Good day, and welcome to the Q2 2018 Annaly Capital Management Earnings Conference Call and Webcast. All participants will be in a listen-only mode. [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 Ms. Jessica LaScala, Head of Investor Relations. Ms. LaScala, the floor is yours, ma'am.

Thank you. Good morning and welcome to the second quarter 2018 earnings call for Annaly Capital Management, Inc. Any forward-looking statements made during today's call are subject to risks and uncertainties, which are outlined in the Risk Factor section in our most recent annual and quarterly SEC filings. 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 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. 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 Web site 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 securities. 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 will now turn the conference over to Kevin Keyes.

Thanks, Jessica. Good morning everyone, and welcome to the call. Last week, we held your midyear management meetings to discuss the progress we made on our five-year strategic plan, what I call, the Annaly 2020, on my role transition in 2015. We reviewed and revised priorities as it relates to the complementary aspects of our diversified 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 projective. In the end, my three main objectives of the meeting were accomplished. First, we confirmed the biggest risk we face, and our strategies to manage them. Second, we reinforced clear views on prioritizing our numerous internal and external growth opportunities, simply refused 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 into company into a well-capitalized, lower-leverage scaleable 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 risk. 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% points than the prior peak in 2009. U.S. corporate debt has ballooned to historical all-time highs to…

Thank you, Kevin. Fixed income market exhibited greater stability in the second quarter relative to the first quarter of this year. Nonetheless, interest rate did continue to rise in the yield curve flattening persisted as the Fed remains committed to hiking while longer term rates were anchored somewhat in light of economic uncertainty at the horizon. Agency spreads were roughly unchanged and credit was reasonably stable in the quarter. We maintain the additional hedges added in the first quarter and we reduced leverage modestly in anticipation of both our expected on-boarding of the MTGE portfolio and also as a consequence of the increase and allocation to 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 the decrease in both our TBA position as well as our specified pool portfolio. However, we did add to our agency multi-family position and spread widening in that sector created a temporary opportunity. On the hedging side, we had longer dated swaps through the exercise of each of our expiring swaption as well as through shifting out some of our shorter dated swap on tracks to manage the roll down of those hedges. The financing environment for agency CMBS remains favorable now withstanding the normalization of the LIBOR-OIS dislocation that characterizes much of the first-half of this year. We did continue to diversify our financing profile by adding more direct repo counter parties through our broker dealer. Linear function, the higher rate environment has materially improved the complexity 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 CMBS sector is in fundamentally sound shape and should…

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 for 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 and interest rates swaps, which declined approximately $634 million. Core earnings, excluding PAA were flat to last quarter at $383 million and $0.30 per share. And the PAA for the quarter was immaterial as projected long-term CPRs were largely unchanged. Moving to the highlights for the quarter, interest income declined due to the higher amortization expense that I mentioned, but 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 lover average TBA positions and higher net funding costs. Interest expense increased $75 million in 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 as the hedge portfolio was in 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 cost, which actually declined by a basis point in the quarter, despite the rise in LIBOR rates. Our key financial metrics remained strong. Net interest margin, as Kevin mentioned, excluding PAA improved for the third consecutive quarter, benefiting from both higher asset yields and the improved funding cost that I…

Yes, sir. We will now begin the question-and-answer session. [Operator Instructions] Our first question will come from Doug Harter of Credit Suisse. Please go ahead.

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

Yeah, I think, you know, 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 -- you know, in an isolated fashion, I think we just look across our businesses and this shared capital model and as we've mentioned before, it's competition for that last dollar, which I think is a very good risk mitigant [Ph] and a 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, we're you're measuring capital efficiency. You know, 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 measured. And then there's risk adjusted measures I had also talked about in terms of sharp ratios, you know, 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 just look at book value moves 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 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 the credit on a relative value basis, you know, tied to a lot of these measures. So at the end of the day 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 downplayed a bit or ignored as the different headlines around the other parts of the market tend to dominate. So that's 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 the context, I mean, how do you think about the liquidity tradeoffs 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 would have enough liquidity, you know, I guess, just how does that factor into the equation?

Yes, that's a good pickup. 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 the kind of the agency portfolio management, but there's kind of a new way we've been describing how we manage this company and I really think of it as a merchant bank where we're managing liquid -- more liquid interest rate strategies and albeit their higher leverage. So in a world that leverages, 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 credit businesses that we're in. That's the offset and the balance that we have. So I think -- but the liquidity measurement, you know, 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 that we look at day in and day out and that's the first concern.

Thank you.

Thanks, Doug.

Next, we have Bose George of KBW.

