Annaly Capital Management's (NLY) CEO Wellington Denahan-Norris on Q1 2014 Results - Earnings Call Transcript

May. 8.14 | About: Annaly Capital (NLY)

Annaly Capital Management, Inc. (NYSE:NLY)

Q1 2014 Earnings Conference Call

May 8, 2014 10:00 AM ET

Executives

Willa Sheridan – Principal

Wellington J. Denahan-Norris – Chairman & Chief Executive Officer

Kevin G. Keyes – President & Director

Glenn A. Votek – Chief Financial Officer

David Finkelstein – Head of Agency Mortgage Trading

Robert Restrick – Head of Commercial Business

Analysts

Arren Cyganovich – Evercore Partners (Securities)

Daniel K. Altscher – FBR Capital Markets & Co.

Michael R. Widner – Keefe, Bruyette & Woods, Inc.

Joel J. Houck – Wells Fargo Securities LLC

Operator

Good morning and welcome to the First Quarter 2014 Earnings Conference Call for. All participants will be in a listen-only mode (Operator Instructions) After today's presentation, there will be an opportunity to ask question (Operator Instructions) Please note this event is being record.

I would now like to turn the conference over to Willis Sheridan. Please go ahead.

Willis Sheridan

Good morning and welcome to the first quarter 2014 earnings call for Annaly Capital Management.

Any forward-looking statements made during today's call are subject to risks and uncertainties, which are outlined in the risk factors in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the forward-looking statements disclaimer in our earnings release, in addition to our quarterly and annual filing. Additionally, the content of this conference call may contain time-sensitive information that is accurate only as of the date of this earnings call. We do not undertake and specifically disclaim any obligation to update or revise this information.

I’ll now turn the conference over to Wellington Denahan, Chairman and Chief Executive Officer. Please proceed, Ms. Denahan.

Wellington J. Denahan-Norris

Thank you, Willa. Again welcome to the Annaly Capital 2014 Q1 earnings call. Joining me on the call today are Kevin Keyes, our President; Glenn Votek, our CFO; Dave Finkelstein, our Head of Agency Mortgage Trading and Bob Restrick, Head of Commercial Business.

The first quarter of 2014 was a mix of conflicting signals. A combination of bad weather and bad communication caused confusion among policymakers and investors. During her first official press conference, Chairman Yellen was coaxed in the Q&A into defining extended period. She sheepishly responded that it was six months, only later to soften the impact of such precision and subsequent speeches.

Yesterday during her testimony before the joint economic committee of Congress, she much more deftly avoided placing an exact measure of time on considerable time, but instead, she threw a number of shifting conditions that would impact the timing of the first Fed funds rate adjustment. She tried to make clear that the Fed anticipates that even after both employment and inflation are near mandate levels, economic conditions may warn keeping funds below normal levels – below levels they view as normal in the long run.

The question now becomes, what does below normal levels mean? We assume it is not 0 to 25 basis points, so our focus will remain on the timing and magnitude of the change in the cost of carry. We remain optimistic on the overall outlook for the agency mortgage market, given the supply/demand dynamic. During the quarter, the 10 -year treasury briefly touched 3%, but had since traded at the richer end of the range, giving us some pause.

We feel there will be opportunity in a weather-related rebound in the economic data that would provide good entry points in the quarters ahead. Nonetheless, we selectively added to our position, and with leverage at 5.2% at quarter end, we maintain a fair amount of buying power for the portfolio. Our commercial position grew about 4.5% quarter over quarter, and now represents 12% of our equity on a net basis and 14% of our core earnings.

Our commercial investment portfolio yields 9.81% -- sorry, 9.18%, excuse me. And we expect to continue to prudently grow the commercial position within our 25% equity allocation. Finally, one important distinction I would like to make about the second quarter and beyond, going forward, our dividends will reflect the true earnings power of our portfolio. And under current market conditions, coupled with this quarter's repositioning of our short dated legacy hedge position, which is not reflected in our Q1 results, we feel comfortable maintaining our dividend at the $0.30 level in the quarters ahead.

