Annaly Capital Management, Inc. (NLY) Q1 2015 Earnings Report, Transcript and Summary

Good morning and welcome to the Annaly Capital Management First Quarter 2015 Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the conference over to Ms. Willa Sheridan. Please go ahead, ma’am.

Good morning and welcome to the First Quarter 2015 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. 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. Participants on this morning’s call include: Wellington Denahan, Chairman and Chief Executive Officer; Kevin Keyes, President; Glenn Votek, Chief Financial Officer; David Finkelstein, Head of Agency Trading; and Bob Restrick and Michael Quinn, co-Heads of Annaly Commercial Real Estate Group. I will now turn the conference over to Wellington Denahan.

Thank you, Willa, and welcome all to our first quarter earnings call. The great monetary experiment began in 2009, predicated on the theory that deflation is a menacing economic conditions that, left unchecked, ultimately leads to depression and should be avoided at all costs. However, a report recently published by the IMF and additionally is supported by the Fed’s own research dating back to 2004 makes a compelling case that asset price inflations, or more commonly known, bubbles, should be avoided at all costs lest they become future asset price deflations. The IMF report covers 140 years of data extracted from 38 economies. With academic precision, it separates capital D Deflation into goods and services price deflation, lower oil prices or healthcare cost for instance, versus asset price deflations, a bursting property bubble or bond market bubble, for example. The authors go on to report that the link between general goods and services price deflations and output growth are weak at best and in fact can actually contribute to better economic growth. Moreover, they cite a fairly strong link between asset price deflation and output growth. The report mentions a few rare periods like the Great Depression which experienced both asset and general price deflations, making it difficult to determine cause and effect. Yet this explains Bernanke’s and now Yellen’s fixation on it. Despite their noble efforts, I believe policymakers have failed to foster the conditions for a credible sustained recovery. They have, however, been very successful in creating both debt and equity market bubbles, however reliant they may be on zero interest rates. Since 2009 when the experiment began, global bond markets have increased in value by roughly $17 trillion, or the size of the U.S. economy, while global equity markets have increased in value by a staggering $40 trillion. Yet the American wage earners have gained a relatively paltry $722 billion in comparison during the same period. Or to put it more clearly, for every dollar gained by the American worker, the global equity markets have the gained $55. I understand the need to inflate away the previous cycles over indebtedness. But I fail to see how encouraging greater indebtedness at inflated asset prices will translate into future sustainable growth. Unfortunately, if policymakers truly hope to avoid the negative economic menace of asset price deflation, they will need to be in a position to maintain their easy money stance for longer than they currently desire. Irrespective of the timing of policy adjustments, we continue to position the company to take advantage of the changing market and regulatory landscape by increasing our investments in talent and infrastructure to capitalize on opportunities going forward. We look forward to the day the central banks permanently retreat from actions that distort the so-called free markets. Before I hand the call to Kevin and the rest of the team, I want to briefly discuss the issue of buybacks. With the stock trading at a discount to book, we are often questioned about buybacks. Unlike a tech or industrial company, we pay out all of our earnings each quarter to our shareholders. We do not have the luxury of retaining our cash flow to expand our investments. Share buybacks come directly out of our capital and I equate it to Apple closing down the very factories that produce the cash flow they used to buy back their stock. Since 1997, our factory has delivered returns that have outpaced both the Dow and S&P by twofold, even after giving us back to the tremendous equity market gains of late. These periods of relative cheapness in our stock have been the same periods that have presented long-term minded investors with attractive value propositions. Since our inception, S&P 500 companies have repurchased nearly 5 trillion in stock. As I mentioned over that same kind period, Annaly has delivered 510% total rate return performance versus 200% for the S&P index. Last year alone, the S&P companies repurchased nearly $550 billion in stock. NLY outperformed the S&P in that same time span. Annaly also substantially outperformed many of the companies that executed the largest buyback plans in 2014. To name a few, IBM, Exxon, Goldman Sachs, Monsanto. In addition to outperforming the S&P, we also outperformed the PowerShares BuyBack portfolio, which is an ETF designed to track U.S. companies that have repurchased at least 5% of their shares outstanding. In fact, the S&P also outperformed that ETF. With that, I’ll hand the call to Kevin to further discuss the quarter’s results.

