Annaly Capital Management, Inc. (NLY) Q2 2020 Earnings Report, Transcript and Summary

Good morning and welcome to the Annaly Capital Management Second Quarter 2020 Conference Call. 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'd now like to turn the conference over to Purvi Kamdar. Please go ahead.

Thank you. Good morning and welcome to the second quarter 2020 earnings call for Annaly Capital Management. Any forward-looking statements made during today's call are subject to certain risks and uncertainties including with respect to COVID-19 impacts, 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 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 hereof. 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. As a reminder, Annaly routinely posts important information for investors on the company's website at www.annaly.com. Content referenced in today's call can be found in our second quarter 2020 investor presentation and second quarter 2020 financial supplement, both found under the Presentation section of our website. Annaly intends to use our webpage as a means of disclosing material non-public information for complying with the company's disclosure obligations under Regulation FD and to post and update investor presentations and some more materials on a regular basis. Annaly encourages investors, analysts, the media and other interested parties to monitor the company's website in addition to following Annaly's press releases, SEC filings, public conference calls, presentations, webcasts and other information they post from time to time on its website. Please note today's event is being recorded. Participants on this morning's call include David Finkelstein, Chief Executive Officer and Chief Investment Officer; Serena Wolfe, Chief Financial Officer; Mike Fania, Head of Residential Credit; Tim Gallagher, Head of Commercial Real Estate; Tim Coffey, Chief Credit Officer and Ilker Ertas, Head of Securitized Products. And with that I'll turn the call over to David.