As a management team, our ongoing goal is to create a more sustainable income profile while maintaining a more flexible business model to better handle the changing investment landscape. Before taking questions, I would like Dave Finkelstein to discuss our agency activity during the first quarter, and then Glenn Votek will discuss the first quarter's results.

I’ll now hand it over to Dave.

David Finkelstein

Thank you, Wellington. And to expand on Wellington's comments regarding the portfolio, specifically with respect to the agency portion of the portfolio, we came into the first quarter at the low end of our leverage range. And as we spoke about in last quarter's conference call, we indicated a willingness to increase leverage selectively as opportunities materialize.

As the quarter progressed, optimism regarding the pace of the economic recovery moderated somewhat, and forecasts for longer-term rates and volatility trended downward. As a result, our outlook for the agency MBS sector turned more favorable. More over agency MBS fundamental valuations looked very reasonable and in spite of the Fed tapering its purchases, the technical landscape for MBS is attractive, given relatively low expected MBS production relative to demand from other buyers in the market.

So with that backdrop, in the latter part of the quarter, we began to grow the portfolio. And on net, added a little over $4 billion in assets by the end of the quarter. Regarding how this strategy has carried into the second quarter, we continued adding in April at a similar pace to last quarter. Going forward, however, MBS have out-performed over the very recent past, so we are content not to chase the market. That being said, if opportunities are presented, we will consider further increasing the agency portfolio.

And now, I will hand it over to Glenn.

Glenn A. Votek

Thanks Dave and good morning everyone. I am going to take through a few key financial highlights for the quarter before opening it up to Q&A. So, to begin, we reported, in the quarter, a net loss $203 million or $0.23 a share, which compares to the prior quarter earnings of about $1 billion, or $1.07 per share.

The sequential decrease was largely the result of about $1.1 billion decline in other income, primarily driven by interest rate swaps which produced unrealized losses about $349 million in the current quarter and that compares to unrealized gains in Q4 of about $561 million, which represents a change of about $910 million sequentially.

Similar but less significant directional swings occurred with trading assets and agency I/Os. That represented a decrease of about $269 million and was partially offset by greater gains on disposals of investments which were up a little over $50 million in the quarter. In terms of economic net interest income, that was down on higher premium amortization.

As we mentioned last quarter – the fourth quarter amortization expense benefited from an adjustment for slower speed. This quarter we experienced more normalize levels, so amortization expense for the quarter was about $119 million and again that compares to the prior quarter of about $31 million and that’s also larger due to the stability and prepayment speeds that we’ve experienced no quarter-over-quarter.

Overall asset yields were just over 3.2% which compares against that 3.5% the prior quarter. Our economic interest expense increased about $6 million on higher swap expenses, which was partially offset by lower repo expense. And this effectively translated into higher cost of funds in the period of about 24 basis points, as swaps represented a greater proportion of the funding, at about 94% of repo versus 92% in Q4.

Our net interest spread as a result was 90 basis points. Our core earnings which excludes realized and unrealized gains and loss on asset sales and derivatives, was $240 million which was $0.23 of share, down from $0.35 the prior quarter and again most significantly impacting that number was the change in amortization expenses and our core ROEs were a little bit low 8%, at 7.7% versus a 11% the prior quarter.

Turning quickly to the balance sheet, the agency portfolio, as Dave mentioned, was up about $4.4 billion, while the commercial portfolio was also up sequentially. The portfolio growth however did not translate into higher interest income in the quarter, as Dave alluded much of the growth occurred in the later part of the quarter and in fact if you look at average earning assets throughout the quarter it was actually lower versus Q4.

Our repo balances increased $2.8 billion consistent with the asset growth and we also consummated our debut securitization of commercial first mortgages issuing $260 million of securities, while retaining the both sub and interest only certificates. This is an important transaction as it provides the model for applying leverage to the commercial portfolio, and will effectively help us in improving the portfolio returns going forward.

Book value grew to $12.6 billion or $12.30 a share that compares to $12.13 the prior quarter at year end. The growth was driven by increased fair value the portfolio, partially offset by both the reported GAAP loss and the quarterly dividend.