Think you, Wellington. During our earnings calls over the past few years, we have shared specific views on the cause and effects of QE, its muted impact on the global economic landscape contrasted with the unprecedented influence it has had on my missed every asset class and market for securities Wellington described. We’ve also asserted our belief that the relative calm amidst this supply demand liquidity and balance was rapidly coming to an end in the form of a more consistent volatility as global monetary policies divert. This past quarter, not surprisingly, as data, policy, and regulation head toward lift-off to the unknown, we witnessed bands of volatility in the agency MBS market that were similar to the disruption in the treasury and equity markets, and by relative margin, not seen since the taper tantrum of 2013 and the onset of QE3 in the third quarter of 2012, a period which I will reference again shortly. Amidst this emerging volatility, we’ve also reiterated that our focus on manufacturing shareholder returns is not a month-to-month nor a quarter-to-quarter mentality. As a product of our long history, our disposition toward risk management and capital allocation is best calibrated in annual 3-, 5- and 10-year increments, a consistent thoughtful approach through market cycles and evolution in alternative investment strategies. To put these comments in perspective and illustrate the stability of our strategy on a relative basis, I took a look at the levels of our core earnings versus the rest of the sector since the onset of QE3, obviously a challenging market cycle over the past 10 quarters, during which the Fed purchased 1.6 trillion of agency MBS. Over this timeframe, Annaly produced quarterly earnings ranging from $0.23 a share to $0.35 a share, a $0.12 range that is 60% less volatile than the average for the agency peers. In fact, half of the peers actually had 100% to 200% swings in core earnings over the same time period. Stability of our book value was on average 15% less volatile than the sector overall. And in a broader comparison market yields, although our overall dividend yield over this period was 770 basis points higher on average, Annaly’s core earnings generating those dividends were 30% less volatile than the equity REIT, utility, and MLP sectors over the past 10 quarters. Finally, as Glenn will expand upon on his commentary it is important to note our stable track record of core earnings over market cycles excludes asset sales, which included the gains of over $60 million this quarter. And more significantly, our core earnings include relatively dramatic swings in amortization expense, which amounted to $285 million in this first quarter. Obviously, this equation flips to our favor with the onset of higher rates and slower projected prepayments we see today. Our experience, size, and liquidity are advantages and measurement over time and these qualities coupled with long-term performance are typically determining factors for a particular investment decision, given most of our shareholders own us for stability and security of earnings and dividends. In fact, even going back further than the core earnings stability test, on average Annaly’s current top 20 institutional shareholders have been owners for 19 of the past 20 quarters, over a third longer than the rest of the agency peers. Also, during these volatile markets, 70% of Annaly’s top 20 institutional shareholders were net buyers in the most recent reported quarter, comparing favorably to the peers average of 40% of their institutional owners adding to their positions. Finally, in addition to the evolving strategy in our core business, we talked more recently about the growth of our floating rate credit related strategies, which help only to insulate our book value from certain market volatility but also provide complementary and durable earnings streams for the company. It is important to note that we continue to invest in people across all of our businesses, including a number of strategic hires we highlighted in a separate press release last evening. Expect these moves to continue as we prepare the company for long-term outperformance over the next decade and beyond. Now I’ll turn it to David who will address agency strategy and outlook.

