the last 3 years, tax affect those earnings and put a different -- put a team multiple on it, put up a yield multiple on it, put any multiple you want on it and you can see valuation arbitrage. I think we've earned the way to start to talk about it. No, it's not just the P/E multiple, it's return on invested capital and it's cash flow multiples. I'd like to triangulate to get to make sure you get to the right answer as you do in your research. But I think -- look, we've got to lay -- the bottom line is we're going to lay it out for the market. I think we're just going to start to do that more, because I think we've earned the opportunity to do it. And then we can debate whether we're right or wrong on that. But I think I would like to separate ourselves from just the 30-day funded, 30-day dividend models that are just taking -- it's an entirely different risk profile than what we're doing. And we're producing better returns with lower leverage, and we still have more liquidity than anyone else as well.

All right. Well, I've always been a little astonished by the lack of differentiation in the sector. So I guess, apology for all the changes that you've made. I think they've all been very positive. Thanks for proving me wrong, and thank you for your time this morning.

The next question comes from Joel Houck with Wells Fargo.

So on Slide 9, you showed that the book value -- the realized volatility is a lot lower than agency and commercial and on par with hybrid. But on the efficient frontier slide on 13, you're showing the most likely, I think these are price volatility returns, are higher than the subsector, which seems to imply that the market is mispricing your relative realized volatility. It's overpricing relative to the mortgage REIT universe. Can you -- do you see it that way? And are you surprised? I mean, to me, I'm shocked that you're further out on a volatility curve than you were as a mortgage REIT on Slide 13.

Joel, this is David. So you're looking at Page 9, which is not addressing the stock specifically, whereas, the efficient frontier takes all the different asset classes and compares it to the stock returns as well as to the mortgage REIT sector. So the point of that slide was simply to say that, if you look at Annaly and you add that to diversified universe for the best risk-adjusted return combination of all the sectors in all markets, then you're going to end up with a more efficient portfolio. And that's the point of that slide. So you're talking about the stock versus dividend stability and book stability, I believe.

Right. No, I get that, David. I mean I'm a CFA. What I'm saying is that you have better -- you're claiming, and I think it's true, better fundamental performance, right, on Page 9, yet the market is not pricing it correctly. It's saying that you are on a -- since 2014, on a monthly basis, your stock's been more volatile than the mortgage REIT universe. That's a disconnect to me. I'm wondering, can you -- are you surprised at that? Is there some explanation that we wouldn't be accounting for that discrepancy?

Yes, I think it's a very basic explanation, Joel. We're the largest, most liquid -- one of the -- it's actually large, most liquid mortgage REIT. But we've one of the most largest, most liquid yield interest rate plays in the equity market overall. There's more hedge funds and more hedging going on in our stock tied to other asset classes or other investments than anyone else because of our liquidity. So we have -- on a daily, weekly, monthly basis, we have heck of a lot more renting going on in the stock than pure long-only value buyers in there. So this past week is a perfect example. We are used as a hedge against what's going on in the -- in not just the secondary markets overall, but what's going on in the new issue market. So there is more volatility tied to our stock over certain windows relative to others. Even though we are more liquid, you think we wouldn't be as volatility, but just look at the last -- look at the past week, when things go on in our sector, we are used as a hedge.

Yes. No, I agree, just the notion that the most liquid stock will be typically in Finance 101, the less liquid security has more volatile. But let me ask a different question. So 2014, obviously, that was, I think, on the heels of the taper tantrum. If you were to some -- if you were able to parse out and exclude that period, which is incredibly volatile environment for mortgage REIT, would this chart now look even better for not only for Annaly, but, I presume the mortgage REIT universe together. In other words, it seems like it's -- the picture trying to paint here is probably better, if you eliminate a 100-year flood event, i.e. the market reaction to the taper, original taper.

Joel, this is David. So 2013 and summer 2013 was a taper tantrum. 2014, we started the year, the tender note yield at 3.03%, I believe. And it actually was quite a good year. We actually were very low levered at the time, but we added leverage earlier in the year. We ended up generating an 18% total return that year and the rest of the sector the rising tides with rallying market and tightening spreads kind of lifted all boats. But the subsequent 2 years, I think, we certainly differentiated ourselves as well. I think 2015, there was not a lot of return in the sector, as there was a lot of volatility. And 2016 generated 5.5% total economic return versus the peer group that really suffered in the fourth quarter lead to that outperformance. So I can't say specifically removing 2014 from the equation, whether that leads to sort of a steeper slope of that line of us versus the mREIT sector. Overall I think on that efficient frontier, if you draw -- or if you draw -- drew lines from the risk-free rate, [r-dot] versus the mREIT sector, you do get a steeper slope. But I can't say whether or not removing 2014 would further steepen us relative to the sector.

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

Thanks, everyone, for participating. We hope to see most, if not all, of you at our shareholder meeting on May 25, and we will speak to you all again next quarter. Thank you.

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