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Executives

Kathryn Fontenot Fagan - Chief Financial Officer, Principal Accounting Officer and Treasurer

Wellington Jamie Denahan-Norris - Vice Chairman, Chief Operating Officer, Chief Investment Officer and Portfolio Manager

Unknown Executive -

Michael A. J. Farrell - Chairman, Chief Executive Officer and President

Analysts

Steven C. Delaney - JMP Securities LLC, Research Division

Stephen Mead - Anchor Capital Advisors, LLC

Stephen Laws - Deutsche Bank AG, Research Division

Daniel Furtado - Jefferies & Company, Inc., Research Division

Joel Houck - Wells Fargo Securities, LLC, Research Division

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

Bose George - Keefe, Bruyette, & Woods, Inc., Research Division

David B. Miyazaki - Confluence Investment Management LLC

David M. Walrod - Ladenburg Thalmann & Co. Inc., Research Division

James McCanless - Guggenheim Securities, LLC, Research Division

Dean Choksi - UBS Investment Bank, Research Division

Jason Arnold - RBC Capital Markets, LLC, Research Division

Mark C. DeVries - Barclays Capital, Research Division

Michael P. Taiano - Sandler O'Neill + Partners, L.P., Research Division

Annaly Capital Management (NLY) Q3 2011 Earnings Call November 2, 2011 9:00 AM ET

Operator

Good morning, and welcome to the Third Quarter 2011 Earnings Call for Annaly Capital Management, Inc. At this time, I would like to inform you that this conference is being recorded. [Operator Instructions]

At the request of the company, we will the conference up for questions and answers after the presentation.

Unknown Executive

This earnings call may contain certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.

Forward-looking statements, which are based on various assumptions, some of which are beyond our control, may be identified by reference to a future period or periods or by the use of forward-looking terminology such as may, will, believe, expect, anticipate, continue or similar terms or variations on those terms or the negative of those terms.

Actual results could differ materially from those set forth in forward-looking statements due to a variety of factors, including, but not limited to, changes in interest rates; changes in the yield curve; changes in prepayment rates; the availability of mortgage-backed securities for purchase; the availability of financing and if available, the terms of any financings; changes in the market value of our assets; changes in business conditions and the general economy; changes in governmental regulations affecting our business; our ability to maintain our classification as a REIT for federal income tax purposes; risks associated with the broker-dealer business of our subsidiary; risks associated with the investment advisory business of our subsidiaries, including the removal by clients of assets they manage, their regulatory requirements and competition in the investment advisory business.

For a discussion of the risks and uncertainties which could cause actual results to differ from those contained in the forward-looking statements, see Risk Factors in our most recent annual report on Form 10-K and all subsequent quarterly reports on Form 10-Q. We do not undertake and specifically disclaim any obligation to publicly release the result of any revisions, which may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

Operator

I will now turn the conference over to Mr. Michael Farrell, Chairman, Chief Executive Officer and President. Please proceed, sir.

Michael A. J. Farrell

Thank you, Sue. Good morning, everyone. And welcome to the Third Quarter 2011 Earnings Call for Annaly Capital Management. I'm Mike Farrell, and joining me today are Wellington Denahan-Norris, our Chief Investment Officer and Chief Operating Officer; our Chief Financial Officer, Kathryn Fagan; and our General Counsel, Nick Singh. As is our custom, I'll begin our call with some prepared remarks, after which we will take your questions. A written version of my remarks complete with any reference graph is available on our website at www.annaly.com.

Today's message and commentary is entitled Lessons From the Emergency Room. The patient is in distress, he arrives at the hospital with multiple symptoms all signaling a major infection. Rushed into the intensive care unit, all sorts of measurements and tests are taken in an attempt to assess the type of the stress of the illness. The goal is to make a correct diagnosis and then prescribe the most efficient course of treatment. As the medical team tried to determine whether the patient is suffering from either a bacterial or a viral disease, these tests are essentially a process of elimination from worst case to best case. Bacterial infections must be identified and either ruled out or dealt with immediately. They can spread voraciously. So the first and best course of defense is to assume that the infection is bacterial and aggressively attack it with powerful antibiotics while the stress tests are being run.

Many times, the cause is not bacterial but it's viral. In those cases, sometimes the best course is to allow the patient's natural immune system to gradually perform its natural healing function. But if the problem is viral, continual administration of powerful antibiotics can oftentimes create more problems than it solves by preventing white blood cells from doing their job. Of course, the patient in this story is the Global Financial System and the ER doctors are policymakers. The defense of the financial system in 2008 was an all-out war of the symptoms of what was assumed to be the bacterial infection of subprime mortgages. All around the world, emergency measures were thrown at the symptoms of the global financial meltdown. In the absence of a complete diagnosis, it was the right thing to do. Staunch the bleeding and stabilize the patient. In the daisy chain of connected economies and stakeholders, however, the weakest links gave out first and the medicines induced to combat this brought risk of a larger, stronger link in the chain being infected through side mechanisms or other holes in the system.

Subprime wasn't the only problem, it was just the external agent that activated the dormant virus of overleveraged, falling asset values, including the oversupply of homes in the U.S. and structural fiscal and current account imbalances. As the patient seems to be stabilizing, the realization that the conditions are not bacteria but rather viral have gotten lost in the treatment. Delaying the inevitable elements of the worst-case scenario through increasingly aggressive and desperate policymaking is simply reopening the wounds of 2008, market-by-market, country-by-country and consumer-by-consumer.

