Annaly Capital Management, Inc. (NLY) Earnings Call Transcript & Summary

Good morning, and welcome to the Annaly Capital Management Investor Update Conference Call. [Operator Instructions] Please note, this event is being recorded. At this time, I'd like to turn the conference over to Purvi Kamdar, Head of Investor Relations. Please go ahead.

Thank you. Good morning, and welcome to the Annaly Capital Management Investor Update Call. Joining me today are David Finkelstein, Chief Executive Officer and Chief Investment Officer; Glenn Votek, Senior Adviser to the company and member of the Board; Serena Wolfe, Chief Financial Officer; Tim Coffey, Chief Credit Officer; Mike Sania, Head of Residential Credit; Tim Gallagher, Head of Commercial Real Estate; Ilker Ertas, Head of Securitized Products Trading; and Peter Koukouras, Treasurer. As a reminder, certain comments referenced during today's call will be forward-looking statements. Any statements made are subject to certain risks and uncertainties, which are outlined in the Risk Factors section in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read these statements and risk factors in 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 filings. Annaly routinely posts important information for investors on the company's website, www.annaly.com. And with that, I'll turn the call over to Glenn Votek.

Thanks, Purvi. Good morning, everyone, and thanks for joining the call today. I want to start by extending our sincere thoughts and prayers to those directly impacted by the COVID-19 virus. These are certainly extraordinary times as this virus is affecting all of us to varying degrees. And it's important that we don't lose sight of the personal hardship that it has and will continue to cause for individuals and families around the world. Here at Annaly, we've taken a series of measures to keep our employees safe. While we're still in the early stages of the pandemic, we've successfully implemented our business continuity plans and transitioned our workforce to fully remote over the course of last week. As a result, we're confident in our ability to continue conducting business without unduly jeopardizing the health of our staff and their families. Earlier this morning, we were pleased to announce the appointment of David Finkelstein as our Chief Executive Officer and a member of the Board. David will retain his current role as Chief Investment Officer, where he's been instrumental to Annaly's success. And I'd like to also thank our Board, particularly my fellow members of the search committee for their efforts during this comprehensive process. The selection is an important endorsement, not only of the Board's faith in David, but also the entire management team. Having known David for a number of years, in fact, I believe we started in and around the same time and worked alongside each other over those years, I'm very confident that the Board made the right decision and that the company and shareholders will benefit from David's leadership as well as the extensive markets and policy expertise that he brings to his new role. And so with that, I'll turn the call over to our new Chief Executive Officer, David Finkelstein.