Thank you, Purvi and good morning, everyone and thanks for joining us on our second quarter earnings call. Today I'd like to highlight a number of current corporate initiatives, provide an update on the market and discuss portfolio activity across our core business during the quarter and finally provide our outlook for the balance of the year and then I'll hand it off to Serena to discuss the financials. Of note, while last quarter each of our credit meters providing an in-depth look at their respective markets and portfolios to be efficient, I'll provide those updates today but as Purvi noted each of our business heads are here as well to join in Q&A. Now to begin with, I wanted to touch on a few strategic corporate actions we've taken as of late. At quarter end, we closed our previously announced internalization transaction, which marks a significant step in the series of measures Annaly has implemented as an industry leader from a government standpoint. As an internally managed REIT, we look forward to demonstrating increased transparency and alignment with our shareholders who will benefit from our ability to be more nimble in the way we do business in order to generate long-term value. We also announced two leadership changes, Steve Campbell was appointed as Chief Operating Officer and Glenn Votek will retire from his role as Senior Advisor at the end of August while remaining a Director on our board. As COO, Steve will expand on the work he's been doing as Head of Business Operations and work closely with the executive team to help oversee Annaly's overall operations and risk management functions. Glenn has been an invaluable part of our leadership team and we thank him for his numerous contributions over the years and look forward to his continuing service on our board. Additionally during the second quarter, we utilized our share buyback program and have now repurchased $175 million common stock year-to-date. This underscores our belief that the stock is undervalued relative to our book value and affirms our support of the value of our stock through the various capital allocation tools we have on hand. These initiatives are a testament to our focus on driving shareholder value, ensuring that the firm as a whole, our structure as well as our portfolio is positioned to continue outperforming as our second quarter results demonstrate. Following one of the most challenging and unforeseen operating environments in analysts history, we were pleased with our performance during the second quarter. We delivered an economic return of nearly 15% and achieved core earnings well in excess of our right size dividend. Our measured approach to weathering the crisis served us well we feel very good about our positioning as the recovery progresses as I'll get into more detail. The economic slowdown brought on by the pandemic has obviously created considerable uncertainty and this is different kind of recession than that which we've experienced in the past, given the unprecedented speed and magnitude of the downturn. Social distancing and mandated shutdowns have damaged certain sectors of the economy and the corresponding impact on the labor market has been substantial. There been some signs that the worst of the economic distress may be behind us although the recent surge in cases in some areas of the US demonstrates the fragile nature of the recovery. Nevertheless, financial conditions have improved considerably. The market dysfunction that occurred amid the initial COVID outbreak in the US has dissipated and we have seen significant improvement in liquidity and asset pricing. This is in large part due to the ongoing decisive actions taken by the Federal Reserve, which have been successful in restoring markets and easing credit strains. Liquidity tools have sufficiently supported funding markets and credit facilities have opened channels to credit for businesses, households and local governments, the temporary adjustments to regulations have somewhat encouraged bank lending and most impactful to Annaly's portfolio the asset purchases have supported the smooth functioning of treasury and agency markets. Now turning specifically to the agency market, the fed's purchase in upwards of $850 billion MBS in just over four months has dramatically altered the supply and demand picture for the sector. After a pace of purchases at the height of the volatility to reach nearly $50 billion per day to help stabilize sector, that is transitioned to a steady run rate of $40 billion per month net of portfolio runoff, which on a gross basis equates to roughly 40% current agency issuance. That has largely taken delivery of the most negatively convex MBS, which has resulted in a shift to the TBA deliverable across production coupons to more newly originated pools and as a result, nominal carry on production coupons TBAs has improved dramatically thereby adding to returns for TBA holders. Given this dynamic, we increased our TBA position in the quarter and gravitated further down in coupon. The lower coupon holdings are predominantly in TBAs and higher coupons are concentrated and specified pools in light of the meaningful elevation in prepayment speeds in this environment. While our portfolio speech did experience an increase on the quarter, prepays on our overall portfolio were notably lower than the GSE universe, which paid roughly eight CPR faster despite the higher average coupon of our portfolio relative to the universe. Now with respect to our hedges, we added to our swap portfolio primarily in the front end and short-term swaps with pay rates close to 0% providing attractive hedge to our financing. This reduced our pay rate as well as shorten the maturity of our swap portfolio. We further reduced the LIBOR footprint of our hedge portfolio with our swap now 80% in OIS and we reinitiated our treasury future short position that was unwound in the first quarter. We also continue to take advantage of the attractive low levels of volatility to hedge the tail risk of a sharp rise in rates in the long end of the yield curve and as such, we replaced much of our legacy swaps in position with additional out of the money payers options. Shifting to residential credit, the sector saw significantly more activity as market dynamics began to improve following the crisis. The housing market remained strong given long-term positive fundamentals, which we believe will help the ultimate recovery. We're experiencing a meaningful imbalance between supply and demand as a cyclically low number of housing units, meets continued strong household formations and anecdotal evidence suggests that pandemic disruptions that limited impact on the home buying and refinancing processes. Non-agency securities across legacy CRT jumbo 2.0 and non-QN have seen substantial recovery. The improvement in singles that the market currently believes that the majority of forbearance cases, which have stabilized over the past couple of months will ultimately be resolved. However, non-agency lending has been somewhat slow to redevelop as credit standards have tightened relative to