Annaly Capital Management Inc (NLY) 2018 Q2 法說會逐字稿

Good day, and welcome to the Q2 2018 Annaly Capital Management Earnings Conference Call and Webcast. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Ms. Jessica Scala, Head of Investor Relations. Ms. Scala, the floor is yours, ma'am.

Thank you. Good morning, and welcome to the Second Quarter 2018 Earnings Call for Annaly Capital Management.

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. These risks and uncertainties include, but are not limited to the ability of the parties to consummate the proposed transaction on a timely basis or at all and the satisfaction of the conditions precedent to consummation of the proposed transaction. 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 this 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.

Also note that nothing on this call constitutes an offer to sell or a solicitation of an offer to purchase any shares nor is it a substitute for the exchange offer materials that Annaly and its merger subsidiary have filed with the SEC.

Annaly and its merger subsidiary have filed a tender offer statement on Schedule TO. Annaly has also filed a registration statement on Form S-4 and MTGE has filed a Solicitation/Recommendation Statement on Schedule 14D-9 with the SEC with respect to the exchange offer. These documents are available for free at the SEC's website at www.sec.gov.

The MTGE shareholders are urged to read these documents carefully because they contain important information that holders of MTGE securities should consider before making any decision regarding exchanging their security. The Offer to Exchange, the related Letter of Transmittal and certain other exchange offer documents as well as the Solicitation/Recommendation Statement have been made available to all holders of MTGE common stock at no expense to them.

Participants on this morning's call include Kevin Keyes, Chairman, Chief Executive Officer and President; David Finkelstein, Chief Investment Officer; Glenn Votek, Chief Financial Officer; Tim Coffey, Chief Credit Officer; and Timothy Gallagher, Head of Commercial Real Estate.

Please also note that this event is being recorded.

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

Thanks, Jessica. Good morning, everyone, and welcome to the call.

Last week, we held our midyear management meetings to discuss the progress we have made on our 5-year strategic plan, what I called the Annaly 2020, when my role transitioned in 2015. We reviewed and revised priorities as it relates to the complementary aspects of our diversified shared capital model. We critically assessed our internal and external growth strategies, including diversification and consolidation, our capital and liquidity management, operating efficiencies and organizational initiatives required to achieve our goals. We debated the current opportunities in today's market environment and scrutinized our performance, both past and projected.

In the end, my 3 main objectives of the meeting were accomplished. First, we confirmed the biggest risks we face and our strategies to manage them. Second, we reinforced clear views on prioritizing our numerous internal and external growth opportunities. I simply refuse to confuse motion with progress. And third, we both challenged and solidified how we measure our performance along the way in order to maximize risk-adjusted value for our shareholders.

We built this company into a well-capitalized, lower-levered, scalable and diversified platform with more options than any other to manage through the unforeseen. With this optionality, we face much less risk in generating our returns for shareholders. We have navigated through various cycles and types of risks. And today, as global QE slows but continues, the risk of excess leverage pervades our markets, economies, corporations and governments.

Last week, we revisited and analyzed the metrics measuring leverage in the system. Aggregate global debt has now reached its highest level ever with total debt outstanding of $177 trillion equating to approximately 245% of global output, which is 13 percentage points higher than the prior peak in 2009. U.S. corporate debt has ballooned to historical all-time highs to $9.1 trillion, an amount that equates to approximately 45% of GDP today and looks a lot like the chart of mortgage debt to GDP just over a decade ago. The current level of U.S. corporate debt has grown 40% from the last time it represented this share of GDP from Q4 2008 to Q2 2009. And based on the Treasury department's estimate for the year, the U.S. government is now really piling on to the debt pile with net issuance projected to be $1.25 trillion for the year, even higher than the $1.1 trillion printed amidst the financial crisis from July to December 2008.

All of this data point -- paints the picture of a world that increasingly prioritize short-term gains over long-term strategic positioning and protection. Too many companies, including most mortgage REITs, are solely relying upon or planning to add leverage in an over-levered market to generate or maintain earnings. In the mortgage REIT sector alone, 80% of the companies have increased leverage an average of over 16% in the past year and 90% of the sector has increased leverage again this quarter by over 10%, while ours is now 2% lower quarter-over-quarter.

When you are trading a portfolio with a short-term disposition and have limited options, by definition, leverage is the only lever to pull. Going from high leverage to higher in an increase -- is an increasingly dangerous and extremely limited business plan in today's markets to state the obvious. By contrast, Annaly remains dedicated to its conservative, long-term diversification strategies. We are consistently producing competitive returns that are safer, more predictable, more durable and with significantly less leverage.