Thank you, Glenn, for the kind words. On behalf of the management team, employees and shareholders, we are grateful for the significant contribution Glenn has made at Annaly over the years, particularly during this transition period. I'm humbled by the endorsement of our Board and management team and this opportunity, and I look forward to building upon Annaly's strong legacy, as we head into this next chapter. As most of you know, I've been with Annaly since 2013 and have served as Chief Investment Officer since 2016. In this role, I've closely managed the overall portfolio, including the Agency platform, our 3 credit businesses and many of our strategic initiatives. Prior to joining Annaly, I had a long-standing relationship with the company. I worked with Annaly as a counterparty, when I was at Salomon City in Barclays and also maintained my relationship while at the Federal Reserve Bank of New York. I believe that my experiences across mortgage markets and housing finance policy, combined with my knowledge of Annaly's culture and operational DNA, provide me with a unique perspective and understanding that will inform my leadership as CEO. Now the purpose of this call, however, is to provide the opportunity to connect with investors, discuss current conditions and provide an update on our portfolio and the positioning of the company. I would first like to echo Glenn's comments and extend our sincere thoughts and sympathies to those impacted by the virus. Now I'll focus my comments on markets, our portfolio and the outlook. Particularly in light of the policy response and then we can open it up for questions. First, markets. We're all aware of the volatility across financial markets as a consequence of the shock to the global economy stemming from the COVID-19 pandemic and the impact of energy prices, given the collapse of oil talks just a week ago. As it relates to our largest sector, Agency MBS spreads have widened considerably. Agency spreads were modestly wider through February due to concerns regarding higher rate of financings, following the initial decline in interest rates, but this was largely contained. As March unfolded, the elevated volatility and prepayment concerns had a fundamental impact on the Agency sector, but the technical backdrop resulting from the sharp decline in rates and spike in refinance origination from mortgage bankers has been even more considerable. The spread widening has been much more significant given inadequate demand for MBS in a dealer intermediation channel facing balance sheet constraints and little ability to warehouse assets even temporarily. We've also observed some market participants delever to improve their liquidity positions and always exacerbated by the Fed, allowing our MBS portfolio to run off at a pace of $20 billion per month. Consequently, Agency participants effectively attempted to slow down the origination themselves by cheapening the basis and curtailing the decline in the primary mortgage rate. Though in credit markets, spreads on securitized products have gapped considerably wider, the levels not seen since early 2016, as expectations of some fundamental deterioration are priced into assets. Commercial and corporate lending channels are constrained, and we do expect liquidity issues to prevail for borrowers unable to draw on lines or obtain financing otherwise. Notably, the bottleneck in the commercial paper market presents a real challenge as companies may be unable to meet working capital needs, which may well be an area that will also need to be directly addressed by policymakers. Now let's turn to our portfolio. As we spoke about on our last earnings call, we did enter the year with lower leverage, and we also modestly reduced our Agency position in January and February. Additionally, on the asset side, we've gravitated further down in coupon and sold more prepayment sensitive pools for lower coupon TBAs with attractive implied financing rates. We've actively managed our hedge portfolio as the market has rallied, reducing our swap position and adding receiver swaptions, all of which are either exercised or currently in the money. While repo has exhibited some premium for term contracts given the uncertainty with respect to policy rates, financing markets for Agency have remained liquid, which should be expected given the Fed's extreme focus in intervention in short-term funding markets. Shifting to credit, as we have stressed consistently, relative value has favored the Agency sector, and we remain at the lower end of our capital allocation range in credit. We also adhere to very rigid underwriting standards across our credit businesses. Our CRE portfolio is underweight retail and hotels. Our middle market lending business focuses on defensive industries with no direct exposure to energy or travel-related sectors. And the key attributes of our residential loan portfolio, our high FICO scores and low LTVs, which average above 70 -- 750 and below 70, respectively. Leverage is very low across our credit businesses, and each are independently financed with warehouse lines, FHLB access or term repo. We do anticipate a slowdown in activity across these businesses in light of some obvious expected deterioration in fundamentals in these sectors, but we will remain opportunistic. Now finally, our outlook. Global Central Bank's response to the noticeable deterioration in markets has been centered around efforts to ensure markets continue to remain functional and there is ample liquidity. Highlighting this, Federal Reserve has taken a number of extraordinary steps in recent days. First, the Fed delivered 2 intermediate cuts for a total of 150 basis points to cut the federal funds rate to 0. Second, the Fed announced asset purchases of $500 billion in treasuries and $200 billion in Agency MBS. According to the scheduled released, purchases will be significantly front-loaded with the New York's Fed buying $80 billion in MBS over the next 30 days. And finally, the Fed announced a number of measures, including lowering the discount window rate to 25 basis points to encourage banks to lend to virus-affected businesses. And prior to last night's announcement, the Fed announced several additional term liquidity operations with unprecedented $500 billion caps last Thursday. Now to put the magnitude of this announcement in perspective, the total liquidity offered to the market over coming weeks is larger than the Fed's current $4.3 trillion balance sheet, and each of these actions altogether should provide a meaningful tailwind to our business. With respect to Agency MBS, this is arguably the cheapest the sector has been since the onset of the crisis. Production coupon yields are opening up this morning between 2.10% and 2.2%. The entire swaps curve is well below 1%. And again, the Fed is creating an accommodative financing environment. The high yields on MBS reflect the negative technical, I mentioned before. But after last night's Fed announcement, the supply and demand outlook just improved meaningfully for the first time in more than 2 years. Additionally, a prolonged time at the 0 lower bound should remain highly supportive of financing markets. And as the dust settles, we expect this to be an incredibly attractive time for our business model. And a final note on liquidity, which is always paramount to us. I can assure you that we have an acute focus on protecting the strength of our capital base and risk management in this environment. Markets with this level of dislocation always lead to opportunities for those with capital, and we remain focused on capitalizing on growth initiatives that strengthen our investment strategies and help them achieve greater scale and market leadership. And as incoming CEO, I feel confident about how well Annaly is positioned for the future. Now with that, I will turn it over to the operator, and we will open the line for questions.