As the American consumer drives the U.S. economy and is thus a key component of global growth, I'd like to take a moment to update you on how the Grimm family is doing through all of this. You'll recall that I introduced the prototypical, average American Grimm family in my first quarter of 2010 earnings call comments, which you can find on our website.

Back then, we estimated that based on the median family income of $52,029, after taxes, insurance and debt service, the Grimms had approximately $730 per month left over to pay for essentials like food, car, phone, cable and Internet, and an occasional movie. As we said then, they juggle their payments, they're occasionally late but they are barely just above water long enough as they stay employed. Not a lot of room for error.

How are the Grimms doing today? After all, policy prescriptions that have been thrown at the economy, they are all essentially in the same place and here's why. Yes, their debt service is falling thanks to Federal Reserve efforts to lower rates across the yield curve and if you assume that the Grimms are good candidates for the new improved HARP program, the graph that you'll find in my written version remark shows that the financial obligations ratio hasn't been on an improving trend for several years.

The problem is, is that while debt service is falling, the Grimm's family income is also falling. As the graph found in my written mark shows, median household income has been on a decline since 2006. Meanwhile, on an inflation-adjusted basis, the Census Bureau reports that incomes fell 2.3% from 2009 to 2010.

Thus lower interest rates and HARP adjustments may help, but they are offset by the reduction in income. In a macroeconomic sense, I believe that the stimulative effect of policy will be offset by the structural issues of unemployment and lack of high income growth. Assuming that HARP 2.0 comes in at the high-end of its advertise success range of $3 million mortgages, we estimate that the HARP 2.0 produces $9 billion a year in stimulus. But the Grimms of America have probably all but lost that in their buying power.

Data out from the Bureau of Economic Analysis on Friday, October 28, showed that personal income was effectively flat in the third quarter, rising a meager 0.08% from June to September. Real personal income actually fell 0.7% during the same period. Consumption rose 1.7% during the third quarter on a nominal basis, and 1% on a real basis. So while incomes are falling, how are the Grimms finding the resources to spend? Unsurprisingly, spending was driven by a drastically declining savings rate, which fell from 5.3% in June 2011 to 3.6% in September of 2011.

While good for quarterly GDP reporting, this may not be the healthiest thing for the Grimms to do.

Circling back to the metaphor. Wherever you are in the emergency room, in America, Europe or Asia, the correct diagnosis is the problem is not bacterial, it is viral. It needs to be allowed to run its course. True valuations need to be established, clearing prices need to be set by capital allocators who can determine valid, unsubsidized risks and rewards. The longer the globe waits to admit this assessment, the greater the risk that the virus mutates. As we've all witnessed, viruses have a way of mutating into a new more virulent form. For problems like we have now, the creative destruction of capitalism is the best medicine.

Again, my remarks can be found on our website, along with our companion video. Operator, we'll now take questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Bose George of KBW.

Bose George - Keefe, Bruyette, & Woods, Inc., Research Division

Have a couple things. One, I just wanted to start with leverage. Our leverage seems to be at a historic low. Was this partly just slow deployment of the capital after the raise? Or could it go up a little bit back to that 6x? Is there any comment there?

Wellington Jamie Denahan-Norris

It's all by design. I think, anybody who's paying attention to the headlines in the volatility in the market and other people can manage their books in different ways. We tend to be a bit more conservative. Leverage is a very easy thing to take up, it's not always a very easy thing to take down as some of the recent headlines have demonstrated. So it's something that we feel more comfortable with. Again, as market conditions change, we can always adjust it when we feel comfortable where it is.

Bose George - Keefe, Bruyette, & Woods, Inc., Research Division

Okay, great, makes sense. And then, actually, a broader question. I just wanted to ask about the -- the Financial Stability Oversight Council has -- they've issued guidelines on institutions that are systemically important. One threshold they have is the $50 billion in assets -- you guys have $100 billion and that could grow. I'm just curious in your thoughts about what could happen if Annaly is deemed systemically important by FSOC?

Michael A. J. Farrell

Well, I think that the FSOC conditions are really going to focus on companies that are primary, systemic integration problems. And I'll point to some of the large financial companies, as well as some of the large insurance companies as a result of that. Certainly, in the 20 or so criteria that FSOC has got out there, we're big enough to fall into 1 or 2 of those categories but we're certainly captured underneath many of the different aspects of the rulemaking that's going to be followed by the people that we integrate into. So I think one of the things, just to follow-up on Wellie's point of view, the way that I look at what we prepared the company for is I think that our balance sheet is in a war chest position. We've got $3.5 billion worth of cash or cash equivalents on the balance sheet. We're using it, as you pointed out, very well, I think, historically low leverage to create a middle teens ROE, which is consistent with the highest returns that we created in the market over time since our inception. We think that there's going to be a number of assets coming to market. We think, from the purchase that we see, a lot of things are going to be delevered and the FSOC rules are going to change around that. If you want to look at MF Global, that's a very easy thing for us to compare because in my mind, MF Global is about the same size as many small European banks who are long sovereign credit. And those kind of conditions, especially with that $0.50 haircut on the derivatives market, and CDS market, is very telling to me about the way that policymakers are going to try to ignore long-term problems to come down the road and punish risk takers. So that's going to mean more and more assets coming to market. And we now are in a great position to acquire those assets at higher yields.