Leverage, as Welly mentioned, increased to 5.2 times, which was versus 5 times at year-end, and our net capital ratio declined modestly to 15.4%. So we are pleased with the progress that we made in the quarter, in starting the year, including the portfolio growth to close out the quarter, which continues, as Dave mentioned, into the current quarter, and should beneficially contribute to our future performance.

So with that, Chad, we're ready to open it up for questions.

Question-and-Answer session

Operator

Thank you. (Operator Instructions) Our first question comes today from Arren Cyganovich with Evercore.

Arren Cyganovich – Evercore Partners (Securities)

Thanks. I was wondering if you just could give us your view on whether or not you think that the agency MBS has fully priced in the removal of Fed purchases? There seems to be some differing views on that, whether or not the production has slowed to a level that is not really reflecting the amount of spread one, and it could happen whenever the fed purchases end. Just your views on that would be helpful?

Wellington J. Denahan-Norris

I will have – Dave will answer the question.

David Finkelstein

Sure, Arren. So, the Fed has roughly $80 billion left, if we believe the expected schedule of the taper. $80 billion left in new purchases. We do feel that that is priced in. And as you alluded to supply has been forecast to be a little bit lower, both gross and net supply. So in terms of the technical landscape in the market, the fed reducing their footprint does – will have an impact, but we believe that that is priced in.

And given the demand from other yield buyers in the market and other investors, we think it will be fairly balanced, as the Fed does exit their purchase program. And furthermore, they are going to continue to reinvest the proceeds, we believe at least for the foreseeable future, following the end of the taper. So in terms of fed-run portfolio runoff, that would be absorbed by the Fed, as well.

Arren Cyganovich – Evercore Partners (Securities)

Thanks, that's helpful. Moving over to the commercial portfolio, do you have additional leverage beyond the securitization that you did on that portfolio? And I guess just your thoughts on using leverage going forward?

Robert Restrick

Sure, this is Bob Restrick. Aside from the securitization, we have some modest leverage against a couple triple net lease deals we've had on our books for a couple years. And on a going forward basis, we continue to look at opportunities in the market to help provide us with accretive leverage. So we're looking into warehouse lines and other securitization alternatives, as well as other financing opportunities that are out there that are available to us.

Arren Cyganovich – Evercore Partners (Securities)

Okay, thank you.

Operator

Our next question comes from Dan Altscher with FBR. Please go ahead.

Daniel K. Altscher – FBR Capital Markets & Co.

Hey, thanks. Good morning. I appreciate you being able to take my questions. So I can help understand, when you said you think the dividend can be – more – the dividend will be representative of what the true earnings power is? What did you mean exactly by, true earnings power? Is that – are you just trying to say that is synonymous with core? Or is there something specific or different that we are not thinking about?

Wellington J. Denahan-Norris

No, it will be synonymous with core. Currently, in the position, as you know, we have about $24 billion in short dated swaps that we were maintaining in the position, given the fact that Yellen put out there that six-month period, which we thought the potential for that position to be useful in protecting not only a change in short-term funding, but the market's reaction to it.

And since they seem to be trying to communicate to the market that level of – or the timing of the change would be pushed out. That that bucket of position, and what it provides in protection for the portfolio, is – we have taken the tack that we would like to reduce that position down. And in doing so, not only materially improve the spread of the Company, but improve the core earnings of the Company, as well. And we will base our dividend on that improvement.

Daniel K. Altscher – FBR Capital Markets & Co.

Great, thank you. That was really helpful. Page 17, which has the interest rate sensitivity and the spread sensitivity, I always love these charts. Quarter over quarter, big drop in both, the relative sensitivity. Can you help us parse out what the delta is between the increased in the hedge exposure versus the lower risk – lower convexity risk and less extension risk, the deltas between the two? And that drove this down?

Wellington J. Denahan-Norris

Yes, well, I just want to say something briefly and I’ll hand it over to Dave who is more intimately involved in the day-to-day hedging strategy, but if you notice in our swap table 2, we did add to the position during the quarter. And it was in the much longer arena of the swap market, and trying to get much more effective long-term protection for the portfolio.

With that said, I will let Dave talk about convexity hedging and spread hedging that went on.