[Operator Instructions] And our first question today will come from Rick Shane of JPMorgan.

In light of everything going on in the world, congratulations. It's a little bit odd, but both congratulations to David and Glenn. I just want to -- I'm curious if you would describe what you think the economics are of the Agency business as of now, in terms of both the yields that are achievable, the funding cost, the leverage, so that we can get sort of an idea of what the ROE looks like today.

Sure, Rick. This is David, and thank you for your comments. In terms of the economics of Agency MBS, obviously, things are moving quite rapidly. But as I've said in the prepared comments, the yield we're seeing on production coupon MBS, this morning, before I came in here was about 2.10% to 2.20%, with swap rates well below 80 basis points on our hedge. And where financing is opening up, it's a little bit -- there's fluidity to it. But I will say that it looks like overnight financing that we've seen thus far, traded as high as 55 basis points, but settled here at around 35 basis points. So we'll see where term repo actually starts to form in light of last night's announcement. But our view right here is that levered returns to 9x leverage in the mid- to lower upper teens right now, and we'll see how the day progresses. But they still look attractive even in light of the announcement.

Our next question will come from Kenneth Lee of RBC Capital Markets.

And once again, just like to echo the thoughts. Congratulations again, David. Just one question. And granted, there's been a lot of volatility in the markets and things could change. But just wondering what your book value per share impact has been quarter-to-date so far?

Sure. So as of month-end February, our book was down just under 3%. And obviously, there's been a lot of volatility this week, and I'll say, little price discovery later in the week. But as of Wednesday, the end of Wednesday, it was down roughly an additional 7% to 8%. But again, there's been a lot of movement in the mortgage basis over the past 3 days and particularly today. So we will see how the quarter turns out.

Our next question will come from Matthew Howlett of Nomura.

Congrats, David and Glenn, well deserved. Just real quickly, I mean, prepayments, I mean, what's the outlook now? I mean obviously -- how is Annaly going to manage? What's expected to be maybe the largest refi wave since 2003? Just curious on those thoughts.

Sure, sure. So with respect to prepayments, we expect our Q1 CPRs to be about a little over 15 CPR, and that's pretty much baked in as we've already gotten this past month's CPR. For Q2, given the rate move as of the end of last week, we anticipated roughly a 60% increase to about 25 CPR for the second quarter with the overall mortgage index closer -- upper 20s to closer to 30, I believe. So how we'll manage this is -- our view is that there are considerable capacity constraints that remain in the mortgage banking sector, given how quickly rates declined. If you do, to your point about back to 2003, 2004, there was over 0.5 million people employed in the mortgage banking industry then and now there's roughly a little over 300,000. Now granted technology has improved, so it's less people intensive, but nonetheless, what we're hearing is certainly that there are pretty considerable capacity constraints, and it's also reflected in the time required to actually close loans, which has extended very recently, and we're not quite sure how this virus will impact the ability to actually close loans. But -- look, we think that prepayments are going up, and they're certainly manageable. They're nothing like they were in 2003, where the entire index was prepaying almost double where we expect Q2 to prepay. But we believe it's manageable. And the fact that the Fed just brought us down to the 0 lower bound is a very welcome offset to higher speeds in Q2 in terms of our overall earnings picture. Does that answer your question?