pre-pandemic underwriting and mortgage originators tend to focused more on agency originations in light of fewer frictions in a wide primary secondary spread. Our residential portfolio was roughly unchanged quarter-over-quarter at $2.6 billion as modest purchases and mark-to-market increases largely offset sales and portfolio runoff. Securitization market started to show signs of life in mid-May and we issued nearly $500 million of expanded prime securities earlier this month, subsequent to quarter end. Aggregate issuance under our OBX shelf has now reached 4.5 billion across 11 transactions since 2018. As I mentioned last quarter, we expect to see more growth in this segment as markets continue to normalize and we are encouraged by the steady pace of securitization activity to support our asset generation strategy. In the commercial sector, we're slowly beginning to see activity pick up but volumes do remain somewhat muted. June however, did bring about an increase in new refinancing requests with some new acquisition activity at post-COVID purchase prices and simultaneously, we've seen a significant number of warehouse providers begin to close new loans although pricing levels have been reset higher. Across sectors within commercial, the operating fundamentals remain challenged in hospitality as the average national occupancy rate hovers around 40% and in retail the prolonged shutdown and increasing number of retailer bankruptcies is continuing to weigh on that sector. On a more positive note, multifamily remained strong throughout the quarter. As the latest data indicates over 90% of renters made a full or partial rent payment as of June and in the office sector, although new leasing has slowed significantly, office REITs have reported strong rent recollections above 90% throughout the back end of the second quarter. With respect to our CRE portfolio specifically, total assets at quarter end of $2.5 billion represented a slight decrease while economic interest remained essentially flat. The decline in portfolio size is driven by approximately $53 million in loan payoff as well as securities sales. On the financing side, our weighted average cost of borrowing decreased by roughly 60 basis points to 2.7% driven largely by a reduction in LIBOR given the fed cuts. Overall we feel good about conservative positioning in the portfolio across sectors and the strength of our relationships with best in class sponsors and operating partners to mitigate in further disruption. Shifting to middle-market lending, activity has also picked up as of late as spreads have tightened and sponsors have refinanced transactions that have exhibited improving underlying leverage profiles. New deal activity is primarily relegated to more broadly syndicated loans however, the context first lien executions on larger transactions have tightened 75 basis points to 100 basis points over the past quarter, while traditional middle-market has shown less movement in pricing. Unit tranches and second lean loans within middle-market are experiencing more notable price discovery than its larger market blathering and we expect these gaps to remain as traditional middle-market participants grapple with their portfolios. Consistent with our communication last quarter, we continue to speak actively with sponsors, borrowers and agents to closely monitor performance. Despite the challenging environment, we're pleased with how the portfolio has performed during the period ending the quarter essentially unchanged at $2.2 billion in assets. As we gain further clarity around the long-term implications of COVID, we are reassured by the stable and defensive nature of our portfolio and remain confident in its ability to withstand prolonged bouts of market volatility. We believe our focused industry-specific positioning within nondiscretionary defensive and mission-critical names will generate the outperformance for peers that will further differentiate our brand in the sector. In fact some of our industry concentrations have maturely benefited from the current environment. For example, government mandates at all levels have created an even greater dependency on technology while also driving demand and behavior in ways that has made once boring annuity business into growth sectors. Portfolio construct has been protected against broader sectors that have witnessed demand destruction and we maintain meaningful exposure where pockets of spend remainder resilient. Now of additional note with respect to our direct lending portfolios, we have taken what we believe to be a very conservative approach regarding reserves and Cecil adjustment which Serena will discuss in further detail. And finally shifting to our outlook, as we think about our capital allocation out of the horizon, we've been focused on preserving flexibility given uncertainty in the greater economy related to COVID shutdown. We maintained the view that the agency sector represents the most attractive investment opportunity currently while also providing strong liquidity. We have entered a more normalized environment with fed action serving as a key driver and spreads have retraced much the widening experienced in March we do remain positive on the sector given ample funding availability at low rates due to rate volatility and a complete reversal of an inferior technical backdrop that characterizes sector at the outset of this year. While our allocation agency may increase modestly, we do continue to evaluate opportunities to deploy capital across our three credit businesses and we are beginning to develop the better lends into how each credit sector is evolving and we expect to shift to a more offensive posture in the coming months as we gain more clarity on the economic and real estate landscape. We were certainly careful to take prudent steps during the early phase of the market recovery to ensure we are well positioned to capitalize on the opportunities that are sure to arise. And as part of our preparation, we've chosen to be conservative with our leverage as well as our dividend. Our goal has been to maintain optimal liquidity thresholds and to manage the portfolio within conservative risk parameters to produce the highest level of quality earnings in this market environment. Consequently, we reduced leverage during the quarter from 6.8 times to 6.4 times and made the prudent decision to set our quarterly dividend at $0.22. The dividend represented 10.5% yield on our book value which is in line with our historical average while being competitive relative to our peers and various fixed income benchmarks. As I mentioned we out-earned the dividend by $0.05 this quarter and absent another market dislocation or other foreseen developments, we expect Q3 core canings to also the dividend. Overall, we maintained a more constructive view of the operating environment and our ability to deliver compelling returns as each of our businesses respected sectors begins to emerge from the initial volatility and destruction caused by the pandemic. And now with that, I'll hand it over to Serena to discuss the financials.