As the success of leverage began to rebuild in the system, Annaly was the first mover in proactively lowering leverage as we embarked upon our diversification strategy 5 years ago where we began to rotate our portfolio into lower-levered floating rate credit investments. Since 2014, we've employed approximately 30% less leverage than the agency mortgage REIT sector and produced a cumulative economic return 150% higher than those peers. Additionally, over this same time period, the average gap between Annaly's leverage and the agency mortgage REIT sector peers has more than tripled from a 0.65x difference to now a 2.2x difference.

Our views have influenced our strategies in optimizing our capital and liquidity and have precipitated our conservativism on how we finance our 3 credit businesses, today made up of over $3.5 billion in capital and yet only 0.9x levered, that's less than 1 turn. Our Residential Credit portfolio is 1.1x levered versus 4.2x for the market. Our Commercial Real Estate portfolio is 0.8x levered versus 2.6x on average for the market. And our Middle Market Lending portfolio is only 0.1x levered versus 1.0x for the market, which will now increase to 2x given the new financial regulation recently passed. Clearly, our credit investments are made up of higher-quality cash flows not reliant upon financial engineering for return.

Our broad investment options and priorities are demonstrated in the results of this past quarter. We successfully originated over $1.1 billion of credit assets across our 3 businesses organically at a levered return of about 10.5%, using less than 1 turn of leverage. Our ongoing investments in our proprietary partnerships and relationships are now seasoning and scaling, enabling us to source unique and complementary investment opportunities where competition is less acute, structures remain favorable and credit quality is maintained.

In addition this quarter, our external growth strategy through consolidation continued as well with our announcement of the $900 million purchase of MTGE Investment Corp. This transaction checks all the boxes. It further enhances the scale and diversification of our investment platform, is accretive to earnings, provides immediate cost savings to shareholders, increases our equity base for continued growth and reinforces our stature as a market-leading industry consolidator.

Our capital efficiency and outperformance in combining these strategies resulted in core ROE of 11%, the highest return level since the initiation of our diversification strategy in 2014.

Lastly, we constantly look at various risk-adjusted metrics over different time periods to ensure our strategies are actually delivering incremental value to our shareholders. Using multiple valuation methodologies, Annaly has delivered outsized returns with a better risk profile since its management team initiated our diversification strategy. Most telling, when analyzing returns relative to capital efficiency and leverage deployed, the results illustrate the vast return differentials among Annaly and the monoline agency REIT models.

There are a few ways to do this. First, total return. The metric we consider is cumulative economic return per unit of leverage, measuring our total change in book value plus dividends over time normalized for average leverage employed. Since our diversification effort began, Annaly's total return on this measure is 2.3x higher than the average agency mortgage REIT. A slight variance of this is a proxy for our Sharpe ratio, which we've discussed before with the market, that measures our cumulative economic return per unit of volatility. On that basis, Annaly's performance is also over 2x higher than the average agency mortgage REIT.

Second, from a levered yield perspective, one can analyze core ROE per unit of leverage, a methodology which is underutilized by the market, that helps to analyze earnings quality and capital efficiency. By this measure, Annaly's performance is 36% greater on average than the agency mortgage REIT sector. On just an absolute yield basis, Annaly's core ROE, not adjusted for any leverage of volatility, is 23% higher than the sector and has increased over 60% since Q1 2014, whereas the agency average has declined by nearly 20%.

Either way you look at it, these ratios illustrate we are not relying solely on higher leverage to produce our core earnings and dividends.

Finally, in assessing the success of our strategies on an absolute and relative basis, I like to dissect yield stability by comparing net interest margins or NIM over time. Our net interest margin of 1.6% this quarter was higher than any of the agency mortgage REITs and is 33% higher than the average for the sector.

Our NIM is not only higher, it's also proven to be more stable over time. Over the past 10 quarters, Annaly has maintained a net interest margin in a narrow band of only 14 basis points versus a 107 basis point range of spread for the average mortgage REIT, a range that is over 8x more stable than the average volatility of our peers' net interest margins, that's what we produced. Obviously, our ability to manage our portfolio's earnings quality and volatility has been a large contributing factor to our consistent $0.30 dividend for the past 19 quarters, while 100% of the agency mortgage REIT sector have lowered their dividends, representing 21 total dividend cuts over the same time period.

Higher risk-adjusted total returns, capital efficiency and unmatched stability have been the outputs of our yield factory. The diversity of our cash flows, organic growth of our floating rate credit assets and our ability to consolidate outsized liquidity and lack of reliance on risky leverage levels are Annaly's strategic differentiators, which have been undervalued in this predominantly risk-on market environment. As reality sets in and as the market begins to revert to its historical means over time, the higher risk models become exposed and the outperformance and consistency of our conservative yield manufacturing strategy will be increasingly understood and appreciated.

Now, I'll turn it over to David to discuss our portfolio and investment activity in more detail.

Thank you, Kevin.