Operator

The next question comes from Mike Widner of Stifel, Nicolaus.

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

I'm wondering if you could talk a little more about the HARP 2 exposure that you guys see potentially within your portfolio and sort of how you're positioning around that?

Kathryn Fontenot Fagan

I think the broad market, and I think we are representative of the broader market, that the expectations are anywhere from 5 to 10 CPR increases. Again, we expect about half of the impact on HARP 1, so about 400,000 or so loans be impacted.

Michael A. J. Farrell

And I think it's all at the margin, Mike. All of the stuff that's fringing around at the margin. The big push in prepayments that you saw and refinancings that you saw in this latest quarter was really, we think a reaction to the cap being lowered on conventional loans from 729 to 625. And allowing that to expire in October 1, a lot of banks were pushing in there and a lot of borrowers trying to get 1/3 of your money at 4% or so as government guarantees. I think that that's going to be an offsetting characteristic or element to some of the things that they're trying to push through in HARP. So the success of that program, I think is that question but it is a marginal program. If you think about my opening remarks about the Grimm family, they are the prototypical people who would be eligible for that. They've been making their payments, they are on time, they're upside down in their house. You know what, those are good people. Those are people who struggle from paycheck to paycheck. If they get extra money, given what we're seeing happening to their income, they're going to pay down other credit card debts or they're going to pay down -- they're going to put it in their savings account. They're not going to go out and buy a big screen TV with it. So that behavior, I think, is over in the markets and I think this is a last ditch attempt by the government to try to save who they can, really, in the market.

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

Yes, well, it's an attempt, whether it's the last ditch or they find a couple of more ditches is...

Wellington Jamie Denahan-Norris

That's another reason why we run leverage where we run it, that's just another element of uncertainty out there.

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

Yes. And I mean, I'm sure you guys know this but that financial obligations ratio is calculated, it's a hypothetical ratio. It assumes people actually can refinance at current low rates.

Michael A. J. Farrell

Yes, you're right.

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

And so -- yes, the practical number may be quite a bit different. So just following up then on the refi issue. Is it fair to say that you guys think that going forward, you might see kind of Q4 levels and maybe you could comment on your October prepaid speeds but Q4 levels kind of in-line with Q3 levels? And then, all else equal, yield curve kind of stays where it is, maybe that flattish to down as opposed to ramping up next year?

Michael A. J. Farrell

I think -- I'd like to see what the Fed says this afternoon but my gut is, is that if you look at the programs in general, QE1 and QE2 have been not providing the stimulus that the Fed thought -- it's not helping them make their mandate, unemployment is staying high. Operation twist, the full effect of that since it’s announced is about 4 basis points of flattening. Nothing material really on the front end of the curve from the selling and the buying that's going on there. So these programs, it's not about low rates, right? I think that we can all agree with that as investment professionals here. It's not about low rates. If you had access to low rates, you've been taking advantage of them. It's really about what's the loan to value ratios and this kind of interference by HARP programs or by 0 bound interest rates for extended period of time do nothing but make markets misprice risk and that's the point in my opening comments is we can try to stem this by making it spiral down at a slower rate through policy but at the end of the day, you're going to wind up with a mess that's morphed into a different virus. And everyone thinks that the Volcker rule can kill risk. To me, it's like Jurassic Park, life finds a way, risk morphs into something else, it just becomes bigger risk.

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

It seems we have a couple of thousand years of capital market's history that support your theory.

Operator

The next question comes from Mike Taiano of Sandler O'Neill.

Michael P. Taiano - Sandler O'Neill + Partners, L.P., Research Division

So when you talk about this deleveraging that you expect to continue to happen in assets that'll become available, anything more specific there? Or are you primarily talking about MBS or are there other assets out there that you're interested in?

Michael A. J. Farrell

I think it's across the board, in the three companies that we have a perch and also in our middle market lending group, as well as in our triple net leasing activities that we just started in the summer. We're seeing massive amounts of assets being shifted around and did want it in effect. I don't think this is a pricing exercise. This is a reshaping of global cash flows in a meaningful way. I'd point to the CreXus transaction that we did earlier in the year where we partnered up with Barclays to take a major portfolio of American-based assets off of their hands because that's no longer a core business for them to be operating in that market, in that particular market. I think there's going to be a lot of transactions like that. One of the headlines that shot across the Bloomberg the other day was that the bank of -- the Central Bank of Norway had effectively sold all of its mortgage-backed securities positions in the United States and they've gotten out. So I think all of this is going to occur across a lot of different asset classes. It's going to be everything from securities to properties and I think that REITs are uniquely positioned to take advantage of the long-term capital formation that's needed to do this. And you have to be well positioned to do it.

Michael P. Taiano - Sandler O'Neill + Partners, L.P., Research Division

Okay, and then just a separate question on the sort of the progression of the SEC comment letter and sort of the way you see that going, how that has progressed so far? And what do you think -- what your thoughts are on that?

