Annaly Capital Management, Inc. (NLY) Q2 2016 Earnings Report, Transcript and Summary

Good morning and welcome to the Second Quarter 2016 Annaly Earnings Conference Call. All participants will be in listen-only mode today. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Jessica LaScala. Please go ahead.

Good morning and welcome to the second quarter 2016 earnings call for Annaly Capital Management Inc. Any forward-looking statements made during today's call are subject to risks and uncertainties which are outlined in the risk factors section of our most recent Annual and Quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the forward-looking statements disclaimer in our earnings release, in addition to our quarterly and annual filings. Additionally, the 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 that this event is being recorded. Participants on this morning's call include; Kevin Keyes, Chief Executive Officer and President; David Finkelstein, Chief Investment Officer, Agency and RMBS; Michael Quinn and Jeffrey Thompson, Co-Heads of Annaly Commercial Real Estate Group; Glenn Votek, Chief Financial Officer; and Tim Coffey, Chief Credit Officer. I'll now turn the conference over to Kevin Keyes.

Good morning everyone. Administer the distraction of the constantly streaming financial, sociological and political news cycle of an election year, corporate earnings and the interrelated trends around these net cash flows are the most obvious and yet perhaps the least fundamentally analyzed product of our Central Bank in government influenced macro and micro economies. The continued outpouring of global accommodative policy continues to drive disparate correlations between market fundamentals and valuations, once a phenomenon which is now become the norm across equity and credit markets across the world. With approximately two-thirds of the S&P 500 Index members haven't reported this quarter, earnings are down over 3% in the U.S. marking the fifth straight quarter of declines. Asia and Europe have fared much worse, earnings have plummeted 19% for the largest companies in Asia, and it dropped 14% so far for the European 600 Index members. Operating profit margins for the S&P 500 fell below 12% for the first time since 2010, and yet against this backdrop, this widely accepted measure of corporate America's value now trades it at historically high PE ratio north of 20 times, an aggregate level not seen since 2004 when the earnings were actually growing 20% representing the standard and reasonable one to one PE growth ratio which certainly does not exist today. Given this continued meltdown in corporate earnings. It's no surprise that U.S. GDP growth averaged only 1% in the first half of 2016. These falling dominoes obviously impacts Fed policy, in order to reach the Fed's growth projection for the year, a level which may potentially justify an additional rate increase, assuming the rest of the world economies are mistakenly ignored. Growth in the second half of the year will need to accelerate to 2.9%, a level not seen in two years and almost two times the average growth rate over that same timeframe. In recent history to mortgage REIT industry has been under pressure as the proxy for lift-off and higher rate. Now that there is a growing and broader acceptance of our longstanding thesis of the need for lower rates for longer, the paranoia that has surrounded the sector and other yield manufacturing industries has begun to dissipate, especially for the larger, more diversified participants. Another significant and recent development in our industry has been an appreciation for the positive impact of consolidation. On July 12, we closed the acquisition of Hatteras, the largest mortgage REIT acquisition ever which illustrates the advantages of our enhanced size, liquidity and diversification, as well as the highly experienced management team that manages Annaly. In a shrinking world of declining profits and margins I just described, with this transaction Annaly has actually uniquely grown its asset diversity earnings, book value, and capital base by over $1.3 billion, while maintaining a leverage ratio of approximately 25% lower than our peer average. Over the past 12 months we'd anticipated, the industry's need for strategic combinations and the rationalization of certain operating models in the sector. And now, since the announcement of our acquisition of Hatteras in April, the market has recognized the numerous benefits associated with this industry-leading transaction with the sector rising in equity value by over $5 billion and Annaly shareholder value increasing by over $500 million in just three months' time. In addition, this past quarter in accordance with our strategic plan of both asset and funding diversification, we secured incremental term financing across all four of our businesses financing the 25 product strategies across our four main asset classes, now includes a dozen funding options adding to our capacity for growth while, as importantly, insulating us from the obvious risks, mono-line strategies faced today. In addition to focusing on the breadth of funding sources in capacity, we have concentrated on term and lengthened our maturities when prudent, a critical component of our financing strategy given the current market reality of the impact of money market reform on LIBOR. Specifically, within the Agency Residential Credit in Commercial Real Estate businesses, we are actively managing our $3.6 billion financing line with the FHLB. This type of financing with its low cost four-year weighted average maturity may be flexibly deployed across these multiple strategies, as our capital allocation strategy dictates. We have also increased capacity under an existing credit facility by 75% to $350 million for the Commercial Real Estate Group and obtained a new $300 million line for our growing middle-market lending platform. In the Hatteras acquisition, with our underlying liquidity, broad financing access, capital [ph] broker-dealer, we seamlessly on-boarded the largest industry acquisition ever, settling a $11 billion of collateral in a single day, barely impacting the firm's overall balance sheet risk ratios. Concurrent with achieving scale across our investment platforms, the plan has been to increase the dedicated financing for each strategy resulting in a more optimal use of our equity across the firm. And it's expected to drive enhanced returns on this invested capital in the second half of this year and beyond. As we enter the second half, while numerous other yield-oriented mono-line strategies are strapped with unsustainable fixed operating cost, lack liquidity and struggle for accessed funding, Annaly remains in growth mode. The liquidity of our balance sheet with unencumbered assets 11 times larger than the median market cap of all 34 mortgage REITs coupled with the liquidity of our currency, our average daily trading volume of our common stock is greater than 70% of the sector combined, uniquely positions us to take advantage of both the internal and external growth opportunities we see on the horizon. Our diversified investment model as a broader real estate finance company is capturing market share in the competition for asset selection, financing terms and finite balance sheet capacity; and relative to our various permanent capital competitors and peers, Annaly has evolved into a liquid alternative asset manager and the equity yield investment option noticeably distinct from the mortgage REIT universe in terms of our stability, diversity, liquidity and size. Now I'll turn the call over to David Finkelstein, who will discuss our agency and residential credit, results and outlook.