Fixed income markets exhibited greater stability in the second quarter relative to the first quarter of this year. Nonetheless, interest rates did continue to rise and the yield curve flattening persisted as the Fed remained committed to hiking, while longer-term rates were anchored somewhat in light of economic uncertainty out the horizon. Agency spreads were roughly unchanged and credit was recently stable on the quarter. We maintained the additional hedges added in the first quarter and we've reduced leverage modestly in anticipation of both our expected onboarding of the MTGE portfolio and also as a consequence of the increase in allocation to our relatively lower-levered credit businesses.

Turning to the portfolio and beginning with Agency, activity in the second quarter was relatively light. The reduction in leverage came as a result of a decrease in both our TBA position as well as our specified pool portfolio. However, we did add to our agency multifamily position as spread widening in that sector created a temporary opportunity. On the hedging side, we added longer-dated swaps through the exercise of each of our expiring swaptions as well as through shifting out some of our shorter-dated swap contracts to manage the roll down of those hedges.

The financing environment for agency MBS remains favorable, notwithstanding the normalization of the LIBOR-OIS dislocation that characterized much of the first half of this year. We did continue to diversify our financing profile by adding more direct repo counterparties through a broker-dealer.

Looking forward, the higher rate environment has materially improved the convexity profile of both the agency market and, specifically, our portfolio. Despite the heavier supply in 2018 from a strong housing market as well as fed runoff, the agency MBS sector is in fundamentally sound shape and should wider spreads materialize from excess supply, this would likely present a buying opportunity in the sector.

Shifting to credit where the majority of our activity was focused in the quarter due to the quality of opportunities we saw across certain markets. In the residential sector, the growth driver of the portfolio was again whole loans as our proprietary relationships have enabled us to more than double the portfolio to $1.3 billion in the past 12 months. We accommodated the onboarding of new loans by further reducing our securities portfolio as the strong technical backdrop of securitized credit has kept the spreads near post-crisis tights in light of negative net supply. We do remain active in secondary markets, however, particularly in CRT, where, since 2015, we have turned the portfolio over approximately 3x, purchasing assets in an average spread of 345 basis points over LIBOR versus selling assets at an average spread of 239 basis points.

As we continued to look for ways to optimize our portfolio, we have priced 2 securitizations this year, our second completed just this week. The successful execution of our securitization is an endorsement of our resi credit strategy and the credit quality of our loans, as measured by LTV, FICO and DTI, were stronger than the average collateral securitized in this space and the pricing we achieved on these securitizations reflected our focus on quality. While our March transaction consisted predominantly of seasoned loans acquired through the execution of call rights on legacy RMBS, our recent transaction consisted of $383 million expanded prime loans organically sourced through our network of originators and aggregators. We retained approximately $80 million of the subordinate and interest-only tranches, including horizontal risk retention, with levered returns in low teens. Going forward, we anticipate that the securitization channel will remain a viable funding source for us as we seek to further reduce our reliance on FHLB funding for residential home loans.

In Commercial Real Estate, we remain cautious yet constructive on this space. We expanded our capital markets focus to drive new sourcing channels and acquire high-quality assets across the capital structure, primarily backed by stabilized assets and strong markets. In the second quarter alone, gross originations totaled over $400 million and low double-digit returns with relatively modest leverage. In the LTVs, net yields and risk ratings on these new investments compared favorably to our existing portfolio. At the same time, we were able to renegotiate existing financing and explore additional financing sources, resulting in a 14% improvement on our financing spread, enabling us to continue to deliver attractive returns without sacrificing credit quality in the portfolio.

Finally, with respect to our Middle Market Lending business, we were able to grow that portfolio to roughly $1.25 billion in assets this quarter. Our MML platform has been amongst our strongest growth businesses over the past 4 years in spite of the broad tightening in corporate spreads, which we believe we have been less susceptible to. In fact, unlevered yields, including coupon and fees earned on our MML holdings, have increased each year for the past 4 years while underlying leverage of the companies in our portfolio has decreased considerably. And interest coverage ratios have improved over that same time period.

Also notable is that our average investment size has increased, which reflects our disciplined approach to differentiating credit quality, while the market increasingly treats diverse credits alike. These investments are on entirely floating rate loans controlled by top quartile middle market private equity firms which have been reliable sources of deal flow to our origination team. And consistent with the past 7 years, we remain focused on the most defensive free cash flow-generating sectors. These are not the loans driving the CLO machine and we remain steadfast in what we want to avoid and persistent with where we want to be and in greater size.

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

Great. Thanks, David. Despite the challenging environment that both Kevin and David described, we delivered another solid quarter.