Michael A. J. Farrell

The SEC letter is definitely -- I think the commentary is up in a week or so. You're going to hear comments from the trade groups, the various trade groups and stakeholders in the industry, as well as from individual companies. I think there's a great deal of confusion about that especially in the sightings that they put out there about Carlyle, as well as a mortgage banker in 2 private investment companies. There had been no sightings against any real estate investment trusts. So at the end of the day, we take an act of congress, we think, to change the mandate that comes out of the exemption in the '40 Act. And I think that's going to be evident from the filings that are put back out, the responses on the comments.

Operator

The next question comes from Mark DeVries of Barclays Capital.

Mark C. DeVries - Barclays Capital, Research Division

Mike, I meant to get your thoughts on the chances that the Fed emerges from their meeting today with a conditional precommitment on another round of large-scale asset purchases targeting the mortgage market. And a lot of your comments about how an effective twist has been what the real impact to that should be on mortgage yield if they did that?

Michael A. J. Farrell

I think that the Fed has been in a valiant attempt to try to keep down rates for consumers since they started to purchase those assets about 2 years ago. I don't think that they want the balance sheet to be as big as it is. Obviously, if you look at the conditions that just went on with, say, the Maiden Lane portfolio where they came back and they wanted to try to sell it, it caused major disruptions to the credit markets while they were trying to attempt to do that. So once again, I think that this is not about interest rates, right? This is about at Loan-To-Value Ratios, equity valuations underneath it. And they may come in and purchase more treasuries but MBS is actually one of the highlights, I think, of REITs over the past couple of years is we've actually been absorbing a great deal of the issuance into REITs that used to go into Fannie and Freddie's hands. So the capital markets is providing private capital solutions for this. And it's very interesting to me to see how they've been so diligent at keeping down rates in general but that foreign sellers continue to sell into that bit. Like the Bank of Norway, for instance. So there's lots of stuff that still come back home. Trillions of dollars worth of deleveraging to go on. And I think that the shape of the credit curve, not necessarily the treasury curve, but the credit curve, is going to reflect wider spreads as a result of that. And that's why a company like Annaly can make the returns that it makes for its shareholders using the least amount of leverage in its history.

Operator

The next question comes from Jason Arnold of RBC Capital.

Jason Arnold - RBC Capital Markets, LLC, Research Division

Mike, as usual, a great commentary. Just curious, you had an uptick in average borrowing cost this quarter. I assumed you put on some term repo but maybe you can comment here, please?

Kathryn Fontenot Fagan

Yes, it's just a small change in the average borrowing costs. It has to do with just the day count. Also, if you look at our convertible debt, interest expense number, there was an uptick there because of the bifurcated embedded contingent option. So it may not be a cash change, but an accounting change on that. But there's not a significant change in the borrowing costs. The weighted average days to maturity also went up slightly from 46 days to 57 days. So you're seeing a small tick-up because of that.

Jason Arnold - RBC Capital Markets, LLC, Research Division

Okay, and then just one other quick one. Swaps are more or less still a lot cheaper now than they've really been ever. I'm just curious if you can comment on your positioning of your swap book here. Do you feel like extending tenure makes sense or kind of sticking with the 2-year net duration?

Wellington Jamie Denahan-Norris

Yes, I mean, we continue to adjust according to the market. And so keeping in mind that you could get more purchases out of the Fed, you could get more attempts out of policymakers to try and do some refi wave. So we just continue to try and match things up where we feel comfortable given the current market environment.

Operator

The next question is from Steve Delaney of JMP.

Steven C. Delaney - JMP Securities LLC, Research Division

I wanted to talk to you a little bit about Fed policy, but you've already made several comments on that. I guess, on that, just on the fringe of that, though, I'm not sure that I mean -- in '08 and '09, the Fed was the great stabilizer and I think we all know what we got there. And now they're trying to be an economic stimulator. I don't know about you but it's not clear to me really what we're getting out of the Fed, and I think you sort of suggested that you might have that same view, at least, as far as the impact on the economy. I guess, my concern is this volatility in the 10-year yield, I mean, we've had 50, 60, 70 basis point swings from low to high here in the last month. Are you surprised by that? Do you think the Fed is contributing unit to that in any way with kind of mixed messages about policy and I guess, specifically, if you could, do you guys have any kind of view on where this tenure might settle in over the next couple of months?

Michael A. J. Farrell

Somewhere in the 60 to 70 basis point trading range. I'll defer to Wellie on that.

Wellington Jamie Denahan-Norris

Yes, I would say that a lot of the volatility you're seeing is not just coming from Fed, policy is coming from overseas. And anytime we solve the Greek situation sold off and then people realize that actually, it's not been solved. So I think this is just another reason why we sit at the leverage level that we do because there's a lot of forces weighing on what's going on in the marketplace. And so until you get some of this stuff out of the way, there's just so many things that are impacting rates of return that aren't normal contributors. So...