Thank you, Kevin. The second quarter saw the passing of a major risk event with Brexit representing a tremendous inflection point across all financial markets. After signs of renewed stability in markets and expectations of continued rate normalization earlier in the quarter, the results of the UK referendum drove a rally across the yield curve with the 10-year note finishing inside of 1.5%. In addition, the outcome of the vote created sizable political and economic uncertainty and increased expectations for central bank accommodation around the world. As a consequence, fixed income investors were forced to re-examine the relative value equation as 10 developed market economies currently have negative yields on a meaningful share of their outstanding government debt. Given agency MBS is attractive liquidity and relative yield advantage, the sector performed reasonably well in this global hunt for yield, despite volatility in prepayment concerns as overseas investors bought sizable amount of agency MBS. In fact in the first five months of this year foreigners have purchase more of the agency sector than what most strategist expected for all of 2016 at the beginning of the year, a trend which we believe should persist in the second half of the year. With respect to our portfolio strategy on the agency front this quarter, we adjusted the composition of the portfolio, primarily to accommodate the on boarding of the Hatteras assets. Given the high concentration of ARMS held by Hatteras, we reduced our holdings of shorter duration, 15 and 20-year MBS and rotated into longer duration 30-year MBS. This was also an extension of our continued strategy to enhance the durability of the portfolio as over the past year and a half we've actively reduced the portion of the fixed rate portfolio without inherent call protection from roughly a third of the portfolio to under 10%. As gravitation into 30 years also fits with Hatteras MSR portfolio, where longer-dated securities provide the appropriate hedge for the negative duration of the MSR aspect. Of additional note with respect to hedges, we also reduced our swap position and replaced a portion of those hedges with Euro-Dollar contracts. Combined with the existing Hatteras hedges this equates to roughly $15 billion two-year equivalents in short Euro-Dollar contracts for our portfolio. Turning to residential credit; spreads tightened over the quarter which served as a driver of the more modest growth in the portfolio. We did ship the composition of portfolio as we prepared to take on roughly $400 million of Hatteras's non-agency assets. The residential credit portion of our investment this past quarter was largely focused on the legacy RMBS sector where secondary market supply was reasonably healthy and valuations appear favorable to us. Furthermore, given that Hatteras assets are predominantly composed of new origination loans, the legacy sector provided us an opportunity to add seasoning to the portfolio. Of additional note, as anticipated, we have wound down Hatteras jumbo-prime origination conduit, though we may still pursue hold on purchase opportunities through other third-party channels depending on the economics for the sector. Now I would also like to expand on Kevin's comments with respect to our financing in the current environment, particularly as it relates to the on-boarding of the Hatteras assets. Prior to the close of the merger, Hatteras assets were funded on a short-term basis and on the closing date of the acquisition, we were able to seamlessly role nearly $11 billion in Repo contracts with an average term of 180 days, predominantly on a fixed rate basis. The vast majority of those Repo agreements were conducted with primary dealer counterparties whom we view with high-quality, consistent and stable financing partners. And we have also been able to optimize the use of our own broker-dealer through this transition. More broadly with respect to our Repo strategy, our methodical approach to financing and the term structure of our Repo is extremely important in today's environment where Money market reform and Brexit had pushed 3-month LIBOR to its highest levels since May of 2009, over 15% of our Repo is termed out over one year which helps to cushion the impact of fluctuation in short-term rates and we do not expect a meaningful increase in financing costs over the very near-term. With respect to our views going forward, we do expect continued global uncertainty as political risks remain high, and economic growth remains weak. We are cognizant of the risks within the broader European banking system and regulatory changes such as money market reform implementation in October; and the combination of all of these factors suggest that it will be difficult for the Fed to hike this year. While we do not anticipate a meaningful market rally from here, we do expect the reality of low yields to remain with us for the time being. This creates a reasonable environment for Agency MBS as valuations are fair and the Global Bond rally should continue to demand spillover into our sector. We do not expect to actively increased leverage, however, as the Hatteras acquisition has achieved that for us and we are comfortable with our post acquisition economic leverage of roughly 6.6 times. This still places us on the lower end of our historical leverage while allowing us to deliver what we expect to be attractive and consistent returns. For non-agency assets, positive housing and consumer fundamentals in the current rate environment should provide a favorable landscape for continued investment in certain sectors. Even though credit spreads are tighter quarter-over-quarter, under our longer term lends, we still view the asset class is attractive relative to historical levels that spreads are still wider than mid-2014, despite equities being at post-crisis highs; therefore we do expect to continue to grow our residential portfolio over the remainder of the year. Now with that, I'll hand it over to Jeff to discuss the commercial portfolio.

