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Annaly Capital Management, Inc. (NYSE:NLY)

Q3 2012 Earnings Call

November 6, 2012 9:00 AM ET

Executives

Wellington Denahan-Norris – Vice Chairman, Co-CEO and Chief Investment Officer

Kathryn Fagan – CFO and Treasurer

Kris Konrad – Managing Director, Head Portfolio Manager

James Fortescue – COO

Analysts

Bill Carcache – Nomura

Jason Arnold – RBC Capital Markets

Douglas Harter – Credit Suisse

Steve DeLaney – JMP Securities

Operator

Good morning and welcome to the Third Quarter Earnings Call for Annaly Capital Management, Inc. At this time, I would like to inform you that this conference is being recorded and that all participants are in listen-only mode. (Operator Instructions)

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

Unidentified Company Representative

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 publically 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 would now turn the conference over to Wellington Denahan-Norris, Chairman and Chief Executive Officer. Please proceed, Ms. Denahan-Norris.

Wellington Denahan-Norris

Thank you, operator. Good morning everyone. Joining me on the call today is Kathryn Fagan, our Chief Financial Officer. I also have with me Kris Konrad, who is Co-CIO of Annaly; James Fortescue, Chief Operating Officer; and Kevin Keyes, who is President of Annaly. I am going to just start with some prepared remarks and then I will open the call up for questionings following these remarks.

First of all, I want to acknowledge and sincerely thank all who offered such warm condolences for Mike Farrell. The outpouring of sympathy has been remarkable. I know Mike’s family and everyone here at Annaly really appreciates all the comforting thoughts and prayers we received. Our thoughts also are with all of those affected by the storm here in the Northeast.

I want to dedicate today’s discussion to Mike and our past earnings calls. Over the years, the daily macroeconomic and market debates of this entire management team have been manifested in Mike’s very colorful commentary. Using personal anecdotes and humorous analogies, he uniquely described the state of the economic conditions through the Annaly lens. So I thought I’d revisit some of the most important market themes our team routinely uncovered well in advance of others, themes which all remain very relevant today, and that Mike translated with such incomparable style.

The first theme is from the second quarter of 2006, when Mike delivered an anecdote titled, The Goldfish is Dead, Senator. This story centered on the passing of the family goldfish, which Mike related to the bursting of the tech and housing bubbles. In an attempt to hide the tragedy from his young children, Mike recounted going to the store to secretly buy a replacement fish. The second fish, however, quickly suffered the same fate as the first.

As the Annaly team predicted at this time, the bubble that we successfully migrated from technology to housing is breaking again. This time, the consequences for our domestic and international economies are much broader than the breaking of a mere tech bubble. We surmised, at the time, that the next discussion would not be about the return on capital, but the return of capital.

From the third quarter of 2007’s earnings calls, Mike wrote a piece which he entitled, Seduced by a Supermodel. The supermodel in this case was an analogy that refers to the complex financial models and financial engineering with which Wall Street became enamored in the years leading up to the financial crisis. As Mike expressed five years ago, structurers, traders, rating agencies, regulators, investors, all became enamored with the same super modeling techniques at the same time. The attractiveness of structured products blinded love-struck market participants, and we all know how painful, even today, the breakup continues to be.

In the first quarter of 2008, Mike retold a story first presented on the Twilight Zone called, To Serve Man. In this particular episode, a seemingly benevolent species of alien called the Kanamits came to earth under the auspices of elevating our standard of living. In the end, the real motive of the Kanamits was to make humans complacent, fatter and healthier for their eventual consumption. As Mike noted back in 2008, these aliens represented the leveraged profile of the global financial system, a boon to our everyday existence until the inevitable consequences became apparent.

This story, again, is just as relevant today as it was when Mike first told it. With the Federal Reserve supplying the market with seemingly unlimited liquidity, one has to wonder if another round of quantitative easing really is the best recipe for the market, or if it is simply another chapter in the Kanamit tale.

Finally, in the third quarter of 2008, Mike’s earning piece was titled It’s Contained, It’s Decoupled, It’s Only Notional. The basic tenet of this piece was to take aim at these three popular phrases, which we believed (inaudible) were, and remain, as dangerous as they were inaccurate. Mike stated at the time that the only decoupling occurring was that the Eurozone’s desire to fight inflation versus asset deflation, and he echoed the sentiment that Europe needs its own Alexander Hamilton. Today, the Eurozone remains in a precarious situation, another current market reality that the Annaly team, through Mike’s voice, identified over four years ago.

These perspectives that Mike shared on a quarterly basis were both entertaining and prescient. His commentary was simply designed to shine the light on certain market perspectives from the Annaly point of view. Most of the critical elements Mike related to years ago still remain. Going forward, Annaly will continue to try and synthesize all that’s happening on the global stage for the betterment of our shareholders.

With that, I will open the call up to questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from Bill Carcache of Nomura. Please go ahead.