Michael A. J. Farrell

I'm not sure that you're seeing Fed policy causing this volatility. I would suggest -- my speculation is you're watching a tremendous amount of liquidations and repositioning going on. Just look at the unwinding of MF Global, for instance. And extrapolate that over into companies that need to get their balance sheets in order -- or hedge funds that have to get their balance sheets in order, leading into some of the Dodd-Frank or the FSOC scrutiny. There's a huge amount of repositioning and unwinding that's going on that I think is actually hurting the opportunity for the Fed to do something more meaningful in some of these programs. But simply because the weight of the supply that's in the market is so great. There's a tremendous amount of bonds that are flowing around the markets from foreign sources as well as domestic sources that are repositioning to either escape currency risk or reposition for industry risk or steeper yield curve or get out of prepayment risk. There's a lot of things going on, a lot of metrics and dynamics in this market that are fascinating to watch day to day.

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

No question on that. I mean, I totally agree with Wellie's comment about the Greece situation and we almost see that -- its direct correlation to the tenure on the hour almost and -- but I certainly can appreciate that whether it's swaps or your bond selection, it really is a challenging time for you when we have this kind of volatility and yields to try to match up funding and try to evaluate cash flows.

Wellington Jamie Denahan-Norris

I mean, the life as a mortgage investor is always challenging. It's just unfortunate that the challenges don't repeat themselves.

Operator

The next question is from Stephen Laws of Deutsche Bank.

Stephen Laws - Deutsche Bank AG, Research Division

Most of my questions covering prepays and leverage and such, I think, you guys have covered. Just a quick one. I expect a pretty short answer, honestly. But do you guys have any exposure to MF Global that you guys are worried about.

Michael A. J. Farrell

Nothing material. And just a note on that for the markets as someone who's been at this for a long time. My observations here is that I can't speak about the commodity side of the business and the issue may have occurred over there. But from a fixed income perspective, this looks like a totally normal Fed-supervised wind down. Supervised very tightly, similar to what went on in Drexel. I expect all of this to unwind repos or bankrupts or remote transactions, and that will unwind first. And we have no material risk out to anyone. But just for everyone to know that, that's what happened in these markets.

Stephen Laws - Deutsche Bank AG, Research Division

Great. And then I guess, Wellington, one quick question on the portfolio. The realized gains ticked up. I imagined it's just likely normal kind of portfolio positioning. But can you maybe comment on that. Was it anything specific you guys were trying to do? Was it a decision specifically to take down leverage? Or it's just simply typical portfolio activity during the quarter?

Wellington Jamie Denahan-Norris

It's typical portfolio activity. Our team is very diligent about constantly combing through the portfolio to minimize our exposure to refi activity, to take advantage of outsized premiums in the marketplace. And so you will see -- going back several years now, it's been a constant presence on our balance sheet, the portfolio gains activity, which is a nice thing.

Stephen Laws - Deutsche Bank AG, Research Division

Yes. I imagine with the unrealized gain position in the marks that we're likely to see that line item be positive for positioning near term.

Michael A. J. Farrell

Yes, I mean, as the Fed comes in and knows another way of buying, you could have 4 at 110, that would be nice. But I think the bottom line is, Steve, is that by being in this position, which I think is a very powerful position, as I said, we've got $3.5 billion cash war chest that's in position for low leverage. The company through 10/31 has doubled the return under the S&P and far outweighs what happened on the Bloomberg REIT Index. So I think that the bottom line is that it validates what we've been saying and that's wider spreads are probably here for a while. This volatility is only going to shake those spreads, right along with the supply that we see coming from the futures markets. Whether it's the Fed that's going to be selling assets eventually or the Fannie and Freddie portfolio being unwound or some sovereign wealth fund deciding that they want to get out or just in general, supply coming out of U.S. institutions so we're downsizing their balance sheet exposure. This is a great time to have this kind of balance sheet to acquire those assets.

Operator

The next question is from Joel Houck of Wells Fargo.

Joel Houck - Wells Fargo Securities, LLC, Research Division

Mike, I'm wondering what views on inflation are longer term. I mean, if you look at what happened in the treasury market this quarter, a little surprised you guys didn't given take the swap book up a little bit more given how much rally we've seen in treasury rates. Is this something that you guys would look to do in terms of locking in spread on a longer-term basis, if we got another rally this quarter in treasuries from perhaps QE3?

Wellington Jamie Denahan-Norris

You always have your swaps against a callable asset. And so we will always keep that in mind. You can have the lowest rates in your swap books, but if you don't have the assets underlying to service it at the levels you need, you're going to run into issues. And for anybody that was paying attention to Dexia, one of their problems was the fact that they had swaps at levels that they no longer could service as rates continue to go lower. So we constantly will balance it out given the backdrop in the marketplace, on what's going on with potential Fed purchases or refi activity and things like that. But yes, you are correct in saying that it's definitely a very interesting time to be able to purchase insurance for the longer term. It's just we'd like to see a little bit more or a little less interference, if you will, which I know will impact those rates, but it will also impact your asset yields.

Joel Houck - Wells Fargo Securities, LLC, Research Division

Okay. And when you say a little less interference, I'm assuming you mean Fed intervention.

Wellington Jamie Denahan-Norris

I'm -- meaning all different of kinds things, whether it's policy makers coming out with HARP 3000 or whatever. So we just kind of want to just to let some of this stuff fall by the wayside and get some of the noise out of the space before we do anything longer term. And again, we will always be somewhat conservative in our approach. And we continue to have swaps rolled down into the new market.