Thanks, David. The fundamentals of the U.S. commercial real estate market continues to demonstrate resilience for the last quarter, although some markets and property types are seeing deterioration. In addition, the publicly-traded capital markets have continued to build on the improvement from last quarter. Equity REIT share prices are up 30% since early February lows, and have reached new all-time high, nearly 5% past prior peak. CMBS spreads have continued to tightening trend started last quarter. In the last 30 days, AAAs have rallied approximately 10 basis points to 15 basis points or 10%. BBB have rallied approximately 30 basis points to 40 basis points or 5% improvement. The moves in the CMBS market have largely followed the broader rally in credit markets. Turning into market transaction volumes, second quarter 2016 acquisition activity was significantly below the comparable period in 2015; $105 billion of property traded hands in the second quarter, a year-over-year decline of 14%. Volumes did pick up towards the end of the quarter as a 25% decline in May was followed by only a 4% decline in June. CMBS volume was also significantly lower with $11 billion of issuance in the second quarter, a 59% decline from the same period last year. As we observed in our last conference call, property pricing has leveled off but not yet been impacted negatively by the slowing transaction activity. As of June 30, 2016, our commercial real estate portfolio stood at $2.4 billion, net of leverage or net economic capital invested in commercial real estate was approximately $1.5 billion, and is producing a levered yield of 8.6% excluding one senior loan held for sale on levered yield of 9.4%. The new business pipeline has picked up as we continue to be very patient and committing to new deals. We have begun to see an increase in opportunities coming out of the elevated maturity way and increased regulation on other market participants. In anticipation of realizing on these new opportunities, we increased our capacity for external financing during the past quarter. We will continue to focus on high quality borrowers with cash equity in new deals, our priority remains the preservation of capital while providing our shareholders with longer-term -- primarily, floating rate cash flows as a strategic complement to our agency portfolio. With that I would like to turn it over to Glenn to discuss our financial results.