Yes, it does. And I appreciate it. And then just to follow-up, I got to ask a liquidity question here. Through the financial question -- through the financial crisis, our haircuts go up. We saw a number of banks pull out just some comments on -- I know you don't have a crystal ball on what we could see in terms of the repo market? And then maybe at the same time, could you comment on securitization? I mean you do buy whole loans that you do exit through a shelf? Can you just comment kind of on the state of that program? Then just maybe more importantly talk about you think if haircuts could rise? I mean, obviously, David spent a lot of time, but you said during the financial crisis, whether some banks could pull away -- foreign banks pull away from this market?

Sure. I'll start with the repo question. So contrasting today versus the crisis in terms of providing financing the Fed is much more accommodative with respect to providing short-term financing for the time being than in the crisis in our view. Again, I think the total potential repo outstanding could be, I believe, $4.9 trillion at some point in April from Fed operations. And so it's a little bit different. They're fully, fully sensitive to financing and they're doing everything they can to make sure it's liquid. How that transpires into the bank community, we have not seen any issues with respect to repo lines dissipating, and we obviously -- given our history, have very good long-standing relationships with the -- with our repo counterparties and the banks and Pete Koukouras, who's been here over 15 years, our treasurer stays on top of these markets and always ensures we're able to finance. Now with respect to haircuts, I will say that the haircuts on Agency MBS that the Fed subscribes to are 3%, and we think that dealers will take their acute in the Fed. Dealer and bank haircuts are a little bit higher, but so long as the Fed remains at 3%, which we expect them to do, we do not anticipate an increase in haircuts, but we're prepared for any eventuality, and that's why being in the strongest capital position and liquidity is paramount to us. So we'll be sensitive to it, certainly, but we haven't seen anything thus far with respect to haircuts. Now on securitization, I think it's fair to say that in light of everything, the securitization market for residential whole loans is probably going to take a slight hiatus for now. Now for us that is okay because we do have FHLB financing through February of 2021 and that hasn't even been used to capacity with respect to whole loans. We actually do finance some Agency MBS on that line just to maintain that capacity. So we feel good, even though the securitization markets may temporarily shut down. It's unfortunate because there has been a lot of success with the reinvigoration of the securitization market. And we do think that it's gaining sponsorship day in and day out and particularly for our Onslow Bay shelf. But nonetheless, until things clear up and we get better clarity, we're content to hold loans through the FHLB for the time being.

And our next question will come from Bose George of KBW.

Congratulations, David. I wanted to just ask about incremental returns in some of the other markets, the credit and the BDC side, how those compare with what you noted on the Agency side?

Sure. So look, on the direct lending side of the equation, there hasn't quite been the transmission mechanism from wider spreads. Obviously, those markets take time to develop in light of changes to liquid or more liquid securitized markets. But I'll give you a little sense on CRT, residential credit, CRT, for example. Spreads have blown out a little -- reasonably considerably there. But here's the silver lining in that, Bose, and that is that refinancing is obviously picking up, deleverage these structures pretty quickly. So you have what is a 2-year asset, roughly, if you project current prepayment speeds on the CRT M2s, and you got a spread or a discount margin of around 400 basis points on a 2-year asset. So yes, spreads are wider. And that is -- should be reasonably expected. But nonetheless, there are still some attractive qualities to that sector at wider spreads. And we'll see how are [ the markets and other things ] but things are still uncertain.

Okay. And then actually, I just wanted to touch on prepayments again and your comment about now versus 2003. And if rates continue, if spreads tighten and we see a primary mortgage rate, sub 3%, do you still think there are sort of structural issues that prevent speeds from going to the levels we saw back then, regulatory issues or industry capacity?

Yes, I do think there's structural issues that will prevent achieving those types of -- those levels of speeds. But look, mortgage banking sector, to the extent this rally is durable, which it certainly appears to be the case, we'll add capacity. And they are moving people from other areas. The banks are moving people from other areas over to the mortgage banking side, but it takes time to train and get people up and running. So we think the capacity constraints will remain for -- over the near term. But ultimately, they'll add capacity. And we'll manage that accordingly with respect to our portfolio. And I will note that -- I did mention in the prepared comments, we have made a reasonable effort to go down in coupon thus far this year. And so we have -- we obviously hold over 80% of our portfolio in higher quality specified pools, but we've also gravitated down in coupon into TBAs, which in 2.5 and 3s are trading special. And sold some of our more prepayment sensitive pools.