Thank you, Kevin. As we have all witnessed, fixed income markets have exhibited significant interest rate and spread volatility over the recent past given the debate over the timing of Fed lift-off amidst continued global central bank stimulus and its impact on U.S. markets. As Kevin mentioned, we expect these competing forces to persist over the near-term and thus volatility is likely to remain elevated. Mortgage investors are particularly susceptible to market fluctuations in the current environment given the amount of negative complexity that is inherent in MBS portfolios at today’s rate levels. We have been careful not to excessively intervene with respect to managing short-term portfolio duration shifts as overly active duration management can erode returns in a rapidly oscillating market. Rather, we continue to proactively manage our interest rate risk profile in accordance with our medium- to longer-term market view. On the asset side of the balance sheet, our risk management strategy is to maintain a relatively low leverage ratio with a focus on cash flow stability and liquidity. On the liability side, we maintain a significant portion of repo book in fixed-rate longer-term repurchase agreements and the maturity profile of our swap and futures hedges remains conservative. Turning to agency MBS activities. Specifically, I would like to follow-up on some meaningful changes to the composition of our portfolio that we touched on during our last earnings call. The most notable portfolio shift we undertook was a reduction in our specified pool holdings in favor of TBA contracts. The primary catalyst for the strategy was to take advantage of beneficial pool pricing as a consequence of lower rates and investor demand for call protection. Payups on specified pools of certain cohorts reached levels that we felt were rich, which suggests reducing a portion of our pool exposure given the risk of payup erosion should rates trend higher. Furthermore, a larger TBA positions enhances our ability to shift the portfolio composition when it is prudent to do so due to the TBA market’s liquidity, whether that involves rotating back into specified pools as pricing improves or other sectors within the mortgage market. Additionally, investing in the TBA market allowed us to move a portion of our hedges away from interest rate swaps into more liquid treasury futures, also providing greater risk management flexibility. Also in the first quarter, we continued to gravitate back into the 15-year sector which we began to do the fourth quarter last year. While a heavier concentration in 30 years benefited us in 2014, the potential for continued rate and spread volatility over the near term led us to seek greater cash flow stability which 15-year MBS provide. As of quarter-end, our shorter duration holdings including 15-year and 20-year MBS in both pool form and TBA as well as ARMS represented just over 30% of our agency holdings. Lastly, we entered into the residential credit space with our purchase of GSE credit risk transfer transactions. Currently this sector represents a small portion of our portfolio. However, we expect to grow this position if CRT risk reward profiles are attractive relative to agency MBS, consistent with our broader initiative to diversify the portfolio that will help us better manage interest rate cycles in the future. Regarding our market views going forward, we do believe that the Fed will raise rates later this year but we expect the pace of Fed hikes will be very gradual, consistent with current market expectations. Agency MBS spreads are likely to remain somewhat tight given continued demand for the sector and again we are considering the possibility that rate volatility may persist and, as such, we expect to continue to operate with lower leverage over the near term. Lastly, we are confident that recent portfolio shifts have been beneficial to the overall risk and return portfolio of the portfolio while also providing flexibility as market conditions evolve. With that, I will hand it to Bob to discuss the commercial sector.

Thank you, David. The fundamentals of the U.S. commercial real estate market continued to improve in the first quarter of 2015. Compared to last year, investment sales volume was up 45% to $129 billion and property values were higher across all property types. Large asset trades in the gateway U.S. cities led to volume spats [ph] as the flight to quality and insatiable appetite of foreign investors continues. Portfolio trades and entity level transactions have been dominating the headlines recently as large private equity shops, debt funds, and sovereign wealth funds search for opportunities to build large amounts of capital to work efficiently. We expect more of the same in the near future. CMBS issuance was over 27 billion compared to 19.4 billion in the first quarter of last year, an increase of 40%. Despite this surge in volume, spreads remain muted with only slight steepening in the credit curve. AAAs at 85 are flat to a year ago and at 350 over BBB- are just 25 wider. Competition in the lending space remained significant. While the multifamily market represents one segment with potential for decreased competition, given the agency slowdown, condos [ph] appear to be filling the void without missing a beat. At Annaly, we continue to see significant deal flow. In the first quarter we reviewed 177 transactions for $8 billion, closed investments of$391 million and received $82 million of payoffs. As of the end of Q1, our commercial real estate portfolio stood at $1.7 billion. On an economic levered basis, our commercial real estate portfolio was 1.42 and produced a leveraged deal of 998. As Kevin mentioned, the durable earnings stream and risk return profile of our commercial portfolio acts as a strategic complement to our agency investments by providing longer-term primarily floating-rate cash flows for our shareholders. As of today’s date, the amount of our investment activity this year is approximately 70% greater than all of 2014. 2015 closings now stand at 595 million before financing and we have an additional 143 million of investments in the closing process. This new investment activity is highly diversified in terms of number of the positions but it’s concentrated in areas where we are very positive on, including multifamily and retail which combined make up almost two-thirds of new investments in 2015. We think the multifamily markets will continue to see strong rent growth and the shopping center market is just now starting to see shop rent growth after years of underperformance. In summary, we continue to pick our spots on a risk return basis across our various investment products including first mortgages, mezzanine loans, preferred equity investments, JV equity, and securities. We continue to aggressively manage our credit risk as we invest new capital prudently and profitably for our shareholders. And with that, I’d like to turn it over to Glenn to discuss our financial results.