Thanks, Jeff and good morning, everyone. I am going to provide a brief overview of some of the key financial highlights in the quarter before opening the call up for your questions. But first, as we've mentioned on the previous calls, we continue to enhance our financial disclosure to provide investors and analysts key information that we as a management team rely upon to both manage and assess the performance of our business while also taking into consideration, regulatory guidance and interpret their releases. So for example, as I'm sure you all know, these non-GAAP financial measures has been an area of increasing focus for the SEC. Beginning with this quarter's results, we've reduced the number of non-GAAP metric to those relevant to management. We've eliminated the normalized core metrics from our disclosures but are still quantifying and disclosing the impact of quarter over -- changes in CPRs, that being what we refer to as premium amortization adjustment. As part of core earnings which has now been redefined to remove the effect of the premium amortization adjustment. And of course, it goes without saying that non-GAAP measures should not be viewed in isolation, and they are not a substitute for financial measures that are computed in accordance with GAAP. So with that turning to the results for the quarter. Beginning with our GAAP results, we reported a net loss of $278.5 million in the quarter or $0.32 per common share which compares to a Q1 net loss of $868.1 million or $0.96 a share. Both quarters were significantly impacted by unrealized losses on our interest rate swap hedge portfolio. The quarterly improvement was largely attributable to a favorable movement in the hedge portfolio mark-to-market value. Our core earnings, which exclude the premium amortization adjustment, were $282.2 million in the quarter or $0.29 a share that compares to $0.30 a share in the prior quarter. Our core ROEs were relatively stable at 9.7% versus 9.9% in the prior quarter. Some of the key factors contributing to the quarterly results were the decline in interest income for the commercial real estate portfolio along with some additional amortization and depreciation expense which related to some final purchase price allocations that were required for a commercial real estate investment, which in combination of those two items represented about $0.02 a share. Our average repo rate was up about five basis points while slop expenses were down on higher received rates as well as lower notional balances, all of which represented a lower economic interest cost in the quarter by that of penny, our projected C.P.R. period end was 30% that was up from last quarter's 11.8% Q2 reported premium amortization expense was $265 million versus $356 million for Q1 and this resulted in a premium amortization adjustment in the quarter of $0.1 versus $0.19 in Q1. Both quarters net interest margin and net interest's spreads were flat on a sequential basis and G&A expense although being up about $1.2 million actually included about $2.2 million transaction related expenses, associated with the Hatteras acquisition. So our efficiency metrics remain strong with annualized operating expenses excluding the Hatteras acquisition process being about twenty four basis points and that's actually down slightly on a sequential basis. Turning to the balance sheet. residential investments portfolio was relatively flat with a slight increase in the reset credit portfolio, the sale of approximately $115 million help for sale loans contributed to a decline in the commercial investment portfolio, and are middle market lending business was up slightly in the quarter as well. The combined portfolio of credit investment which includes a ready credit commercial, real estate and middle market corporate lending at that represents 24 % at the end of the quarter. And finally book value declined slightly to $11.50 a share leverage as traditionally reported with flat at 5.3 times and our economic leverage which captures the effect of the TVA contract declined slightly the 6.1 time. So with that ma'am, we're ready to open up the question.

Thank you. [Operator instruction] First question comes from Douglas Harter of Credit Suisse. Please go ahead.

Hey thanks, this is actually Josh Bolten filling in for Doug. Amortizations expenses down in the quarter are just curious any updates on how residential prepayments are trending this far in 3Q. And also how you guys saying you know what C.P.R.'s going forward given the current low rate environment. Thanks.

Sure. Just this is David with respect to prepayments over the near term. They have turned it a little bit higher this past month relative to last quarter and probably one C.P.R. higher in this past month we do expect a slight decrease the current month which will find out tonight actually. Just given date, time issues and then will pick back up again the following month. so they'll bilk over the near term will probably be one of the two C.P.R. hirer we're getting out of the summer season also, we do think the peak will occur in probably September based on these rate levels and we'll see where rates go from their current 30 year mortgage rate at about three by these or thereabouts. There's still a lot of -- A lot of loans that are in the money and prepayments should remain elevated but the summer months of probably -- late summer months probably can see that peak.

Thanks and second question talking about lower leverage you gets a slightly lower leverage than your peers. It looks like leverage is going to be up after with the on wording of the Hatter's assets, how should we think about leverage going forward and it is 6.5 or 6.6 times that you mentioned with Hatteras assets a good look at level and finally what do you guys need to see in order to take leverage up from these levels.