Okay. Actually, just one more. Just on the book value comments you guys made. Can you just break that out just in terms of how much of that was driven on the Agency side versus the other credit side?

Yes. Just due to the fact that 93% of the balance sheet is Agency MBS, the vast majority of it is Agency and a small fraction comes from the credit side and securitized credit. I'd say less -- or 1%, call it [indiscernible].

Our next question will come from Doug Harter of Crédit Suisse.

Can you just -- I know it's kind of early, but can you just talk about kind of how the -- how spreads are trading today on the back of the Fed announcement last night? And just size that relative to what we've seen month-to-date in terms of widening?

Sure, Doug. So I'm actually looking at on my app -- at your app, the CS app, and it looks as though mortgages are considerably tighter. So versus the swap curve, Fannie 2 and as, for example, are about a point tighter. 3s as well. Even higher coupons are -- or outperforming pretty considerably this morning and that is not the target of Fed purchases. But the rising tide does lift all boats. It's a little difficult to put that into spread perspective, but it is -- it looks to be, at least for the time being, very considerable tightening in the basis. And you can thank me for the plug on your app later.

No, no worries. I appreciate it. And then you talked about having kind of sold assets ahead of this move in January and February. I guess, how do you balance the attractive returns you've highlighted versus the uncertainty and kind of wanting to remain liquid in the current environment when you think about putting that money back to work?

Yes, yes. No, it's a great question. And some we wrestle with, nobody likes to part with what are cheap assets. But I will say the vast majority of our selling did occur before the month of March. We did a couple of things. We sold roughly $7 billion in assets, and we also sold pools to go into TBAs, which have obviously exhibited specialness. Now the question you're asking, the trade-off between managing the portfolio and the business versus cheap assets, I will say that hands down being in the best capital position and liquidity situation is the absolute drop, of course, here when you have volatility like this, and it always will be. So we haven't -- over the last week to 2 as volatility really picked up, we weren't -- certainly weren't for sellers. We did trade opportunistically. There was, for example, some bank demand and upon those reverse inquiries, we did transact a little bit into that bid, but by no means did -- where we for sellers by any stretch. Now in terms of our overall leverage with some book value deterioration, our leverage has increased back to where we ended Q3 at roughly 7.7x before this week. But that's a level we're comfortable with. But we will, first and foremost, maintain liquidity, and we're happy with the position. And again, when you look at the economics of the Agency trade right now and out the horizon, what we expect in terms of policy accommodation, we're -- we feel pretty good about the position.

And does the Fed announcement, in particular, really starting to buy Agency mortgages again, does that change your view as to when you might be willing to kind of put -- take leverage up a little bit from where you were and where you are today?

We haven't come to that conclusion yet. Again, we do just want to maintain the best capital position we can. Could it be up when things do calm down. But there's -- look, the Fed announcement was great for our business, but there's still a lot of uncertainty with respect to how this economy unfolds and volatility could remain. It's nice and very comforting that the Fed will effectively this year buy potentially $400 billion more Agency MBS than they would have otherwise and that does provide us some comfort. But we're just not ready to say we'd increase leverage yet.

[Operator Instructions] Our next question will come from Eric Hagen of KBW.

Congrats on your promotion, David. I think I have 3 questions. Number one, can you guys quantify your liquidity position from both unencumbered assets and unrestricted cash? Number two, how are you guys thinking about reinvesting back into the specified pool market given such high dollar prices on those securities? Number three, does the Fed cutting rates to 0 change your expectations for how you might hedge or where along the curve you might hedge?