Beginning with our GAAP results, second quarter GAAP net income was $596 million or $0.49 per share compared to approximately $1.3 billion or $1.12 per share in Q1. The primary factors impacting the GAAP results were higher amortization expense, which increased approximately $107 million as the prior quarter had a meaningful PAA benefit, combined with lower unrealized gains on our interest rate swaps, which declined approximately $634 million. Core earnings, excluding PAA, were flat last quarter at $383.3 million or $0.30 per share. And the PAA for the quarter was immaterial as projected long-term CPRs were largely unchanged.

Among the highlights for the quarter, interest income declined due to the higher amortization expense that I mentioned, but it was up modestly, excluding PAA, largely driven by increased contributions from the credit portfolios, which were up over 10% sequentially. Our dollar roll income declined to $62 million from $88 million in Q1 on lower average TBA positions and higher net funding costs. Interest expense increased $75 million on higher rates, with the average repo rate for the quarter rising 35 basis points. However, our economic interest expense, which factors in the impact of our swaps, actually declined by roughly $5 million. And the hedged portfolio was in a net receipt position for the full quarter, generating $31 million of income. Further evidence of the effectiveness of our hedges is reflected in our overall funding costs, which actually declined by 1 basis point in the quarter despite the rise in LIBOR rates.

Our key financial metrics remained strong. Net interest margin, which Kevin mentioned, excluding PAA, improved for the third consecutive quarter, benefiting from both higher asset yields and the improved funding costs that I have mentioned. Core ROE, ex PAA, increased 35 basis points to 11.05%, reaching, as Kevin mentioned, the highest level since beginning our diversification strategy. And our operating efficiency metrics remained at favorable levels, consistent with the scale benefits of our operating platform.

Turning to the balance sheet. Portfolio assets ended the period down approximately $2 billion or 2% with the decline coming from the Agency portfolio, which, combined with the TBA position, was down just under $3 billion. Each of the credit group portfolios grew in the quarter. Commercial Real Estate portfolio was up over $250 million or 12% on just over $400 million of new investment. And the Middle Market Lending portfolio grew $104 million or 9% on approximately $280 million of new originations. Our Resi Credit business grew slightly, with the growth concentrated in whole loans.

And from a capital allocation standpoint, the credit portfolio has represented 28% of allocated capital, up from 26% the prior quarter and 24% as we started the year. Both balance sheet leverage and economic leverage declined slightly to 6x and 6.4x, respectively, and book value declined to $10.35 per share from $10.53 the prior quarter.

And lastly, an update on the MTGE transaction. We have actively been performing a preparatory integration work, which has validated our initial diligence findings in terms of the overall fit and economics of the business. We currently expect to close the transaction in Q3.

And with that, Mike, we're ready to open up for questions.

(Operator Instructions) Our first question will come from Doug Harter of Crédit Suisse.

Kevin, just to touch more on your comments around kind of the level of return per unit of leverage, just -- does that kind of imply that, all else equal, that the allocation to credit would be biased higher as you would kind of look towards lower leverage assets?

Yes. I think, no, that's a good headline to take from it. And I think the reason I introduced that -- and it's not to be overly technical, it's -- is an isolated fashion, I think we just look across our businesses and this shared capital model. And as we've mentioned before, its competition for that last dollar, which I think is a very good risk-mitigating discipline that we have, which is unique.

But we have to measure our investments across the board apples-to-apples. And I think that's one -- the ROE per unit of leverage I don't think is talked enough about where you're measuring capital efficiency. We're better utilizing our asset and hedge selection to maximize yield without maximizing leverage. So it's a big part of how we look at the businesses across the board just like how we look at economic return per unit of leverage. That's another measure of capital efficiency I measure. And then, there's risk-adjusted measures I have also talked about in terms of Sharpe ratios, economic returns relative to the variability of that return, which I think is another way to analyze not just our consistency and stability but others.

So I just get a little bit -- we don't just look at yield and we don't look at just book value moves or -- in anticipating how we're going to deploy capital. I mean, we project our capital deployment based on these very stringent measures. Core ROE is a good indication of -- a proxy for dividend yield, which is fine, but we like to do everything kind of a bottoms-up risk-adjusted basis. And right now, we pivoted to credit on a relative value basis tied to a lot of these measures.

So at the end of the day, we can -- we're producing just higher ROE, more stable returns with less leverage. And in my comments about leverage in the system, I think it's being a bit -- it's being downplayed a bit or ignored as the different headlines around the other parts of the market tend to dominate. So that's my -- kind of my comprehensive explanation to not just the one measure, but how all the measures interrelate and how we think about it.

And then, I guess, just in that context, I mean, how do you think about the liquidity trade-off? Since agencies are clearly a more liquid asset, if you wanted to move that around or kind of given your portfolio size, you still feel like you have enough -- you would have enough liquidity. I guess, just how does that factor into the equation?