Thank you, David and good morning, everyone. I will provide brief financial highlights of the quarter ended June 30, 2020 and while earnings release discloses our GAAP and non-GAAP core results, I will be focusing this morning primarily on our core results and related metrics or excluding PAA. As David mentioned earlier, the stabilizing actions of the Fed coupled with our active portfolio management resulted in improved fed value of our agency assets and significant improvement in financial performance. Our book value per share was $8.39 for Q2, a 12% increase from Q1 and we generated core earnings per share excluding PAA of $0.27, a 30% increase from the prior quarter. Book value increased our GAAP net income of $856 million or $0.58 per share, which includes $0.05 related to Cecil and specific reserves and higher other comprehensive income of $721 million or $0.51 per share on improved valuations on agency MBS resulting from lower market rates. GAAP net income improved this quarter as a result of higher GAAP net interest income of $399 million, primarily due to lower interest expense from reduced repo rates and balances and we also experienced lower losses on our core portfolio of $92 million. Last quarter I noted that most of assets and liabilities are at fair value and that our book value decline was not a function of post asset sales but rather unrealized mark-to-market losses with potential for recruitment. This point was evidenced the quarter with the improvement in fair value measures and resulting improved book value. While financial conditions have stabilized, there is still significant uncertainty around the long-term economic picture. This makes analysis regarding Cecil reserves particularly challenging. As a result we ran numerous scenarios in excess of 20, to determine the appropriate amount of Cecil reserves to the quarter and ultimately booked reserves that were considerably more conservative than our base case scenario. In comparison our base case scenario was altered in a modest release of reserve, which we felt inappropriate given the continued economic uncertainty centered around the evolving pandemic. We recorded reserves associated with our credit businesses of $68.8 million on funded commitments during the second quarter. Consisting of $22 million of additional reserves during the quarter primarily resulting from the impacts of COVID-19 on our [indiscernible] and more general reserves related to forecast for a deterioration in economic conditions and market values of $46.8 million. Total reserves now comprise 5.32% of our acreage in MML loan portfolios as of June 30, 2020. As a reminder, the impending model introduced by the new Cecil is based on expected losses rather than incurred losses, which was the previous management for reserve historically. Under the standard an entity recognizes its estimate of lifetime expected credit losses as an allowance, which the fed believes will result in more timely recognition of such losses and while changes in economic scenarios and asset performance in the future will impact Cecil reserves in subsequent quarters, current reserve levels should not be considered as a pervasive credit issue within the portfolio or an indication of what reserves may be recorded in the future. We have previously discussed our methodology and are thorough and thoughtful approach to Cecil reserves. As always we spent time analyzing the results of the reserve calculations and ensuring our expectations align with the quality of the portfolio and the performance of the borrowers. We continue to think it critical in the current environment to consider the address economic scenarios available in this process and to err on the side of conservatism given a significant uncertainty in the economic and market values scenarios. We remain comfortable with our existing credit portfolios and the associated Cecil reserves and will continue to monitor specific asset performance and economic projections as we determine future reserves. Turning to earnings, the largest factor quarter-over-quarter to quote an ex-PAA will lower interest expense of $186 million versus $503 million in the prior quarter due to lower average repo rates and balances as well as higher TBA [indiscernible] income of $96 million versus $44 million in the prior quarter, due to higher average balances partially offset by higher expense from the net interest component of interest-rate swaps of $65 million visits $14 million in the prior quarter and higher average balance. As David touched on, our economic leverage declined to 6.4 times from 6.8 times quarter-over-quarter, which was mainly due to a decrease in repo balance of $5.4 billion and an increase in our equity-base of $1.1 billion that was partially offset by an increase in TBA contracts of $5.8 million and an increase in net payables for investments purchased of $1.5 billion. Out treasury function is the best in the business and their expertise and exemplary market timing was a key component that helped us weather the market dislocation last quarter and our ability to deliver strong core earnings this quarter. Additionally as noted above, core did benefit from a reduction in financing costs with low average repo rates down to 79 basis points from 1.77% combined with lower average repo balanced stands at $68.5 million from $96.8 million and we achieved these results while opportunistically extending our repo book term increasing our weighted average date of maturity by 50% from 48 days to 74 days. Signaling from a fed on continued low rates combined with considerable injection of additional reserves in the financial system through repo operation and asset purchases have led to very stable funding conditions with repo markets experiencing no signs of stress through the quarter even on pivotal month end and quarter end days 1.8. And to repo financing remains ample. With the improved stability in the financial markets, we've seen an improvement of lenders appetite to finance credit assets particularly in the residential space in anticipation of the expiration of our FHLB membership in February of 2021, we're executing an offset financing strategy involving committed funding facilities for our residential credit business and as David mentioned, we maintain a strong presence in residential securitization market. Consistent with that strategy, since the beginning of the second quarter, we added $1.125 billion of capacity across two new credit facilities for our residential credit group, the permanent nonrecourse financing. The portfolio generated 188 points of NIM up Q1 of 118 basis points, driven primarily by the decrease in cost on funds that I mentioned a moment ago. Annualized core return on average equity excluding PAA was 12.82% for the quarter in comparison to 9.27% for Q1. Our efficiency metrics changed modestly relative to Q1 being 2.1% of equity for the second quarter in comparison to 1.98%. Also as David mentioned, our internalization transaction closed at the end of the quarter and we anticipate generating cost savings over the long time as we embark on being an internally managed company. Annaly ended the quarter with excellent liquidity profile within $7.9 billion of unencumbered assets an increase of $1 billion from prior quarter and including cash and unencumbered agency MBS of $5.3 billion. And finally, the company has performed exceptionally well given the challenges faced from remote work and market uncertainty. We continue to be impressed by the resiliency of our workforce and the exemplary service that our IT infrastructure team has provided to every one of us during the time of remote work. Everyone at Annaly contributes to our success and we're proud of the results that we've reported for the second quarter and expect to continue providing best in class results for our shareholders. And with that, I'll turn it over to operator for questions.