Thanks, Bob, and good morning, everyone. I’m going to provide a very brief overview of our key financial highlights including some additional disclosure that we provided in the quarter based on some of the investment activities that David alluded to before we open the call up for your questions. Beginning with our GAAP results, we reported a loss of approximately $477 million in the quarter. That compares against a $658 million loss the prior quarter. This quarter’s loss, similar to the prior quarter, was largely attributable to losses associated with interest rate swaps. Our core earnings which exclude realized and unrealized gains and losses on derivatives, asset sales, and certain other nonrecurring items was $254 million or $0.25 per share, and that compares against $0.30 a share in Q4. And our annualized core ROE was 7.7% versus 9% for the prior quarter. Factors contributing to the quarterly results were dollar roll income which added about $60 million or $0.06 to core. That was offset by a $42 million decline in coupon income or about $0.04 a share. The decline in coupon income was predominantly due to the large asset sales in the quarter related to the portfolio repositioning that David had described earlier. The sales that we had in the quarter generated $62 million in gains, which Kevin had mentioned, which represents $0.06 a share but again that’s excluded from our core earnings. Additionally, we recorded amortization expense of $285 million in the quarter. That was an increase sequentially of about $87 million or $0.09 a share. Premium amortization is a point in time estimate that fluctuates from quarter to quarter based upon changes and assumptions underlying our estimation of prepayments, among those assumptions being interest rates. For example, if you looked over the past eight quarters, amortization expense has averaged about $190 million and that’s ranged in any particular quarter from as high as $320 million to as low as about $31 million. And as a further example underscoring the variability of this estimate, were we to recalculate amortization expense based upon the current level of interest rates, amortization expense would be about $55 million lower today, which again would translate to about a $0.06 a share improvement in core earnings. And as Kevin mentioned, despite that variability, our core earnings over a relatively prolonged period of time has been in a relative tight band as well. The effective amortization expense in this quarter led to declines in both margin as well as net interest spread. Turning to G&A expense. It was down about $7 million in the quarter. Noteworthy here being that we reclassified certain commercial real estate operating items like depreciation and deal expenses into other count income or loss. If you were to look at a comparable basis, G&A was down $2.8 million sequentially largely related to a decline of professional fees. Turning to the balance sheet. The agency portfolio was down $12.4 billion to $70.5 billion. It included $108 million of agency CRT transactions or securities that David had mentioned. Excluding the effects of consolidated VIEs, our commercial portfolio which includes corporate debt grew about 15% in the quarter. Our balance sheet depicts greater increasing commercial investments, which is the result of a purchase in the quarter of the junior class of Freddie Mac securitization that we were required to consolidate. And that consists of about $1.5 billion of assets and $1.3 billion of liabilities. Our book value declined $12.80 per share in the quarter and leverage as we have traditionally reported it was reduced to 4.8 times as our retail balances declined about $11 billion following the asset sales that were previously mentioned. Given the significant increase in TBA contracts, we have supplemented our disclosure to now include economic leverage which captures the effects of the TBA contract. And that measure in the quarter was 5.7 times versus the prior quarter of 5.4 times. With that, Morra [ph], we are ready to open it up to questions.

We will now begin the question-and-answer session. [Operator Instructions] The first question is from Joel Houck from Wells Fargo. Please go ahead.