Michael A. J. Farrell

I mean, our perception is just that all of this continued deleveraging is deflationary over the short to the intermediate run. Ultimately, it could have inflationary expectations built up into the system. But in my shelf life, most inflation has come from things like wage inflation, that was built into things like union contracts, et cetera. I just don't see that occurring. CPI is being driven by food and energy, which they don't want to count in those numbers and I think, that just eats into more discretionary spending. So consumer balance sheets are in good shape, better shape. They're making rational decisions. They just don't have as much money to throw around, so they're not going to go to McDonald's, they're not going to go -- they're going to use the money more wisely than they did in the past.

Joel Houck - Wells Fargo Securities, LLC, Research Division

Okay. And then kind of switching gears. If you look at the amount of homeowners that are underwater today and for generally 10 degrees, your comments in some near-term deflation, one would assume that home prices are probably not going up any time soon. There are billions if not trillions of mortgage losses that have to be absorbed by somebody, either investor, the taxpayer. Did you -- does Annaly have a sense or an estimate for how large those losses are that need to run through the system? And do you have a view on how those losses manifest themselves, split between taxpayer, investor or any other entity?

Michael A. J. Farrell

We have a lot of work that we've done that as part of our proprietary projections and thoughts and speculations about how we think this is going to play out. But it's a $5 trillion government market. So any policy like HARP, essentially, is going to be additive to the deficit. But it's also going to have the side effect of destroying bank earnings because bank earnings are based off of premium amortization write-down. You saw our amortization go up this quarter. Think of that as long term that would hurt the private sector, as well as the taxpayer. I don't sense any appetite for that down in Washington in the discussions I had down there. And I think that's a pretty big number. The other balance, the other $5 trillion or $6 trillion worth of non-agency paper, I think that anything written there after 2007 is probably in decent shape, assuming that the fundamentals of the economy stay around these levels with the 9% unemployment or so and low income growth. I think the loan-to-value ratios and underwriting standards that went into 2007 and forward were pretty good. I think a lot of that stuff, though, will spill over into -- if not into the insurance companies who put on private mortgage insurance, it will also spill over into the banking sector again and then waterfall effect over into second liens. So I understand the urgency of the Federal Reserve policy to make sure that everybody who can stay in their house will stay in their house. Alan Greenspan once said at a dinner that we were at, in response to our question about why did he agree to the RTC so quickly. It's very simple. The Federal Reserve doesn't want to cut grass and it doesn't want to paint houses. And I think that is still there. I think we'll ultimately wind up with some kind of RTC-like solution to this. It's just a question of having the right administration policies to do that.

Wellington Jamie Denahan-Norris

I think the Fed's doing a disservice to the market by -- I mean, to the banking sector's ability to absorb the eventual impact by flattening the curve.

Operator

The next question comes from Dean Choksi of UBS.

Dean Choksi - UBS Investment Bank, Research Division

By my estimates, the dividend included are a component of the taxable income from a gain on MBS sale. Can you just talk about how gain on sale fits into your dividend policy?

Kathryn Fontenot Fagan

The gains on sale securities have to be paid out 100% to avoid excise tax.

Dean Choksi - UBS Investment Bank, Research Division

Do you look at it on a quarterly basis or an annual basis?

Kathryn Fontenot Fagan

I, typically, look at it on a quarterly basis. There are some book tax differences. And when we do declare the dividend, it is an estimate at that time because it's prior to quarter end, but I try to look at that quarterly and then by year-end, do an estimate to avoid excise tax and pay out that -- declare that dividend at the end of the year. But just keep in mind, on the spread income, we have to declare 85%, which includes some carryover from the prior year. So it's not an exact number that you can tie back to because there are some book tax differences.

Dean Choksi - UBS Investment Bank, Research Division

Okay. And then a question on the decline in book value in the portfolio. Can you provide a little color, I guess, on the net duration that you are running, I mean, how we should think about it given that rates rallied in the third quarter and sold off in this October kind of quarter to date?

Wellington Jamie Denahan-Norris

The book value will, again, will always just be a snapshot in time. And there's a lot of moving parts with the swap position and the mortgage position and the impact that certain announcements will have on prepayment expectations and things like that. So we try and keep the portfolio in a net positive duration. But as things move around, that can also move around. So again, but I would caution it is a snapshot.

Operator

The next question is from David Walrod of Ladenburg.

David M. Walrod - Ladenburg Thalmann & Co. Inc., Research Division

You commented that you have no material exposure to MF. Can you provide some color on your counterparty exposure on the repos and the swaps as far as the number of agreements that you have? And any significant exposure to any 1 or 2 counterparties?

Michael A. J. Farrell

No, we don't provide that.

David M. Walrod - Ladenburg Thalmann & Co. Inc., Research Division

Okay. Well, just -- you've obviously had a lot of concern several times in the last quarter about liquidity and that's just question that pops up a lot. So was that something you can ...

Michael A. J. Farrell

No. We dealt with that issue back in 2007 when we founded RCap.

Operator

The next question is from Stephen Mead of Anchor Capital Advisors.

Stephen Mead - Anchor Capital Advisors, LLC

What's happened in terms of the repurchase market in terms of overnight funding costs? And because I noticed that 3-month LIBOR has ticked up, but I was just curious in what's happening in the repurchase market.