Bill Carcache – Nomura

Good morning, and thank you very much for taking my question. I wanted to start off, if I may, with some questions on your buyback announcement and just wanted to get a little more color on that. Can you talk about how likely you are to execute on the buyback authorization when shares are currently trading where they are relative to your book value, if you could just give some perspective on that? And what would you envision as a source of funds for any buybacks?

Wellington Denahan-Norris

First of all, if anybody who’s known us for a long time has known that management has never announced a share buyback. Actually, I am sorry, we may have back in 1999, when the company was trading below book for a brief period of time. But we take these things very seriously, and given the backdrop of what I just described with the Fed’s influence on the market, the management here just wants to maintain maximum flexibility for shareholder value. And if the company is trading below book for a significant period of time, at per a significant amount, we want to maintain the option to go ahead, given the backdrop of the investing environment, to go ahead and retire some of the stock.

We get a tremendous amount of principal and interest every single month that we can either allocate to new purchases or we can allocate to a share buyback.

Bill Carcache – Nomura

And the principal and interest each month, if they get allocated to buyback, would that bring down the leverage ratio further?

Wellington Denahan-Norris

It would maintain it fairly constant; it actually might go up slightly until more principal and interest come in. But we would constantly monitor a comfortable leverage level, given everything that’s going on.

Bill Carcache – Nomura

Okay. And along those same lines, in order just to have an understanding, and make sure I understand how this works, so in order to have your income remain exempt under REIT taxation laws, does the income that gets applied to share buybacks get treated, is that treated as distributed?

Kathryn Fagan

(Inaudible). We’re still going to pay out the dividend based on taxable earnings, but just with the amount of principal alone that we get in every month we would have enough to do the buyback. But we would not necessarily take and buy back enough that it would affect return on capital.

Bill Carcache – Nomura

Okay. And then shifting over to prepayment speeds, even though your prepayment speeds only up went to 20% CPR from 19% CPR, the spread compression that we saw during the quarter makes it seem like you have some higher yielding securities in your portfolio that are prepaying. Can you talk about whether you’re seeing faster prepayment speeds on some of your higher yielding securities? Any commentary you can give on that would be helpful.

Kris Konrad

Sure, this is Kris. Definitely, prepayments picked up during the quarter, as we reached new lows in mortgage rates. I would characterize as the bulk of the pickup coming from some of the securities that we own that are either faster, faster in prepayment or shorter securities, whether they’re 15 years or CMOs. So as they gravitate more towards – as we receive more principal from those types of assets and they pay off, which is the case in some of the CMOs, we are forced to realize more of the premium.

Wellington Denahan-Norris

And just to put in perspective, when you get the Q, you will see that we got back $10 billion principal this quarter, which compares to around $8 billion last quarter.

Bill Carcache – Nomura

Okay, thank you very much. Appreciate it.

Operator

The next question comes from Jason Arnold of RBC Capital Markets. Please go ahead.

Jason Arnold – RBC Capital Markets

Hi. Good morning and my condolences, again, on Mike’s passing. I know he’ll be missed by all of you, and certainly will be missed by us in the investment community as well. But I guess, Wellington, I was curious about the comment that you made on the relative value opportunities across asset classes on both sides of the balance sheet out of the release. I guess there’s some reference to the buyback in there, but curious if you could comment on any other items you might have in mind?

Wellington Denahan-Norris

Like I say, with the Fed being such a large and active player, we do have an election here that hopefully we’ll get some clarity today. The way I see it is if Obama wins, that we potentially see more policy meddling, and there could be the point at some time where you actually see assumability in mortgages. There was a time in the past that mortgages were assumable, and if house prices don’t allow for mobility in the system, I could see them instituting policy that would make it so that people could still move around and maintain the very low coupon mortgage.

For us, we continue to try and just assess, within the confines of the market, where the best relative value is among the various sectors we deal in, whether you want to own a mortgage that has significant amount of prepayment protection, that ultimately may be good for a couple of quarters. But that pay-up may not get the value in the repo markets, it may not get the value in the TBA markets.

There’s a lot of difficulties that go with turning your balance sheet into a trading strategy versus an investing strategy, and we have maintained a fairly conservative stance, rightly or wrongly, as we’ve navigated through these markets. We’ve never had such a large, uneconomic competitor, and so to adjust the entire strategy of the company for a couple of quarters to make sure that you can survive through that uneconomic presence is, the way I look at it, we need to be a little bit more long-term in our view. And so if we have a quarter or two where the kind of assets that we own are not performing as well as they would over the long-term, as we expect them to over the long-term, we would make adjustments.

So we are constantly assessing, knowing all that we know from the asset and liability side of how these assets are viewed, to make sure that we’re doing all that we can to maintain shareholder value in the long term.

Jason Arnold – RBC Capital Markets

Okay. Great. Thank you for the color there. And then just one other quick follow-up on the repo rate side, a little bit higher here this quarter, I assume, due to greater utilization of some term repo that carried through year-end, but maybe you could expand on that as well please. Thanks.