Yes, that's a good pick up. I mean, that's really how we drive our business. And we're starting with these -- the valuation measures are kind of a product of how we manage our liquidity. So unencumbered assets and the liquidity of our liquidity, as we like to talk about, has really been never this high in the history of the company. And that, again, is tied to some of the credit diversification, right, because obviously credit is less liquid.

David can speak to kind of the Agency portfolio management, but there's kind of a new way we've been describing how we manage this company. I really think of it as a merchant bank where we're managing liquid -- more liquid interest rate strategies and -- albeit they're higher levered. So in a world that leverage is, I think, more risky given where the curve is and other aspects of our business is less levered, longer-term cash flows that are predominantly these 3 credit businesses that we're in, that's the offset and the balance that we have. So I think the liquidity measurement, what's in our box and how we run the business on a daily basis, that's really where it all starts from.

And Doug, this is David. I'll just add. Obviously, liquidity is the primary consideration for us. To the point about unencumbered assets which are over $7 billion, the majority of which are agency assets, that's the first thing we look at every day.

And also I'll point out that our financing options are of significant focus day in and day out. On the agency side, we obviously have a lot of diversity in our financing from traditional repo to a broker-dealer to direct repo and we continue to build that out. On the credit side, whether it's securitization or additional warehouse lines, we're constantly working on those as I mentioned in my comments. And so we feel like we have ample liquidity, but nonetheless, it's something we look at day in and day out and that's the first concern.

Next, we have Bose George of KBW.

Can you talk about where you see the best incremental returns in each of your different buckets?

Yes. Bose, I'll just kind of do a general overlay because I think that's the basic question we ask ourselves every day. In a quarter like this where we're -- we focus a little bit more on the credit businesses, it's the relative value tied to the agency levered yield as my comments on valuation. But I think the headline, the biggest thing here is among the businesses, I guess, relative value versus the Agency return in terms of each one of the businesses, there's unique aspects in terms of what we think are driving the decision to put capital to work.

I think -- in Resi, we're selling CRT while others are buying it just on a relative value basis to where we brought it in. And David mentioned that in his comments just on the spreads. Our whole loan business has grown really as a function of our partnerships growing and our proprietary access. So you see that as a driver where we can pick off and originate business there without competing in the secondary market. And how we've securitized those assets the last couple of quarters really speaks to our capital efficiency in the business. That's kind of the mix of there.

Commercial Real Estate, we have a new origination team we've invested in. Part of it is a capital market strategy that we haven't really focused. And Tim Gallagher has joined us recently along with a few others that really had the relationships that we didn't have before. So that's driving some of the things we're doing there. We're in more stabilized investments than the rest of the market so, by definition, there's less leverage needed there. And the portfolios performed so we're -- and it's grown, albeit conservatively. So we really attracted better financing in that business, which has helped returns. So it's a combination there.

And then the deciding factor is in Middle Market Lending, which -- that business has continued to grow whether people notice it or not, but the unlevered returns, we're 0.1x levered there, we think are very competitive. And the reason we're really able to track those is that business has been here since 2010. The relationship matrix has only grown. We're doing a lot of repeat business and we're doing larger deals as that business has performed and which are, by definition, a lot less competitive. I would argue the things we're doing can only really be competed on by a handful of the public BDCs for instance.

So it's a combination of themes across the businesses, but it's all relative to where we think the interest rate risk is today. The power of this origination platform -- I think I used the words seasoned and scaled. I mean, we've had this now under one roof for 5 years. It should be producing more proprietary origination.

And the last thing. We don't even really talk about it a lot because some of our partners and joint ventures that are in place are not public, but we are public with a number of -- 17 of those partnerships, which really helped to help us originate and finance more business that is less competitive.

Okay. That makes sense. Is it just -- is it -- in terms of the relative returns, is it, I mean, safe to say that when you look at the returns on agency, say they're in the low double digits, the returns on credit, your increased allocation to credit this quarter also reflects just the quality of that return versus necessarily a higher ROE?

Yes. I think it's -- I mean, we're -- there are competing -- competitive returns on credit with a lot less leverage.

It's scalable. So it's not -- it's going to continue if that relative value opportunity is there.

Okay. That's great. And then, just going back to your comments right at the beginning just with the growing leverage and the economy, et cetera, given that backdrop, what do you think is the biggest risk for your company? Just -- and just tying it back to rates, is it rates going up a lot or down a lot or just how do you think about that?

I think what's the biggest -- the biggest risk is we always just measure our liquidity. So if we're -- if we have an opportunity, we have to prepare for it. We turn -- we're turning a lot of things down that others are doing. So -- and we're giving up incremental return without levering too much, but what I think in this environment, you want us to be -- have a safe investment and a cash flow and cash yield that should be durable. And by definition, ours is durable and less levered.