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

Yes, Bose, I'll just do a general overlay, because I think it's the basic question we ask ourselves every day. In a quarter like this we focused a little bit more on the credit businesses. It's the relative value tied to the agency levered yield is my comments on valuation, but I think the headline -- the biggest thing here is among the businesses -- again, it's relative value versus the agency return, in terms of each one of the businesses, there is unique aspects in terms of what we think are driving the decision to put capital to work. You know, in resi we are 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 your 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. So that's kind of a mix there. Commercial real estate, you know, we have a new origination team we've invested in, part of it is a capital market strategy that we haven't really focused on 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 portfolio has performed, so we're -- and it has grown, albeit conservatively. So we really attracted…

Okay, that makes sense. Is it in terms of the relative returns, is it I mean safe to say that when you look at the returns of on agencies 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 I mean they are competing competitive returns on credit with a lot less leverage.

Okay, great, that helps.

That is scalable, so it's not it's going to continue that relative value opportunities there.

Okay, okay, that's great. And then, just going back to your comments towards the beginning just with the growing leverages in the economy et cetera given the backdrop what do you think is a 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 how do you think about that?

I think look the biggest risk is we always just measure our liquidity, so if we have an opportunity, we have to prepare for it and we're terming 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 and you want us to be have a safe investment and cash on cash yielded should be durable and by definition ours is durable unless levered. I think in other reason for instance we're onboarding MTGE acquisition, I mean where 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 the future of this company is we want to attract the yield investor not just the mortgage rate 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 for this company is frankly we confuse motion with progress and we get we get a lot out over our skis in any one way because we do see a lot of different things that others don't or can't have the ability to do it. But I don't see it as having that problem because of the shared capital model. I really look at the marketers, we're stressing some of these model line 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 in the same type of asset class only is one is a different type of risk to taking in that in that type of model.

Okay, that's helpful. Thanks. And then actually as one on the dollar roll balance coming down, can you just talk about being a specialist in the TBA market and how that looks in the third quarter?

Sure. This is David. So specialist has dissipated over the recent past we've 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 the past having the Fed in the market taking out that cheapest deliver bucket as well as just creating excess command 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 no problem we continue. Although, I will say there is some about specialness as we increase in rates as you get new coupons that are being originated for example 4.5 where we've gravitated into that coupon or that contract has exhibited some specialists and they'll be about here and there.

Okay, great. Thanks again just sneak one more in. Your head ratio now is 95%, so you're very well hedged and just given your positioning do you worry more about rates going up or rates going down?

Well, I'll say this we are almost fully hedged. The risk to us I would say is somewhat more to the downside in raids when you just look at the overall symmetry in performance and convexity of the portfolio but appoint to know mention this in my comments about the complexity profile of the overall portfolio. There is very little color risk in the portfolio right now for example where 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 me extension side of the equation an important takeaway from Q2 is that roughly a third of the pay downs we received on our agency portfolio were on discount securities meaning that assets that were priced below far paid down and immediately accreted the par so that turn over 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 with an anecdote I think when you talk about our biggest risk or reward about rates going up or down volatility has hit this market infrequently the past couple years but when it has hit whether rates have gone up or down or what happened if credit is sold off or not, the first quarter of 2016 credits sold of that's when we really put a footprint on a resi credit platform and made some very good timely investments, and by the way, we bought a $1.5 billion public company in Hatteras in the midst of some hyper volatility. And then this first quarter 2018 when things were getting pretty messy out there. We bought another company. So I think everything's relative we're not insulated from any risk, 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 up most opportunistic.

Okay, great. Thanks for the answers.

Thanks.

Next we have Vivek Agarwal of CompassPoint.

Hi, good morning, and thanks for taking my questions. So over last five years you've done some acquisitions including commercial REIT and agency REIT point about opportunity and credit REIT now can you talk about when you way the off decision between build versus buy on the middle market side and when opportunities where 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 on leverage yields that are well more than 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 underline leverage of our portfolio relative to the public tier 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 coverage 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 risk outs to the extent that there are liquidity issues that may pop up with the BDC or say 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 bind.