[Operator instructions] Our first question comes from Eric Hagen with KBW. Please go ahead.

Thanks. Good morning and nice quarter guys. Hey how much did TBAs add to your net interest margin for the quarter? Is this special mix reflected in both the asset yield and the cost of funds and then how big is your TBA balance now versus the end of June?

With respect to the incremental benefit of the TBA position for the second quarter, I'll say I think the actual dollar contribution or in pennies was about $0.07 and with respect to the NIM contribution, Serena you can…

Yes the TBA role provided about $97.5 million post NIM for the quarter.

And then our TBA balances roughly unchanged for the quarter and with respect to what we expect for the third quarter is likely to be in the proximity of where we were at for Q2 maybe a touch higher.

Right. Okay. Thanks for that. Just on the TBAs again just every mortgage rate, it feels like accounts for $I specialness a little differently in their NIM. Is it picked up in your asset yield or your funding costs or both?

In terms of how it's actually reflected in the yield it's not…

Right. Okay. So it's reflected in your funding cost.

No, it is not reflected in the funding cost. We add the incremental dollar role income to core income and then the outcome.

Okay. So the NIM itself is not reflective of TBAs at all to your dollar role at all?

No. No. TBA dollar all income, correct.

Sorry, I think we're thinking about it a little differently, but yeah that's correct. Total core income is used to buy, Eric.

Okay. No, I think I understand. For the agency derivatives portfolio, I realized you guys maybe [indiscernible] surface very often, but how much of your cost basis was amortized through core earnings in that portfolio last quarter and then with rates having coming down quite a bit, presumably some of those assets are cheap and how are you guys thinking about your footprint in that portfolio?

Look, first of all I'll talk about the footprint and agency derivatives for example and what we're talking about here Eric is the difference between balance sheet leverage and instructional leverage. So right now balance sheet leverage pools of finance through the repo market is more attractive than structural leverage meaning derivatives who when I say structural leverage I mean an asset whose outcome is dependent on a larger asset like derivatives are. So balance sheet leverage is incredibly inexpensive right now and abundantly available because of the reserves in the system and in the agency space it's more favorable than structural leverage through derivatives. So that could change but derivatives without achieving a little bit as well as MSR for it to be more attractive. MSR has different structural aspects to it that make it very cheap, but nonetheless structural leverage is a little bit inferior right now to balance sheet leverage. Now in terms of amortization of the cost, I'll give you the MSR for example, which mimics the derivates portfolio. There was a depreciation in the amount on the balance sheet of MSR, half of which was amortization and the other half of which was the multiple compression. So I think we had $25 million of the $277 million in the MSR that started the quarter was actual amortization and derivatives you might say on the ISI would mimic that.

Okay. And did you guys say what your book value was through July?

I didn't in the prepared comments. It's been relatively calm. We've isolated around where we ended the quarter and right now as about last night it's up roughly 1%.

Our next question comes from Rick Shane with JPMorgan. Please go ahead.

I wanted to talk a little bit about dividend policy. David you had in your comments suggested that Q3 earnings core earnings are on track to exceed the dividend again and I'm curious when you guys think about dividend policy, currently your ROEs are very high. I suspect that one of the things that influences the outlook is reinvestment risk as the speeds pick up. I'm curious how you guys are looking at this and especially in light of having cut the dividend earlier in the year?