David Finkelstein

Sure. To add to Wellington's point regarding the long end of the curve versus the front end, we have seen a meaningful flattening in the yield curve since the beginning of the year. And the transition hedging on the longer end versus the front-end make sense, given the fact that, for example 2's to 10s in terms of yield spread, has narrowed about 30 basis points since the beginning of the year, or thereabouts.

With respect to spread and rate sensitivities, one thing I will note is that we did have a meaningful increase in mortgage dollar prices over the quarter. And as that occurs, the convexity portfolio of the portfolio there erodes somewhat, and also the duration shortens a little bit. And so, to the extent we don't have as much downside in a sell off as we did at the end of last year, we also don’t have as much upside and a rally.

So if we made no changes to the composition to the portfolio, the spread sensitivity would look very similar to this. However, it's more a function of the increase in dollar prices and the lower rates that change this profile quite a bit. And if we look back to the end of the third quarter of last year, when mortgage dollar prices and longer rates were close to the levels that we have at the end of Q1, this spread sensitivity looks very similar to that, in terms of what we benefit with reduced rates, versus cost is of higher rates.

Daniel K. Altscher – FBR Capital Markets & Co.

Great, yes, that was helpful, as well. And maybe just one quick one also on the commercial real estate side. Last quarter, you talked about a relationship or getting into the flow with an originator. Can you maybe provide an update on that, if that is happening or has happened?

David Finkelstein

Well we’ve done a couple of things on that front since the beginning of the year. One is we – which we released a while ago. We hired a gentleman, Michael Quinn, to help us in the equity side to start building a triple net lease portfolio. And so far – you will see the benefits of that effort in this current quarter. In addition, we have started a relationship with Inland, who is a large player in the triple net lease space, who will help us to leverage ourselves in terms of sourcing, underwriting, closing and managing triple net lease assets and we expect that to be very beneficial over the net year or so.

Daniel K. Altscher – FBR Capital Markets & Co.

So specifically, you mean lending to triple net lease, or lending to their non-traded REITs, as opposed to buying the equity?

David Finkelstein

Buying the equity.

Daniel K. Altscher – FBR Capital Markets & Co.

Buying the equity. Okay. Interesting. Okay.

David Finkelstein

So our dual strategy this year is both pursuing debt as well as [how right] (ph) equity positions.

Daniel K. Altscher – FBR Capital Markets & Co.

All right, interesting. Yes, we will look for that as it comes up. Thanks.

Wellington J. Denahan-Norris

Yes. One thing we should know when you – someone asked a question earlier about leverage on our commercial position. The leverage that we on a couple of pieces are equity pieces that we have in the triple net space that’s we’ve had for some period of time.

David Finkelstein

Right and that leverage is in the form of first mortgages.

Wellington J. Denahan-Norris

Yes. First mortgage debt.

David Finkelstein

But with third-party just…

Operator

Okay. Our next question comes from Michael Widner with KBW.

Wellington J. Denahan-Norris

Hi Mike.

Michael R. Widner – Keefe, Bruyette & Woods, Inc.

Hey, good morning guys.

Wellington J. Denahan-Norris

Good morning.

Michael R. Widner – Keefe, Bruyette & Woods, Inc.

So let me just follow up on what you were saying about the swaps, just so I'm clear.

Wellington J. Denahan-Norris

Sure.

Michael R. Widner – Keefe, Bruyette & Woods, Inc.

So you were basically referring to the $24 billion in that it was zero to three-year bucket. I mean as what I am – am I hearing that you're essentially going to eliminate that -- liquidate it? Or are we talking more, let it run off, and not think about it, as far as core earnings go—I guess I just…

Wellington J. Denahan-Norris

No we are in the process of repositioning that position, which will result in a material improvement in our core earnings profile and our spread profile. The thought process prior to this was that it maybe beneficial if the fed was really serious about adjustments on short-term rate. I think the commentary coming out has been pretty – I guess as clear as they can be that they don’t want to set a time period on that first rate adjustment, as she initially was coaxed into at six months. So the utility of that position is somewhat diminished, and the protection that it provides in an environment where you are not really going to have any kind of material adjustment upward in the forwards, would suggest that it's time to bring that position down.