I think the reason, for instance, we're onboarding this MTGE acquisition, I mean, leverage came down this quarter, as David mentioned, in preparation for onboarding those assets. We didn't lever up to take that company down -- to buy that company, I mean.

So it's a function of our -- not just our quarterly planning, but as I mentioned, our 2020 plan where I think that the future of this company is we want to attract the yield investor, not just the mortgage REIT investor. And I think the way we're going to do that is produce more durable, longer-term cash flows with lower leverage.

So the biggest risk to this company is, frankly, if we confuse motion with progress and we get out of our skis in any one way because we do see a lot of different things that others don't or don't have the ability to do it, but I don't see us having that problem because of the shared capital model. I really look at the market as we're stressing some of these monoline strategies. I mean, I think those are -- they may be producing current returns that are competitive, albeit they're doing it in one market financed one way at leverage that is a lot higher than ours. So I think that is not the type of business I would like to be compared to near-term or longer-term because I think that's a different type of risk. And even though we're in the same side of an asset class, you're only in one, it's a different type of risk you're taking in that type of model.

Okay, that helps. And then actually just one on the dollar roll balance coming down. Can you just talk about specialness in the TBA market and how that looks in the third quarter?

Sure. This is David. So specialness has dissipated over the recent past. We brought down our TBA balances pretty considerably. A lot of that does have to do with the fact that the Fed is unwinding their portfolio. And as we've talked about in the past, having the Fed in the market taking out that cheapest to deliver bucket as well as just creating excess demand has created specialness for some time, and that's dissipating. And so as a consequence, we think the better value is in pools currently and that will probably continue. Although, I will say there is some bouts of specialness as we've increased in rates, as you get new coupons that are being originated, for example, 4.5 where we gravitated into. That coupon or that contract has exhibited some specialness and they'll be bouts here and there.

Okay. Great. If I could just sneak one more in. The -- your hedge ratio now is 95%. So you're very well hedged. Just given your positioning, do you worry more about rates going up or rates going down?

Well, I will say this. We are almost fully hedged. The risk to us, I would say, is somewhat more to the downside in rates when you just look at the overall symmetry in performance and convexity of the portfolio. But a point to note -- and I mentioned this in my comments about the convexity profile of the overall portfolio -- there is very little call risk in the portfolio right now. For example, we're 50 basis points away, we believe, from having just 25% of our portfolio where it's justifiable to refinance those assets. So we don't feel like we bear much call risk.

And on the extension side of the equation, an important take away from Q2 is that roughly 1/3 of the pay-downs we received on our agency portfolio were on discount securities, meaning that assets that were priced below par, paid down and immediately accretive to par. So that turnover that we're seeing in the market currently has benefited the profile of the portfolio certainly. And so it's a pretty healthy market in terms of convexity for agency MBS.

Let me just finalize it with an anecdote. I think when you talk about our biggest risk, are we worried about rates going up or down? Volatility has hit this market infrequently the past couple of years, but when it has hit, whether rates have gone up or down or what happens if credit is sold off or not. The first quarter of 2016, credit sold off, that's when we've really put a footprint on our resi credit platform and made some very good timely investments.

And by the way, we bought a $1.5 billion public company in Hatteras when -- in the midst of some hyper volatility. And then this first quarter 2018 when things are getting pretty messy out there, we bought another company.

So I think everything's relative. We're not insulated from any risks, especially interest rate risk, but when volatility hits, we've really taken advantage of other weaker players in the sector. And that's why I talked about managing our liquidity is really what we focus on. When we see the market become more risky, that's when we can be most opportunistic.

Next, we have Vik Agrawal of Compass Point.

So over the last 5 years, you've done some acquisitions, including commercial REIT and agency REIT, you pointed about opportunity and -- at credit REIT now. Can you talk about, when you weigh out the decision between build versus buy on the middle market side, and what opportunities you're seeing there?

Sure. I think as it relates to some of -- this is Tim Coffey speaking. I think as it relates to what we're doing organically, we're seeing pretty attractive unlevered yields that are well north of what you would see in the public -- out of the public BDCs and what they're generating from new originations. So we feel pretty comfortable from an earnings yield perspective that we're getting well north of what you're seeing from our publicly held competitors.

And I would also add as it relates to the weighted average underlying leverage of our portfolio relative to the public peer set, we are well underneath where they are. And from a cash flow basis, we believe our portfolio is well north of where they are from a covered standpoint. So all those things considered, from an earnings and a credit quality perspective, we feel like we're generating a whole lot better by doing it organically.

Now, that isn't to say that being able to do asset lift-outs to the extent that there are liquidity issues that may pop up with a BDC or if certain names were to trade-off that we wouldn't be opportunistic. But right now, just given the characteristics that I described earlier, we feel very good about what we've done organically relative to buying.