Michael A. J. Farrell

Actually, very stable, the Fed is very active in there, tie that into the previous question. The overall color that I would give you, Steve, is that I think the Fed is doing a heroic job at maintaining the balances and instituting new controls and supervision techniques into the market. There was hardly a blip on the MF Global. The way that those things are generally broken down when you're a primary dealer is that the Fed puts out a team into your office, and they start to unwind the matchbook first, especially as it relates to the government securities. And they start to send back the collateral and check the cash balances, et cetera, across the board. For those who are in constant dialogue with these borrowers and in the case of like Annaly where we borrow a lot of money from a lot of different people, we do have policies that we don't expose any more than say 10% outstanding with our guidelines. But you learn a lot from those discussions. And as we learned in 2008 when we avoided Bear Stearns and Lehman, the practice of the lenders is really what comes under question. I think that's what the lesson that the Fed has learned. That when you start to see things like excessive haircuts and excessive prices in interest rates on repo, it raises questions about the guy who's doing the lending, not the borrower. So all of those supervisory techniques are in place. There are regular dialogues between the buy side and the sell side that did not exist prior to 2007. And I think that they're doing a very good job on being a policeman on the deck.

Stephen Mead - Anchor Capital Advisors, LLC

And can you comment on just the increase in the CPR in terms of what actually happened in your portfolio versus your expectations? And sort of what's happened since the end of the quarter?

Michael A. J. Farrell

Well, we won't know the end of the quarter until this weekend when we start to see the prepayment rates come in. So whenever we do our dividend projections, we're always basing that off of a guess as to what the last month's activity would be. But in the second quarter's call, we made a point of trying to make people aware that the cap on conventional loans was dropping from 729 to 625. And that in fact, some lenders had already cut off underwriting at that level because they didn't think they we're going to get in all the loans that they thought, all the refis that they thought they were going to get in by October 1. And that there would be a flush forward across the board of people who normally would not have qualified for any kind of government loan pushing through that window finally through October 1. And I think that's the balance of what you saw. It's not HARP-related, it's more about the dropping of that cap from 729 to 625, that's our best intelligence.

Stephen Mead - Anchor Capital Advisors, LLC

And then just -- but you don't know what's sort of happened in October in terms of CPRs?

Michael A. J. Farrell

No, we -- I mean, we could tell you we'll know a lot. The whole market we'll know on Friday when the first speeds [ph] come out. I expect them to be balanced to moderately higher or lower, not anything outsized.

Wellington Jamie Denahan-Norris

We continue to be conservative in our estimates.

Stephen Mead - Anchor Capital Advisors, LLC

Right. But I would just -- from my perspective, the 8 -- 11 to 18 increase in the CPR comes out as being a huge negative. I think pretty reasonable.

Michael A. J. Farrell

Well, don't forget that prior to 2008, a conventional loan in the United States was maybe a $450,000 balance. During the crisis, the government raised that $729,000 and now you're seeing that be unwound. That's the first flash of it, right? So there's been a number of problems raised in Congress about the inequities of that decision. And in fact, they're trying to reinstate it back up to $729,000. But that cap is now closed. So that's taking away more credit from the market, would eventually will lead to slower prepayments, less money being originated at those levels. And also, further pressure on house prices as a result because real estate prices will fall to the level of which they can be financed.

Operator

The next question is from Jay McCanless of Guggenheim.

James McCanless - Guggenheim Securities, LLC, Research Division

The first one, just wanted to revisit your commentary about ICA '40. Did I understand you right that you all believe there's going to be need to be a legislative solution if the mortgage REIT industry were going to be governed or I guess, regulated under ICA '40? Is that correct?

Michael A. J. Farrell

No, you're talking -- the '40 act, is really what the issue is, right? And if you look at the language for exception in there for mortgage interest and mortgage cash flows, it's a very broad definition. And even though the markets have morphed over the past 70 years and since mortgage REITs in general are consistently issuers of securities and how they go through registration process, et cetera, and actually have a separate S-11 that they sign and file when they do that. That's unique to mortgages. That has always been reaffirmed during the course of that process were due diligence of underwriters and lawyers and accounts, et cetera. So literally, in order to change the mortgage REIT status, you'd have to undo a great deal of what was done in the 1940 act, which is the territory of Congress, not of the SEC.

James McCanless - Guggenheim Securities, LLC, Research Division

Okay, understood. And then I wanted to ask about the foreign situation. And I guess, it's a 2-part question. Can you discuss the causality between what's happening in Europe and the potential deleveraging there relative to the amount of cash that you were carrying at the end of the quarter? And then also, if there is going to be a significant deleveraging by the European banks, do you all have any estimate of the amount of whether their agency or non-agency MBS holdings in the larger European banks?

Michael A. J. Farrell

No, we do discuss some of that in our commentary that's on the Website, in general. We don't put specific numbers on it because we think the disclosure that's coming out of Europe is especially good. But I will say that as we demonstrated with the Barclays' transaction and with other European banks that we are under nondisclosure agreements with. It's raining assets. And you want to be bulletproof as you can be during that period. And I would just look at Annaly's return, since inception it's 618% through Halloween from IPO. Most of which came back to investors in the form of cash compared to the S&P's just below 8%. So the value of those cash flows is really what's going to be embedded into the market going forward. And you want to be in a position where you have a lot of dry powder to take advantage of that. It's not going to happen in the fourth quarter. We're not running the company for one quarter, we're running it for the next 1/4 of century. And the result is that we're going to be able to very opportunistic as this stuff comes back.