Josh, it is Kevin I'll start on and let David Fill in the gaps. I mean we you know we're asked this question as you ask it of others quarter-after-quarter, month-after-month in terms of leverage that in the way the simplest way that we think about it is it's really opportunity cost really and risk, and you know the way we look at it is we're backing into a return that a risk weighted return for all four of our business is tied to the underlying liquidity. so leverage is it's part of the equation but it's not the determining factor, the Hatteras acquisitions a perfect example if we would have been more aggressive or if we would have been less liquid, we would have been able to move like we did in that transaction. So the way I look at it is we weigh all our opportunities in terms of where we can put our capital and we layer on leverage in the right side of the leverage maintaining frankly the biggest focus around here is with quiddity. So we're Hatteras we've picked up $165 million of core earnings. And a nice a relatively modern sizable discount to the value of those earnings, and frankly were able to do that in less than three months and on board in a day and extend them maturities of the collateral five or six times out further, because we were conservatively position. The other part of it and I will let David speak Probably in more detail about the businesses pacifically but the credit business is the three credit businesses that we have, their loan they're obviously more -- they're less leveraged in nature, we can capture the same amount of returns without the type of leverage in their floating rate and they're complimentary to the interest rate strategies, so by definition since we have those businesses and their sizeable we can generate the same type of return with less leverage which points as to why we're at it while we're at it you know 25% to 33% less levered then among on a line out there. So it's a combination of factors we don't think that this is the type of market we should torte leverage to generating comment on return because frankly in a 10% or 11% dividend in this world or no yield. We don't think that's a prudent strategy based on what value we get from the market for it.

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

Thanks for colors guys.

Thanks.

Our next question comes from Bose George with KBW. Please go ahead.

Thanks, good morning. A couple of questions I was on some other calls them some might have been asked earlier. But just first on your credit -- the capital that's in you know in the credit area just have you talked about how large it could that could go over time is there kind of an upper bound for that.

We didn't miss it. We didn't we didn't address that specifically. So you know we have -- it's hard on the market. I think we want to be fair and in managing expectations that you know in terms of what this platform can generate on the credit side among the three credit of businesses, right now we stand at about as about a quarter of the capital in those businesses. I like to remind people that that from you know this time last year that some from 14% to 24% that's a 70% increase. So we think we've grown the business as nicely going forward I think the easiest way to think about it is to calibrate we told the market up to a third of our capital could be moved into three credit businesses, in the next so six to nine months. but that's kind of the beauty of our model our model, It's all relative value driven and as we've talked before with you that we don't have a gun or had in any sector and it's tough find value at the risk -- level of risk that we want to take but we're thankful that we have 25 different options in terms of products among these four businesses, because we obviously have the optionality that no other company does in the sector. So we have the options we can we can move with the same business platforms and business plans in with our liquidity. It's really that the ending -- the end driver is really how we weight the risk of the return among all the strategies and as I mentioned before you might join just liquidity underneath those investments we need to maintain that to make sure we're flexible for when something opportunity comes along like a Hatteras transaction, or a large commercial deal that we did you know few quarters ago but if it's 25% now it could go up to a third, but if it does then it's just because there's relative value somewhere else. The last thing I would say which in my prepared comments if you missed them we have structured finance, we have term financing now in this quarter that we've captured for the middle market lending this is an incremental capacity for the commercial real estate business, so by definition we don't need to put as much capital the work we can use that financing to preserve our capital and still capture the return. So that percentage may stay the same even if -- even if we have more assets on it in terms of the percentage as a capital because we have the financing -- more financing today than we did a couple months ago.

Okay, great that's helpful. And then have talked about where you see the best incremental value.

Yes, this is David. In my comments as well as Jess I think we did talk about increasing our investments in the credits sector, and I think that on the residential part of the equation, There are some sectors that are now perform like non-performing loans securitizations about perform as well as jumbo prime securities AAA off the crimes but the CRT still represents reasonable value as creditors transfer, as well as Will legacy sector where there's $600 billion in bonds still outstanding and we have seen some secondary market trading in that sector over the past quarter, and we expect that to continue So those are two areas where we can find value and ready space and Jeff can add any commercial.

Sure. So we're you know whether it's regulatory or seem to be a structure that separating liquidity issues out there in the lending front where so our plate is robust and we expected to be so for the next couple of years. So you know we're seeing great value out there with respect to the lending environment, we're being selected to when we look at our investments about the value of across the firm but we're positive on what we see coming up.

Great, thanks a lot.

The next question comes from Joel Houck with Wells Fargo. Please go ahead.

Good morning. I am wondering if you can maybe talk about the geography of the book value composition or change in -- in the second quarter. I mean what I think huge but it was slightly down which is somewhat not what we were modeling. Can you talk about the composition of agency net of edges and ready credit how much you want to contribute or took away from book value in the second quarter.