Michael R. Widner – Keefe, Bruyette & Woods, Inc.

So I guess, two related follow-ons to that, I mean first, I'm not an accountant, and I'm glad I'm not. But there is some different – I've seen mortgage REITs use different policies; some that when you liquidate swaps, they say: Well, we have to amortize the position and the value of the position over the course of the remaining life.

Wellington J. Denahan-Norris

Yes, that’s correct.

Michael R. Widner – Keefe, Bruyette & Woods, Inc.

And so, from that standpoint, I mean would there still not be a – at least a GAAP cost or – and then I suppose the question is: Would you consider that core, even if it remains in GAAP?

Wellington J. Denahan-Norris

I will let Glenn answer the accounting.

Glenn A. Votek

Yes, from an accounting standpoint, you would realize the gain or loss at the time of extinguishment of the instrument. For tax purposes, you would defer and amortize that over the original term of the transaction. But for GAAP purposes, it would be realized in the current period.

Michael R. Widner – Keefe, Bruyette & Woods, Inc.

Okay. And so, presumably, that – same goes for core then. I mean if you take the one-time charge now, and then core would be.

Glenn A. Votek

Yes.

Michael R. Widner – Keefe, Bruyette & Woods, Inc.

Okay. And so, then the second question related to that: I don't know if it's going to be the full $24 billion or whatever it is, but is there any idea – notion about – your weighted average pay rate is 1.78%. I mean that's about where five-year swaps are so I mean today. So any idea about sort of just liquidating them and adding longer positions or should we expect a net reduction in the total balance notional amount of swaps?

Wellington J. Denahan-Norris

As you see, we have added dated positions. And our goal, obviously, is to maintain significant or sufficient protection on the book value of the Company. So it's not – the amount of protection that this bucket is providing relative to the drag is creating on core earnings and it doesn't justify maintaining it any further, in light of the policy communication that has been coming out of the Fed.

So we will certainly be mindful of rates moving in the future, and how to protect – how to best protect the position. So I wouldn't say this is just a completely saying we are no longer going to maintain sufficient protection on the book value of the Company. I will let Dave elaborate any more, if he.

David Finkelstein

Sure, I think when you look at rates in the forwards for example right now the markets implied forward rate on 10-year note 1 year from now is roughly 2.95% this morning, that relative to consensus forecast, is a little bit lower. I think at the end of the quarter, consensus forecast was for 3.25% on the 10-year note at year end.

So what that view reflects is that we think that the forwards on the longer end of the curve are probably little too optimistic and we are willing to pay on those forwards and given the fact that the front end policy is fixed for the next year and perhaps longer. We feel like the front end and having rate exposure short rate exposure that part of the curve. Just doesn’t give us the protection that having swaps on at the longer end of the curve provides.

Michael R. Widner – Keefe, Bruyette & Woods, Inc.

I don't think you'd get any argument, probably, from very many people on that. So certainly makes sense; appreciate the clarity. And then if I can, just one other quick one, or at least hopefully. There was a pretty sizable drop in the G&A expenses this quarter. And it's the lowest level in at least a long time. Are there any one-time sort of benefits in there? Or should we think I mean is that what we should think about as a run rate or kind of what’s going on there with the big Q-over-Q change.

Glenn A. Votek

Yes, so a couple of things there. One is, the run rate going forward will be more consistent with what you see here they were some activities that we were conducting within our broker dealer that were no longer doing so we have lower broker fees as a result of that, so that’s that something that will continue. We did have a true-up in the Q1 numbers for a couple million dollars. So that obviously was a one-timer. But generally speaking, you should see this more consistent as a run rate going forward.

Michael R. Widner – Keefe, Bruyette & Woods, Inc.

Okay. Thank you, as always, guys. And definitely appreciate the detailed comments.

Wellington J. Denahan-Norris

Great. Thank you.

Operator

(Operator Instructions) Our next question comes from Joel Houck with Wells Fargo.

Joel J. Houck – Wells Fargo Securities LLC

Good morning.

Wellington J. Denahan-Norris

Good morning, Joel.