Sure. So first of all, with respect to liquidity, I will say that we have in excess of $6 billion in unencumbered assets, the breakdown between cash and Agency, et cetera, I'll hold off on discussing that, just simply because we don't disclose that typically. But rest assured, we're in a very good liquidity position. Your second question was on specified pools and how are we managing our full position, what's our view? Look, the value of prepayment protection is very high right now. The pay up on our pool portfolio over the course of this quarter has gone up roughly 3/4 of a point. And so dollar prices are certainly elevated, and that informs our view of how we want to manage our portfolio. And you had asked this a couple of quarters ago about total amount of premium in the portfolio, and that's something we consider certainly. So our anticipation is that we will likely be more focused in lower coupons. Very much like the specified pool portfolio that we own. And again, those assets were purchased in a different environment for the most part at much lower prices. So where we own them, we're very comfortable with. But generally speaking, we expect to gravitate or net purchases -- sorry, reinvestments will be focused more on lower coupon MBS. Now your last question about the Fed cut and how it informs our view on our hedge position, it's a good one, and it's something we've given a considerable amount of thought to. Our overall hedge ratio, we expect, if we didn't do anything for the rest of the quarter, we go from roughly 75% to down to the low 60s percent, around 62% is our expectation. Now look, with the Fed's actions, rates are likely to remain relatively anchored here. And so we don't expect a meaningful sell-off. And we've obviously added duration as the market rallied, which has brought our hedge ratio down in addition to some runoff. And so we're comfortable with a lower hedge ratio because we do think that rates are going to be here for foreseeable future. Does that help?

That was a very good answer. Yes, I appreciate it.

Our next question today will come from George Bahamondes of Deutsche Bank.

Question I have today is really, what are you most concerned about? I know there's a ton of uncertainty, and you've given some great color this morning. But I wanted to get a sense for what you -- maybe you're most concerned about -- or focused on? And secondly, if you could just maybe touch on where you've seen maybe the most opportunity recently, just given the amount of volatility dislocation that's been going on?

Sure, George. So with respect to concern, in volatile markets like this, we're concerned about everything, hands down. But generally, our concern is typically first on financing. And fortunately, the Fed's actions give us comfort in the financing side. So we're less concerned about that right now, but it still remains a top priority in terms of focus. Now secondarily, I'll say our next concern is the liquidity of markets. Volatility like this does cause a lot of anxiety in markets and makes it very difficult to manage portfolios. And that is precisely what the Chairman said last night, they are trying to restore functioning in normal order to markets. And so we're also comforted by that. But generally speaking, making sure that markets are orderly and liquid is our top concern. And I'm sorry, your second question on opportunity, correct? Where do we see...

That's right.

Yes. So look, as I said, right now, the way these episodes typically transpire, when there is necessary selling in assets from fund redemptions or delevering, it typically impacts the most liquid sectors first. And in this case, Agency MBS has been what participants have been able to sell even if they hold Agency as well as credit. And so this widening that we've seen in Agency MBS is more, in our view, outsized relative to credit than it should be. So that's where we see the best opportunity in the current environment. And we'll see how everything transpires with respect to the evolution of this virus and what impact it will have on the economy and credit. But generally, the opportunity right here is in the Agency sector.

Great. David, congrats again.

And one more point I'll make is that with the rally we've seen in mortgages this morning, we reversed much of the widening last week. New investment returns, mid-double digits. There's considerable support in financing markets, and the outlook looks much more constructive for us. I believe, operator, that was our last question, correct?

Yes, sir. So this will conclude the Q&A session. And I will turn back to you, David Finkelstein for any closing remarks.

Thank you all for joining us, and we cannot stress enough that our thoughts are with everybody affected by this virus. And particularly the community on this call right now, equity investors, analysts, mortgage investors, you're all people we've gotten to know very well over the years. And we hope everybody stays safe, and we'll talk to you again next quarter. And hopefully, we'll be on the backside of this epidemic. So be well, everybody, and we'll talk to you soon. Thank you.

The conference has now concluded. We thank you all for attending today's presentation, and you may now disconnect your lines.