Sure. Joseph this is David with respect to be asset side of the equation. As I said the portfolio we didn't change much. We did shift out of 10 in the 30 but it was largely unchanged that should have been somewhat consistent with your model and credit actually did appreciate to some extent where you know we did suffer I guess was $0.11 in book value deteoration in or just under inside of 1 % was primarily on the on the head side. I think going into Brexit which obviously was a binary event, book was trending higher. We did take a conservative posture heading into that, when we all know how the outcome of that materialized, so we were a little defensive heading in the Brexit set and also our hedges were further out the curve and the curve obviously flattened quite a bit last quarter 16 to 18 basis points depending on with -- depending on whether you're looking at slots or treasuries and half of that flattening occurred post-Brexit it so that's essentially it it's on the it was primarily on the hedging side where we were more conservative than you might have modeled.

Okay, that was helpful Thanks David and prospectively if you obviously you guys buy Hatteras for much lower price to book where the assets are trading I'm assuming it was no evaluation adjustment as to overall affect or improves you close in July. There may be a range of book value contribution we can think of from the Hatteras deal that we'll see in Q3.

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

Okay, thank you.

Our next question comes from Jessica Ribner of FBR & Company Please go ahead.

Hi, this is Tedd here for Jessica. So first off do you guys think the C.R. origination will continue to slow.

I think it will continue to so slow for some of the parties that we've mentioned earlier you know just enhanced regulation in CNBS or a structure everybody seen a pretty significant drop in CMBS. I think the market will adapt. I think the drop a significant this year for a couple of years though nobody know exactly what it would look like a star from using some of your first pools come to market under the new structure so I could see CMBS picking up, at their peak I think there were $220 billion in my Q this year. You know I will throw out a guess for next year but there's no way to get back to the peak so the revive way that's coming over the next currently coming we're seeing deals now, there originated 10 years ago looking for refinancing you combine those two factors and it creates a great opportunity for a balance sheet -- flexible balance sheet like we have floating with that.

Okay, sounds good. And secondly can we expect any more acquisitions. Is this a possibility going forward.

It's a question we are asked a lot now that we've done one. Well we don't need to do acquisitions to meet our returns targets and meet the financial metrics that the market expects, I view are our prospects is we have four scalable businesses that can grow internally, and external growth that's what I would call that acquisition is kind of the cherry on top. So you have seen a lot of people doubt it I think some of the -- some of the activity but I think it's been healthy for the sector obviously I think we've gone from 41 mortgage rates to you know there's been 5 that have been taken out in a couple that have been restructured which I think are healthy for the industry, but that's not the say I would project that we would -- We're not we're not banking on doing a specific number over a specific time period because we don't need tom

Okay, thanks guys.

Our next question comes from Ken Bruce of Bank of America. Please go ahead.

Good morning thanks guys. I see you back year old cheery self. My question I guess kind of stepping back and looking at the longer term, I guess is the last year they ROE kind of migrate a little bit lower. And you know a couple various kind of moving pieces within that it looks like you know T.B.A. dollar all income is to come a little bit less it's been offset by little bit less swap expanse a little bit less premium amortization. My question is do you think you can get back to a point where yields can grow from here or is this a situation where what you see in terms of the return profile is probably as good as it gets and frankly with the flatter curve maybe even grows lower from here or is there something that you can do Aside from maybe just gearing up the company to increase that the yield in the portfolio.

Ken, I'll start. First of all, we're cheery about our business prospects. I think your comment on -- your question about returns I mean that's what I'm focused on if you're on the front of the call I just focused on the market economy as it is mean we are talking about dearth of yield out there given what's going on the central banks you know the irony is that there's a dearth of earnings power in this economy. So all this all this money supplies it wasn't by design We the will be shrinking everything. So for us if we can maintain our returns in this environment that are the widest is frankly arbitrage spreads or the yield in the history of the company and we do have history that most others don't I mean I think that's pretty good and I think as you and I've talked and debated as long as we have -- as long as we build the model that's diversified liquid and frankly a little bit more hopefully even more predictable terms of cash flows then I think you know if the returns stay the same we should at least be somewhat rewarded in some form of premium you started to see those values, as you know that just let the bifurcate for those models are larger more liquid in and are more durable. So, and that's just not my elevator in the speech it's relative to the marketplace and we're not. We'd love to have incremental returns and I think Hatteras was it was a deal that provided that right we bought discounted assets that were basically in a primary market. We didn't' buy them in the secondary market plus a unique opportunity, but we're not going to have those every quarter, but I think we've really weight our returns relative to not just the sector, but to the market overall. And I think if get more cash-on-cash returns that are double-digits in this world you look at the any sector ROEs and leverage especially in the financial part of the world that you know think that's pretty competitive and I'll leave it to the market, to value it I don't think we're going to reach, nor should we haven't been. We've been overly conservative as you and probably less -- and others for I think good reasons. We're in this for a long time and I think that shareholders won us because we're really good part of their risk taking portfolio, don't really have to worry about them.