Hi, Joel.

How are you doing?

Good.

The market opportunity slide is very helpful on page three. Thanks for that. I guess when you look through, all of the individual asset classes seems fairly similar on a levered basis. The question is, what is the potential for any of those sectors to improve as the year plays out in light of what looks to be some Fed rate increases either middle of the year now I guess looking toward later on in the year?

Yeah, I think when you look across the menu of options presented on the page, what we do have to take into account is which asset classes are going to respond more quickly to changes in policy as you assemble them together and try to make the most solid earnings and risk profile. So I would say obviously commercial assets and even some of the credit risk assets would have a slower response time but also an associated lower liquidity profile as well. So, we try and take all of that into account as we look at the relative options in the basic numbers looking relatively the same but there’s a lot of subtle differences that will come through with respect to how the liquidity in the marketplace for these various options plays out as the Fed starts to hopefully at some point retreat. I don’t know if that answered your question.

Yeah, it’s helpful. I guess as a follow-up, one of the things we see from some of the mortgage REITs is they’re moving into the MSR business, mainly through flow. What’s your viewpoint of that or even potential bulk purpose given the disruption with some of the publicly traded services out there?

Hi, Joel. This is David Finkelstein. I would say that with respect to MSRs, it’s something we look at on a regular basis. As a substitute for that product, we do have an I/O portfolio which has similar characteristics in terms a positive yield with negative duration. So there is some hedge to the broader portfolio. But generally speaking, the MSR space is a very different trade insofar as there are lot of legal and regulatory hurdles associated with that trade. So to the extent we did enter that market, we would have to be comfortable with the environment with respect to those hurdles. And as we’ve all seen over the past number of months, there has been a lot of litigation and other factors that have potentially led to an unclear view of how the MSR market will shape up going forward. So again, it’s something we look at on a regular basis. We’re not inclined to get into the market right now.

One thing I’ll add to that, I think when you’re in this transition, hopefully we’re in this transition period on the policy front. And my comments, I don’t know how many calls ago, I talked about the fact that the regulatory framework or the changing regulatory framework has not really been put to the test in a retreating liquidity environment. And so, we’re mindful of trying to make sure the composition of the portfolio is as liquid as it can be. And one of my sayings is make sure your liquidity is liquid. And what we try and do is make sure whatever vehicles we’re using to hedge or whatever vehicles we’re using to offset potential moves in interest rates, we want to make sure that we are thinking about holistically in what kind of response the market will have as things start to change.

Joel, I think I would just say one last thing. I think in this environment that is everyone is talking about volatility. It’s the word of 2015. We were set up for this. We’re happy that we’re not a mono line. We’re strategically positioned to - there’s different products within David’s portfolio that we can use, not only just to hedge but to frankly generate incremental returns off that volatility. But you heard Bob Restrick on the commercial business, you will see - I mean, you’ve seen a lot more activity there this year versus last, 70% more year to date. That’s really based on, frankly, relative value And if this volatility continues, and we expect that it won’t go away anytime soon, we’re all for adding layering in the durable earnings, those five-, six-, seven-year cash flows from those investments. And I think that’s what we set out to do when we bought CreXus a couple years ago. And no, we haven’t been amping it up or chasing volume at the expense of risk but that’s been by plan. I think now what we’re seeing is just this volatility in the agency market relative to the durability of the commercial market. We’re pleased that we have an option for both and I think you’ll just see continued progress in that in building that complementary mix.

All right, thank you very much. Sounds good.

Thanks, Joel.

The next question is from Doug Harter from Credit Suisse. Please go ahead.

Hi. This is actually Sam Cho filling in for Doug Harter. I wanted to understand your reasoning behind investing in the GIC transfer during the first quarter. More along the lines of why was the timing right as opposed to the previous year? Thank you.