And that's exactly right. Reinvestment is a key criteria here. So we set the dividend at $0.22 because we believe that to be the sustainable level for the foreseeable future as long as we had a lens into the horizon. Now core earnings in Q2 were above that dividend and we expect them to be so in Q3. A lot of that is driven by the tailwind from the fed and specialism and TBAs where our role income doubled over the quarter and it is currently existent today and if we look at past episodes it [indiscernible] persisted for some time. But when we think about reinvestment into for example, pools where we see the levered returns on agency MBS is in the context of 11% to 12% maybe a little bit higher and so as we look at the dividend right now at 10.5% yield on book value the reinvestment of agency runoff is perfectly consistent with that longer-term more steady-state level assuming rates in this context, but keep in mind we do have this near-term tailwind of specialness and some other factors that are beneficial to the portfolio where were out-earning the dividend this quarter. We can't say how long that will persist for, but we do think about this for much more than just the quarter or two where we do have the specialist and we're trying to get the appropriate level where we know it's sustainable and that's how we feel about it and if we continue to out-earn it that's perfectly okay because we're given the shareholder a 10.5% dividend yield on their book value.

And actually as you're answering that question, I'm realizing there's another element to that, which is that some of that additional that excess earnings is coming back to you shareholders in the form of the repurchases at a discount as well.

Exactly, exactly and we'll see where we end the year but we feel good about where we think it is.

Okay. So is it fair to say that the repurchase will be part of the flaps in terms of using that excess earnings in the short term?

It's all dependent Rick on the attractiveness of the repurchase option relative to other options in our capital allocation policy. In the second quarter and beyond as we mentioned, we bought back $175 million worth of stock. The average price of those shares was I believe $6.30 or meaningfully above that level now. So we're very happy that the market picked up the slack and did a lot of that work. As we look at the buyback policy, it's not a point in time estimated, everything changes on a daily basis because asset prices changes in the relative attractiveness of buying back stock versus putting that capital to work in the portfolio changes and if you just think about the immediate accretion of the stock buyback in terms of book value versus the longer-term earnings of the portfolio, there is a trade-off there certainly and we generated 25% accretion from the buyback thus far. But when you look at the portfolio and the economic return of the portfolio on the quarter, that was 15% and that persists we think. So it's not an apples-to-apples comparison. We have to look at how attractive assets are and then put that in the context of where thee stock prices make a buyback decision based on that.

And everything you said the two words that stood out everything changes. I think that's probably the best description of what we brought them through the shares. So thank you, guys.

Our next question comes from Kenneth Lee with RBC Capital Markets. Please go ahead.

Wondering if you could just provide a bit more color on your prepared remarks on the potential to increase agency allocation. Do you expect any meaningful shift in terms of equity capital allocation going forward, thanks?

Sure Ken you bet and what I meant by that is that the increase in agency could occur over the very short term as credit markets are still redeveloping and we do have some runoff in that capital will be reallocated to agency over the very near term and when we say that, a very small percentage. We don't anticipate increasing agency meaningfully, but we do recognize that these credit markets are a little bit slow to redevelop. We don't complete clarity on the economy and some of that runoff could go into the agency sector. Now that being said, we are starting to get through this phase 2 as I mentioned last quarter where it's really about recalibrating each portfolio in the business and making sure we're optimizing each of the businesses and we're starting to get a better look at how things are going to unfold and we're seeing opportunities in credit and we're very strong constructive and it just may take a little bit of time to make sure we have the right approach and we have complete clarity on how things are going to play out. So we don't expect a meaningful increase in agency, but over the near term you can see a small uptick.

Great. Very helpful and one quick follow-up if I may, you mentioned in terms of the agency funding composition extending out the repo financing terms, wondering going forward, would you expect to either further lengthen the repo financing terms or maintain what you've been doing, thanks?

Yeah it depends on the shape of the curve, like over the last couple of months, the term structure of repo has flattened pretty considerably, which has enabled us to extend out curve at very attractive rate. So we like to see it flatten a little bit further and we think it should given the posture the fed and when you look at the last set of economic projections, so lift off not likely to occur for the next couple of years, you could see some further flattening in the term curve but we're watching it and we're making incremental steps to term out our repo.