And Ken, this is David. I'll just add to your observation about the trend in dollar roll income and that's correct. Beta rolls [ph] have not provided as much value and that's because the market hasn't provided as much value given the fact that the curve is flattened quite a bit and the carry has deteriorated somewhat. With respect to going forward, we'll take what the market gives us. There is -- we've seen quite a bit of flattening in the yield curve is inside a 50 basis points and about 85 basis points in treasuries. What's interesting to note is that if you look what the market's priced in two years out, there is no more flattening expected when you look at the swaps curve and there's about 20 basis points of flattening still left when you look at the treasury curve. So, if the market's right, then we can continue to hopefully generate a reasonable return in this rate environment with a 10-year note around 1.5%, but at the end of the day we'll see how the market evolves and that's going to determine where returns go. And it's also important to note that we have evolved, as Kevin addressed, and we've moved a lot of our portfolio into shorter-duration loading rate assets on the credit side and that's helped us maintain stable earnings over the recent past.

I would agree. I mean, the Annaly today is very different than the Annaly from many years ago and you know I think the risk is considerably lower, given kind of the nature of leverage and kind of the portfolio position. It is what it is, it just feels like the reality is that we're kind of living in this low-rate environment and you guys are producing a very high return, I would agree that you have -- the market's got to figure out where it wants to price a yield of this nature. It's at the widest ranging that we've kind of looked at and maybe that changes over time. I just wanted to get a sense to stay where you think it can -- incrementally you can squeeze any more out of it without taking more risk. I guess the answer is no, it's really just about maintaining a very healthy return profile that you've got today.

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

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

Our next question comes from Rick Shane of JP Morgan. Please go ahead.

Thanks for taking my questions. I will echo Ken's comment in terms of -- and perhaps it's in some ways it's a little bit harder to observe having followed the company for a long time, but there is a very significant evolution that's going on here both in terms of business model and in terms of disclosure. I'd love to start to talk a little bit about rate sensitivity. Obviously, your outlook is -- the world's coming away in terms of lower for longer, and the hedge ratio has come down a little bit over time and I think that's consistent with that outlook. I am curious given as the world sort of shifts to your view and cost some things like swaption coming in a little bit, does it make sense at this point to protect yourself a little bit against that held rest?

Hi, Rick, this is David. That's very good question. With respect to first of all, our hedge ratio your assume referring to coverage over Repo, one point to note is that baseline number just consists of swaps, when you consider the future's and our long-term Repo which is hedged effectively that number is much higher. So, considering in the post-Hatteras acquisition pro formas where we show nearly $47 billion in overall hedges, we're roughly at 68% I believe of our Repo balance, with the Hatteras Repo and then you factoring 15% of our Repo being one year or longer and we get it was 75% coverage or thereabouts, so we still do have a relatively conservative posture with respect to managing risk in the portfolio and it does show up I think in our supplement on page 17 where we show the rate shock that actually the lowest sensitivity it's been in quite some time. So we do have a lot of protection but that being said we're opportunistic with respect to hedges we do believe that the rates are going to remain at the very end--at the low end of the range. We're opportunistic with our hedges and should rates drift higher probably find opportunities to take some of those hedges off

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

Rick, this is David again. One more point with respect to your question about swaptions, it's something we look at all of the time We have not had a meaningful swaptions position in our portfolio since 2013 and what we found is that it's easier and less expensive to dynamically hedge the portfolio as rates evolve. If you just look at the cost of swaptions, for example, the breakeven on a one-year 10 swaptions; so one-year option on 10-year rates is about, it's about 40 basis points breakeven. So the move you have to see in the market to do even breakeven on that is relatively high and we found over the past 2.5 years, that it is much more efficient for us to manage the duration dynamically. And I think that there is out in our performance over the past 2.5 years as well. But that being said, we do really feel like we need to we need that type of exposure, we will enter into swaptions market.

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

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

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

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