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

I think in the questions, it's a very fundamental question it's a prudent one. I look at across the board, the answer is from just the sector and it's always kind of we were will be opportunistic and certain times and certain spread levels. I mean, look I think and 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 one 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 are going to be able to -- that we want really leverage anytime soon when everybody else is talking about it. So we are building more for the longer term on a lower level levered diversified model. I saw some commentary where companies are talking about no problem over back to 10 or 11 times because this sector used to be at 14 times a pre-crisis. Well, there is a reason we had a crisis because leverage got too high and we then end up with these levels on and just by accident. We ended up with these levels because the market frankly dictated it, not the operators. So my long waited answer is we of course we can turn up leverage when David and the team sees an interest rate or an opportunity but what else we can also increase leverage on the credit business is if we have a acquisition opportunity or if we want to have a different capital efficiency equation. So its different answer for us, I think we are not expecting to normally planning on going from 6.5 times to 9 or 10 times because we just don't have to create the return or others don't have that, they don't have that luxury.

Okay, thanks for answering my question.

Thanks.

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

Thanks. Good morning everyone. So you've talked about this morning in over previous quarters, the difference in your model relative to a lot of the mortgage REIT peers and certainly 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 kind of the net of that you would think as if you would have a lower cost of capital inferred by the market on your shares and that's clearly what you are trying to get to and haven't quite managed to convince the market for whatever reason, if that's case. I'm in interested in what we've talked about in the past, what do you think it takes or do you need the transition shareholders in order to do that. I guess I have today is how as you've taken this conglomerate models 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 anyway?

What can I -- you know, I think your questions are -- as we said overtime we talked about a lot of the same issues. I think that's why this call and no quarters in epiphany, because we are always thinking ahead, but the reason I'm focused on leverage levels is I think the market is not differentiating among leverage and not just our sector but in the market overall. So by definition we are not getting the credit to your point on valuation because the market isn't differentiating returns trying to leverage that's why I'm focusing on it especially today. In terms of the longer term valuation recognition for what we are doing, look I think just like any other sector their needs to be changed and not that I'm Jerry Maguire but I think we got, we talked about consolidation and values had lifted because of supply demand and balance is starting to be corrected. That's the first thing. The second thing is a lot of these models, they talk about their operating expense advantage or they point to their structural advantage, whether your 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 sectors have been known for issuing too much equity for instance is one example at the wrong time, disciplined valuations start to peek above book value for instance if I'm an institution and I'm holding a company or the 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 hadn't raised it in six years before that and the reason we raised to…

That's really my end question for this morning. But I appreciate all your other comments and congratulations on another good quarter. Thank you.

Thanks, Ken.

Next we have Rick Shane of JP Morgan.

Hey, guys. Thanks for taking my question and I'm looking at the 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 in to a counter cyclical business model, some pro-cyclical businesses. Our expectation would be as you do that, that your equity data actually increased slightly. How do you think about that?

I think about it as -- first of all, I'll answer the last part. Our data overtime has been half years in peace data 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 an isolation. So by anecdote and then I'll trying to be less long winded here but by anecdote the commercial real-estate businesses by definition cyclical, right? You are making an investment typically a loan based on rent roll increasing or occupancy increasing and tied to growth of some sort on a tenant basis, which kind of explain why we've been less aggressive as with some of those overvalued or understated in terms of the risk of that happening given the level of valuation. We are in the middle market lending business for instance and both Tim Gallagher and Tim Coffey can speak to us but Tim Coffey's portfolio is highly defensive, even though where lending to corporate America. I mean, there is defense stocks in the healthcare services company that are not tied to for instance the consumer. So even other both credit businesses once cyclical, once converse cyclical 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 we may not be squeezing the extra juice out of everything with financial engineering and with a more aggressive understabilized property or Tim, you know, 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 five years, I think the counterbalances worked out. Not to mention, what David has done in the portfolio and he turned it over from his predecessors and frankly there's a lot of floating rate "Exposure" there 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 the stuff out, we debated all the time and I think, you know, there was a prior question, are we getting valued for it. I think we get valued 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 countercyclicality and cyclicality.

Got it. And look, 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 to sort of the business leaders to want to expand their fiefdoms. 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 the way you say.

You know, that's a great question and it really -- it's 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 describe it as this. I mean, among our four businesses, there's three senior people in each of the four 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 and as a group I'm not always in the room, but there is risk controls and the investment leaders that debate -- every last deal. 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 outcome committee we call it 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 turned a lot of things down. There's heated debate and there is 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 two or three years, but five or six, seven years. And I think we just have it -- we're building that track record of consistency. But there is a lot of debate. No one acts as -- David's CIO, but he's not the judge and the jury. Each of the investment teams have senior people that argue it based on the financial metrics I described in my prepared remarks.

Great. Well, it wasn't meant to be softball question, but I really do appreciate the answer, thank you.

Okay. Thank you, Rick.

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 the 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, and to the rest of the management team for your time also. Again, the conference call has now concluded. At this time, you may disconnect your lines. Thank you. Take care, and have a great day everyone.