And then, Kevin, you talked about keeping a lower leverage. What would make you change that mindset? What would you need to see in the marketplace for you to take up leverage a little bit from here?

No, I -- that question, it's a very fundamental question and it's a prudent one. I look at it across the board. The answer is from just a sector and it's always kind of where we'll be opportunistic at certain times at certain spread levels.

I mean, look, I think David can answer as well. We debate this all the time. I think the whole context of this call is that we have a platform that, regardless of what market, we think we can consistently produce returns with lower leverage. If there comes a time or when there comes a time -- I'm not assuming that we're going to be able to -- that we'd want to raise leverage anytime soon when anybody else is talking about it. So we're building more for the longer term on a lower level -- levered diversified model. I saw some commentary where companies are talking about, yes, no problem, we'll go back to 10 or 11x because this sector used to be at 14x precrisis. Well, there's a reason we had a crisis. It's because leverages got too high. And we didn't end up at these levels on -- just by accident. We ended up at these levels because the market, frankly, dictated it, not the operators.

So my long-winded answer is, of course, we could turn up leverage when David and the team sees an interest rate are of opportunity. But we can also increase leverage on the credit businesses if we have an acquisition opportunity or if we want to have a different capital efficiency equation. So it's a different answer for us. I think we're not expecting to nor are we planning on going from 6, 6.5x to 9 or 10x because we just don't have to, to create the return where others don't have that -- they don't have that luxury.

And next, we have Ken Bruce of Bank of America Merrill Lynch.

So you've talked about this morning and over previous quarters the difference in your models relative to a lot of the mortgage REIT peers and certainly the broader universe of investment vehicles. And obviously, getting to lower risk with better returns is kind of the goal and I think you've done a good job of making that distinguishment. But the -- kind of the net of that, you would think is that you would have a lower cost of capital inferred by the market on your shares and that's clearly what you're trying to get to and haven't quite managed to convince the market, for whatever reason, that that's the case. I'm interested in what -- we've talked about in the past, what do you think it takes or if you need to transition shareholders in order to do that. I guess, the question I have today is how -- as you've taken this conglomerate model to maybe paraphrase it, how long are you willing to kind of endure a market that has not quite understood the value in what you've created at Annaly?

Well, Ken, I think your questions are -- as we've said over time, we talked about a lot of the same issues, I think. That's why at this call and -- no quarter is an epiphany because we're always thinking ahead, but the reason I'm focused on leverage levels is I think the market is not differentiating among leverage in not just our sector, but in the market overall. So by definition, we're not getting the credit, to your point, on valuation because the market isn't differentiating returns tied to leverage. That's why I'm focusing on it especially today.

In terms of the longer term valuation recognition for what we're doing, look, I think, just like any other sector, there needs to be change. And not that I'm Jerry Maguire, but I think we got a -- we talked about consolidation and values have lifted because the supply/demand imbalance is starting to be corrected. That's the first thing.

The second thing is a lot of these models -- they talked about their operating expense advantage or they point to their structural advantage, whether internal or external. I just look at -- too many of these companies, frankly, the governance around them and the capital markets activities around them are just -- historically, over the past 10 or 15 years, the sector has been known for issuing too much equity, for instance, this is one example, at the wrong time just when valuations start to peak above book value, for instance. And if I'm an institution and I'm holding a company as a sector and I see that happening over and over again, that's a definite ceiling on valuation. We raised capital last year, a couple of times in 2017. We haven't raised it in 6 years before that. And the reason we raised it last year was the relative value arbitrage in agency -- in the agency asset class. So it's -- that's a big part of it.

I think leverage is not taken into account in returns, right? I think governance and corporate kind of responsibility isn't really been factored in, in terms of how you structure it, again, whether internal or external. And at the end of the day, we're -- our shareholder base has grown very nicely. I think we have been on the road, as you know, a lot, meeting with investors, whether they were current owners or prospective owners, and I think people are getting it. We picked up north of 200 shareholders in the last couple of years, institutional shareholders that are long-term buyers.

And at the end of the day, I think, look, we have a management team here that is putting its money where its mouth is. We're not granted stock. I've asked 65 people here to buy stock with their after-tax dollars over the past 2 years and all 65 have done that and they've agreed to do it for the next 5 years, especially me personally or including me. And I look at other management teams in the sector that have sold over $150 million of stock and they're granted another $350 million on top of that. So there's a lot -- long history to it, but it's our job to continue to just grind it out.

And I think, look, this market -- the rising tide has lifted all the boats in this sector. I think there's too many boats with too much leverage and not enough options. And the more volatile the market is, the better it is for us. And typically, our valuation tends to reflect that. The more volatile marketplace, the big, liquid, diversified players in any industry tend to have a larger valuation premium.