Joel J. Houck – Wells Fargo Securities LLC

Hi, Wellington, just the question is on the commercial real estate portfolio. You have a little over 50%, at least on asset weighting on mezz and preferred. And one would think that this obviously business is a nice hedge to the agency business. Can you give us some thoughts or guidance on how, as you guys continue to build out that – the allocation there, what we should expect in terms of where you're going to be investing in the capital structure in the commercial real estate side?

Wellington J. Denahan-Norris

Yes, again, we look at the balance sheet holistically and as you mentioned, we approach this in a way as a macro hedge position but the micro commitment of capital along the capital stack. I will let Bob Restrick talk a little more about that.

Robert Restrick

Hey, Joel. The thing to keep in mind on the first mortgage positions is that our intent is to attain financing on them in some form. So that market somewhere in the 4.5% to 5.5% coupon range, something like that, which is obviously a lot lower than what we’re getting in the med and preferred arena.

So, what we do there is, which we did with your firm, is securitize those first mortgages as the model that we have been using so that in the end we will take $400 million of first mortgages, and turn them into double be a below and as well as the I/O position having replaced the investment grade with investors. So even though we have a sizable first mortgage position we do see financing on those. And that's – so in the end, the finished product is sort of our own made mezzanine position.

Joel J. Houck – Wells Fargo Securities LLC

Okay, but I mean, I guess I'm wondering, like in terms of – I see, at the end of March, you've got a roughly 54% in mezz and preferred. Should we expect that to grow over time, in terms of percentage weighting? Or is it just investment specific and…

Robert Restrick

Well I think that's on the balance sheet so it doesn't take into account the liability side of that, which is the securitized debt. So, that would change your percentage.

Joel J. Houck – Wells Fargo Securities LLC

Okay. Would you have that percentage offhand?

Robert Restrick

I don't have that.

Wellington J. Denahan-Norris

I mean generally speaking, we will not hold a position of first mortgages. They will be a temporary position on the balance sheet until they move into securitization.

Robert Restrick

Yes, I mean in the perfect world, it will all be in some form of mezzanine investment. It just going to be a timing issue between aggregating first mortgages and turning them into bonds.

Joel J. Houck – Wells Fargo Securities LLC

Okay, got it. I guess maybe just more of a philosophical question – back on the agency business. It seems like everyone is – it's a foregone conclusion that the Fed is going to finish tapering, and is going to be out, at least as far as new purchases go. How would you handicap – if the economy and housing market really starts to weaken in the second half, is it your view that Yellen and the Fed will continue to move down this path, regardless of the data?

Because it seems like there's an element or a faction of the Fed that believes that QE is not working, and they just want to end it. On the other hand, as you're I'm sure very well aware, if you withdraw the accommodation, you could really exacerbate a very weak economy into a very nasty recession, which I tend to believe that they would try to avoid that at all costs.

Glenn A. Votek

To address the question as to whether we think that, in the event the economy further deteriorated, would the Fed either pause the tapering or perhaps even increase the size of it? Our view is that the bar is very high to not follow through with the taper. I think that when you look at the size of the Fed’s balance sheet, approaching $5 trillion, the cost associated with that both direct cost to owning a portfolio of that size to the Fed over the long-term plus the costs associated with market functioning in terms of owning significant portions of the flow to book treasuries and mortgages.

There are some pretty significant cost and the increased with the size of the footprint of the Fed. So our view is that not so much that QE was an effective but there are some limits to the extent that you can use that as a policy tool. So in the event that things did further deteriorate we would anticipate that forward guidance gets extended and that's the path that the Fed goes down.

Wellington J. Denahan-Norris

Yes, and if it's any indication, we actually have three employees – ex-employees that work on the Feds portfolio that are currently employees of ours.

Joel J. Houck – Wells Fargo Securities LLC

Interesting. Okay, great. Thank you.

Operator

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

Wellington J. Denahan-Norris

I just want to thank everybody for taking the time to listen to our Q1 earnings call. And we certainly are happy to discuss anything into quarter and we look forward to speaking to you on the second quarter. Thank you.

Operator

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.

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