[Operator instructions] Our next question comes from George Bahamondes with Deutsche Bank. Please go ahead.

Just one [indiscernible] quarter, really favorable backdrop funding cost attractive, specialist TV end market. Just had a curiosity what are some things that you are concerned about or really looking closely at, you kind of in the end and immediate term. Things do look I think positive generally, but just wondering how you guys think about downside risk from here? Yeah I think prepay is kind of an obvious one outside of that.

Sure. So look with respect to the agency market, we are in an environment where funding is abundantly available and will be for some time given the reserves in the system. Volatility is low and the fed is specifically directing volatility lower and they also happen to be a huge tailwind in terms of purchases of agency MBS, so the technicals are very favorable and to your point, it does appear to be a very good backdrop for the foreseeable future for agency. And prepay is obviously being the uncertainty and the risk which we I don't think you heard a lot about I'm sure this quarter and I think we managed prepay risk as well as anybody. 96% of the portfolio is in specified pools and we built that portfolio we'll over a number of years and we use the opportunity in March to reduce the pool holdings that we didn't find as attractive and what we're left with is a portfolio that is very high quality. And as a consequence of that portfolio, we did see a fair amount of appreciation in those pools in the second quarter as markets stabilize and that is one of the risks I think going forward. Beyond just prepays is what happens to pool pricing over the next quarter or two. We feel good about where pools are at. The reason why they appreciate is because there worth it. They provide a much better competitive profile with lower prepayment characteristics than the market, but generally speaking pool pricing can be variable and so that's probably the risk in any agency. In credit as we've said, we like our portfolio. We appropriately conservatively reserve for any what we think to be of any eventuality down out the horizon but there's idiosyncratic risk in every credit asset and so we feel good about it, but there could be one-off disruptions and so that's we're looking at as well. So broadly speaking in agency it's probably pool pricing and in credit there could be unforeseen events given the economy that could disrupt individual assets.

And my other questions have been asked and answered. Thanks again.

Our next question comes from Doug Harter with Credit Suisse. Please go ahead.

Hey guys, this is actually Josh Bolton on for Doug. I was wondering if you could talk a little bit more about the thought process around the hedge repositioning in the quarter, adding more hedges on the short end of the curve and then I guess should we expect more options hedging going forward. I know you mentioned in some of the tail risks and just any more additional comments on the hedge positioning will be great thanks.

So first of all with respect to the repositioning, what we experienced in the quarter was initially a pretty insignificant steepening of the curve, which we anticipated I think got to roughly 20 basis points to 25 basis points higher than it was now. At the time we started quarter with a swap portfolio of about nine odd years I believe, now given how long that portfolio is in duration as we mentioned last quarter provides multiples of interest rate protection relative to the assets, which are much shorter in duration. So given the slope of the curve, given the significant decrease in front end OIS rates to zero roughly, we took the opportunity to add hedges and move down the curve and better balance out the hedge profile to bring the average life to about half what it was at the end of the first quarter and it's still about twice the duration may be a little bit more than twice the duration of the asset portfolio currently, but at 40% hedge ratio being more -- a little bit over twice the duration you get to roughly 80% to 90% may be a little bit more interest rate protection assuming a parallel shift in the curve with a still slight steepening bias which we think is the appropriate approach. But nonetheless it's a more balanced hedge profile now with a slight steepening bias and we took advantage of near zero rates at the front end of the curve, which we think has very limited downside potential in terms of those hedges losing money because it's not our view that we end up in a negative rate scenarios negative policy rate scenario that is. So we feel good about it. Now with respect to options, we did reinvest a lot of the runoff in our swap portfolio back in out of money options and I'll tell you going forward that will be a function of the level of implied volatility. When I look this morning three month 10-year swaption was up 53 basis points. It did get below that level in early 2019 to about 49 basis points and then the last time prior to that was 2017 and before that it was pre-crisis. So while implied volatility is very low and that's by design on part of the part of the fed and to the extent it continues to decline, it will be a more attractive hedge to our agency portfolio and I would say that in current levels, you should expect it to be a critical component of the portfolio going forward. Does that answer your question?

Yeah that's great. Thanks David. Appreciate the color.

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

Okay. Thanks Brendon for your help and we hope everybody stay safe. Thanks for joining us today and we'll talk to you soon.

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