That’s a good question. First of all, with respect to broadly speaking about credit risk transfers, the benefits that we’ve talked about in terms of diversification are clear. They’re floating-rate instruments and it’s mortgage credit, which tends not to be correlated with the rate and convexity trade associated with the agency markets. So it’s a very good fit for the portfolio. And in terms of why it came onto our radar, there’s a couple reasons. Number one, that spreads looked attractive to us. They were relatively tight for most of last year and they did become more attractive as the year progressed and into the first quarter. So that’s what, from a relative value perspective, that’s what gave us the impetus to get into the sector. The second reason is that we are hopeful and we have seen some evidence that there are going to be more of these types of customize credit risk transfer transactions that do cater to the REIT business model. The traditional structures, the cash flows are not directly derived from the real estate assets so as a consequence, they’re not part of our good REIT income bucket but nonetheless we have plenty of room for the traditional structures but we are hopeful that as the market evolves, there will be more customized deals that cater to REITs. So our footprint is obviously in the traditional structures but we hope to expand it more into the customized structures.

Okay. I have a follow-up question. The repositioning of the agency portfolio, this really depends on market conditions but do you continue to see you guys moving towards the TBA contracts and the shorter maturities in coming quarters?

I think we’re in a good place with respect to how the portfolio looks currently. I would say that dollar roll specialness is still prevalent in the current coupon portion of the agency market and so there is some benefits and some rents to extract from financing. I don’t see us increasing it meaningfully but, that being said, it depends on the relative value between TBAs and pools. If specified pools appreciate further, then we would consider adding to it, but right now we’re at a good place for us. To the extent specified pools cheapened back up, as I mentioned in my comments earlier, then we would very likely go back into specified pool sector. But it’s purely relative value.

Right. So for the coming year, I guess can we think of it as more of the same? I mean, will it stay pretty constant? Or I guess there’s some variability.

There is some variability. We’ll see how the market evolves. It hasn’t changed materially since the end of the quarter but we don’t know how it’s going to play out.

Okay. Thank you so much.

The next question is from Brock Vandervliet from Nomura. Please go ahead.

Hi, Brock.

Thank you. Hi. Thanks for taking my question. In terms of the TBA, could you talk about during the quarter when you got that on, how quickly it built to the 14 billion or so that we saw at the end of the quarter?

Sure. We began the trade at the beginning of February. Actually the market initially sold off after the January payroll print and that gave us a little bit of a tailwind as specified pools were somewhat sticky in the selloff. So we were able to sell our pools into a good bid given the demand for call protection. And then the TBA market that was selling off as well. But given the duration differential of pools versus TBAs, we felt that we got very good execution. We completed the trade in about three to four weeks and all during the month of February.

Okay. That’s very helpful. So, you got about two-thirds of the quarter on for full contribution?

No, no, I would not say that. The settlement period for TBAs is in the middle of the month. So in the month of February, we got a small portion of those contracts on and then the bulk of which actually came on in March.

Got it. Okay. That’s very helpful. I didn’t catch the beginning of the call. Could you talk about the CPR speeds throughout the quarter? And maybe touch on what you’ve experienced going into Q2?

Sure. CPRs were slightly elevated from December. We obviously had a meaningful rally in January and that led to a lot of borrowers to take advantage of those lower mortgage rates. It does take time obviously for loans to close so we didn’t see the peak of repayments in the first quarter. In the second quarter, prepayments are elevated, as I’m sure you’re aware. Our portfolio for the month - or rather the report we received April in May, we have both of those as we got our prepayments last night for May. And they increased a small amount to roughly 12 CPR in each of those months versus nine CPR for the first quarter. It’s likely if rates do remain at these levels after this recent selloff, it’s likely that the second quarter will probably be the peak of speeds given we are also getting into the summer seasonals. But that being said, it’s all rate dependent. If the mortgage rate holds above 4%, then I think second quarter will probably be amongst the fastest. But if we do rally back, then we could see faster prepayments going forward. Another point to note is that our portfolio speeds are roughly two-thirds of that of the overall agency universe, so the specified pool trade does help cushion some of that.

Okay. Thank you very much.

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

Thank you, everyone, for taking time to participate in our Q1 call. We look forward to speaking to you after Q2. Thank you.