Next, we have Rick Shane of JP Morgan.

I'm looking -- I've been looking at this 31-page PowerPoint. Now, I realize, based on the Jerry Maguire reference, it's a mission statement. Kevin, I was waiting for you to laugh there.

Look, one of the things that you've done is you have layered into a countercyclical business model some pro-cyclical businesses. Our expectation would be, as you do that, that your equity beta actually increases slightly. How do you think about that?

I think about it as, first of all, I'll answer the last half. Our beta, over time, has been half the S&P's beta. And I think it is a function of us combining counter-cyclicality with cyclicality. And it's something that, frankly, the credit -- our credit business, as we look at the portfolio, is not in isolation.

So my anecdote -- and then I'll be -- I'll try to be less long-winded here, but my anecdote is that the Commercial Real Estate business is, by definition, cyclical, right? You're making an investment typically along -- based on rent roll increasing or occupancy increasing and tied to growth of some sort on a tenant basis, which kind of explains why we've been less aggressive there because we think some of those metrics have been overvalued or understated in terms of the risk of that happening given the level of valuation.

Where in the Middle Market Lending business, for instance, and both Tim Gallagher and Tim Coffey can speak to this, but Tim Coffey's portfolio is highly defensive even though we're lending to corporate America. I mean, there's defense stocks in there, healthcare services companies that are not tied to, for instance, the consumer. So even though they're both credit businesses, one's cyclical, one's countercyclical, and you measure those cash flows, regardless of what happens in the macro economy or the micro economies of those investments, it's a natural hedge. So you may not -- we may not be squeezing the extra juice out of everything with financial engineering and with more aggressive under-stabilized property or Tim lending to a tech company, albeit we do that, we just want to have a cash flow matrix that has lower beta with less volatility and longer -- just longer, more easily projected turn to it, which I think, in the past 5 years, I think the counterbalance has worked out. Not to mention what David has done in the portfolio. He turned it over from his predecessors. And frankly, there's a lot of floating rate "exposure" there today in terms of how we're hedging it. This is why we're able to maintain the earnings on the Agency business.

So we balance this stuff out. We debate it all the time. And I think to the prior question, are we getting value for it? I think we get value for it more when there's more disconnect in the market and more volatility. And we all know we've been kind of waiting around for that to happen. And the stimulus has kind of sugarcoated things and made it less fundamental. So that's kind of my answer to counter-cyclicality and cyclicality.

Got it. And I understand from a financial perspective that the incentives are designed to prevent your different business units from taking excess risk. But at the same time, there is always, within an organization the size of yours, an incentive in terms of building businesses -- sort of the business leaders to want to expand their fiefdoms. I -- you talked about your framework for allocating capital in terms of thought process, but I'm really curious, from an administrative perspective, help us understand the decision-making process. Who's involved so that it really is about allocating capital along the lines of what you say?

It's a great question and it's really a softball to me because it really defines how we're unique. We're sitting in this conference room today having this earnings call and everyone in this room is a decision-maker. And it's not a big room.

So I would argue -- or just described it as this. I mean, among our 4 businesses, there's 3 senior people in each of the 4 businesses, along with, frankly, the capital allocation group, which really acts as Switzerland in modeling out the cash flows of that. We get in a room and debate every single investment as a group. I'm not always in the room, but there's risk controls and the investment leaders that debate the -- every last deal. And I think -- look, that's why I make the merchant bank reference because we don't have -- we're not spread across the globe and we don't have people all over the place. The decision-makers are constantly debating in terms of -- in committees. There's an alco committee we call asset liability committee. We have an enterprise risk committee. We have risk wrapped around each decision, but at the end of the day, it's all about relative value, very -- with broad decision-making.

And like I said, we turn a lot of things down. There's heated debate and there's rigorous analysis done and it really comes down to what's the best return on invested capital tied to liquidity, tied to leverage. And I think what we've built now is a matrix where things fall out a lot more frequently. But the things that we're doing, we're doing larger things, larger investments with sponsors, for instance, that we've been working with the past not 2 or 3 years, but 5 or 6, 7 years. And I think we're just having -- we're building that track record of consistency.

But there is a lot of debate. No one acts as -- David's the CIO, but he's not the judge in the jury. Each of the investment teams have senior people that argue it based on the financial metrics I described in my prepared remarks.

Well, at this time, we have no further questions. We'll go ahead and conclude our question-and-answer session.

I would now like to turn the conference call back over to Mr. Kevin Keyes for any closing remarks. Sir?

Thank you, again, once again, everyone for your interest in Annaly and we look forward to speaking next quarter. Thank you.

And we also thank you, sir, to the rest of the management team for your time also.

Again, the conference call is now concluded. At this time, you may disconnect your lines. Thank you. Take care. And have a great day, everyone.