James McCanless - Guggenheim Securities, LLC, Research Division

Okay. And my last question. I know you've already addressed MF Global but what are the opportunities for RCap in this environment. Does MF Global disappearing help RCap? And could you give just kind of a snapshot of what's going on with that portion of your business?

Michael A. J. Farrell

No, RCap is still in a growing phase. It's doing a very good job for us and helping us create a separate balance sheet, which we were concerned about in 2007. That allows us to have access to borrowers and lenders that we never touched before. The activities in there are growing but you can be assured that it's going to be consistent slow growth pattern for us, just like the other businesses that we put in place. It could be torturously slow for us to make sure that we're doing it correctly. The opportunities, I think, are pretty wide open across the asset allocation market, right? And leverage, I think, from the Federal Reserve's point of view, is going to be -- they're going to accommodate that through the low interest rate structure and after the supervision that they put in place. The forming of the repo markets is working very efficiently, and very well supervised. That's not what caused MF Global to blow up. They were along Italian debt less than 1.5 years duration, I think, Italian debt. And at 40:1 leverage, that's going to kill you. No matter how sure it is, very unfortunate, very unfortunate.

Operator

The next question is from Dan Furtado of Jefferies.

Daniel Furtado - Jefferies & Company, Inc., Research Division

Mike, what are your expectations for a GSE pilot program to sell credit securities? I mean, do you think will happen? And if so, do you foresee FIDAC taking a role there?

Michael A. J. Farrell

That's a great question. The stackers [ph] program that they're talking about is, I think, another way that I would point to the markets that GSE reform is really back-burnered, with 95% market share coming out of the agencies right now in terms of mortgage origination, as well as FHFA raising rates not behaving like they're going out of business. And along with the aspects of research and development going on, we are working with the GSEs on pilot programs like this. And yes, we think there are opportunities for us inside of our advisory company and, as well as within our balance sheets to do that. We have a great opportunity within the 3 companies, actually.

Daniel Furtado - Jefferies & Company, Inc., Research Division

Great. I mean, I don't know if you care to kind of take a stab on kind of like a timeline. But I mean, do you see this is more of a near-term issue or is this kind of more down the road? Or do you have any sense of potential timing of something like this?

Michael A. J. Farrell

I think it's going to become more urgent as we head to the first half of next year because I sense in Congress -- I think Congress went home in August and came back beat up. In the discussions that I had done when I did the testimony, I really sensed with the Congressional audience that they are tired again and beaten up by the consumers and voters on house pricing. Someone said this to me, realtors are the teachers of national presence. There's realtors in every district. And the screaming that's going on at some of these town hall meetings, especially from people who are involved in property administration rights or realty, is amazing for these congressional players. And they realize that their fetes are at risk. So I do sense that they've been thinking about these problems for a long time. And they are waiting for private sector solutions. The one thing that I learned from all my visits on the hill regarding the SEC letter is that, that is a bipartisan issue that everybody can agree on. If you're on the far right and you want to kill Fannie Mae and Freddie Mac or if you're on the far left and you think we need to form more of them, the one thing that you can all agree on is that they need more private capital and that we've been the providers of it in this sector.

Operator

The next question comes from David Miyazaki of Confluence Investment Management.

David B. Miyazaki - Confluence Investment Management LLC

I was wondering during the summer when there was report of shortages of U.S. dollar availability in Europe, did you see that affecting the willingness or the attitude of your European banks with regard to repo financing?

Michael A. J. Farrell

No, actually, it was exactly the opposite. They were doing everything they could to get dollar-denominated assets.

David B. Miyazaki - Confluence Investment Management LLC

That's interesting. Do you think that as they move through their deleveraging that you're anticipating that, that willingness will remain?

Michael A. J. Farrell

That depends on the swap agreements that the Federal Reserve entered into with the European Central Bank. Those expire in January. If they roll them over, that will slow down and let them spiral down into a slower pace. If the Fed cuts that back or they make that a shorter period, then I expect that to be a faster pace. Those swap agreements were very.

Important element of what slowed down the discussions in Europe.

David B. Miyazaki - Confluence Investment Management LLC

Okay. And then if we look at the other side of the world with a sharp move in the yen versus the U.S. dollar, are you seeing that affect the appetite for repo financing from the Japanese banks?

Michael A. J. Farrell

We're actually seeing more allocation of dollar-denominated activities out of the Japanese banks. Actually, I spoke with 2 of them in the past 1.5 weeks. They're shutting down European operations, and they're moving more of that capital and resources into the United States. Actually , it was a story about Nomura the other day, they had purchased the Lehman activities in Europe. And they're taking that capital out, and they're going to reallocate it into Nomura in New York.

Operator

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

Michael A. J. Farrell

Yes. Well, thank you all for being with us today. Hope you find this educational and helpful. We look forward to seeing you again at the next call.

Operator

Ladies and gentlemen, if you wish to access the replay for this call, you may do so by dialing (877) 344-7529 or (412) 317-0088, with an ID number of 10005691. This concludes our conference for today. Thank you for participating, and have a nice day. All parties may now disconnect.

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