Wellington Denahan-Norris

Okay. No, I mean, we – Jimmy Fortescue is here who’s head of our liabilities, as well, I’ll have him go into a little bit more detail. But again, we look at this rate landscape, and the fact that you have a lot of shifting regulatory pressures on balance sheets of the large banks and everybody’s struggling for return on capital, so you have to deal within the confines of what your counterparties are looking for versus what you are looking for. And so we make adjustments in our repo position to help manage those varied cross-currents that we’re running into. I’ll let Jimmy expand on it.

James Fortescue

Yeah, at the end of the day, we were always taught by Mike is to have a fortified balance sheet and not to build the business for one quarter, but we’re building a franchise. So we continue to get the unique opportunity because we’re creditworthy to extend liabilities here. You’ve had the Fed say things that are unheard of before about policy extensions to 2015. So there are opportunities to extend and add life insurance to some of our positions here.

And with all of the regulation that’s coming down the pike, we’re plugging in across the sector to try to kind of make safe and sound rules for the system. We may not all love the rules, but I think everyone wants to plug into them properly, and what we’re seeing is with this next leg of regulation and it is just a lot of the bank balance sheets want to extend liabilities and to make continued profits with all the cash that’s in the system. So we consider ourselves fortunate to have those opportunities and work with our partners in that.

Jason Arnold – RBC Capital Markets

Excellent. Thanks for the color. I appreciate it.

Operator

The next question comes from Douglas Harter of Credit Suisse. Please go ahead.

Douglas Harter – Credit Suisse

Thanks. I was wondering on the pickup in premium amortization, is that all related to the current experience or is any of that accounting for future increases?

Wellington Denahan-Norris

No. I mean we tend to do what our actual experience is. Keeping in mind that our portfolio has been around for a while, and you may have securities that were purchased at much lower dollar prices, yet we continue to have, in those securities you didn’t have as much prepayment protection as you do in some of your newer purchases.

But nonetheless, we try not to take just a one-sided view with our assets. We do have securities that may underperform in an environment like this, which will clearly outperform, let’s just say, given a change of administration, which is possible. But we try and strike a balance between the types of assets that we buy: we don’t ever take a one-sided view with the portfolio. It is not a trading strategy.

Douglas Harter – Credit Suisse

Great. And then just given what rates have done since then, what would be your view for prepayments, fourth quarter and heading into 2013?

Kris Konrad

You know, I think a lot of that will hinge upon what happens tonight, and certainly there are a lot of challenges to this economy that will be in the forefront very soon, whether it’s the fiscal cliff, and as, certainly, the market is contending with potentially better growth, at least until the recent developments from Sandy.

So, as Wellington said, we are always trying to strike a balance on how much call protection we have in the portfolio. There’s certainly a cost for that protection and we have certainly managed this portfolio through different markets where that cost was virtually nothing.

Wellington Denahan-Norris

Yeah. Doug, I would say that if Obama maintains office, that you will continue to see policy meddling and you will continue to see attempts at making sure borrowers continue to have the flexibility. So, I would see an elevated level, all else being equal, in prepayments.

Douglas Harter – Credit Suisse

Great. Thank you.

Operator

The next question comes from Steve DeLaney of JMP Securities. Please go ahead.

Steve DeLaney – JMP Securities

Hey, good morning, everyone.

Wellington Denahan-Norris

Good morning, Steve.

Steve DeLaney – JMP Securities

Wellington, you’ve gotten a couple of questions from Douglas and Jason about the premium amortization.

Wellington Denahan-Norris

Right.

Steve DeLaney – JMP Securities

And I heard exactly what you said about some bonds that carry more premium, may prepay faster in a particular period, and create a higher percentage premium amortization than would only be reflected by CPR, because it is a big – CPR is at 5%, premium amortization is up 50% on what is only a slightly larger portfolio.

But, and you said it’s really like responding to what you actually lose that $10 billion that Kathryn referred to that came in the quarter, not necessarily some sort of adjustment of the future – at least that’s what I heard you to say. Help me understand that in the context of the spot spread and the spot yield at September 30 was 20 basis points, 25 basis points higher than actual, so you had a 102 spread for the third quarter with the premier amortization. But it seems to me you’re expecting a spread, an asset yield that’s going to be higher, looking out here into the fourth quarter or going forward. So just help me understand that, please.

Kathryn Fagan

Steve, this is Kathryn. Maybe I can just go through the calculation how the amortization is determined. So on the securities, we come up with a yield to maturity. We base it on our expectations of prepayment fees for the life of the security.

Steve DeLaney – JMP Securities

Yeah.

Kathryn Fagan

And you had to do both prospective and retrospective, just as in anticipation that the life of the security is going to be a lower yielding asset, you do a retrospective adjustment also, so you want to make sure that over the life of that security you are capturing the actual yield.

With that being said, you do see an increase, but you also see more premium, $900 million on the books at the end of the period. So as the purchase price picks up, you have more unamortized premium on the books that you have to take into consideration. With each individual bond and portfolio, we do do a yield to maturity and then do the calculations prospectively and retrospectively.

Steve DeLaney – JMP Securities

Okay, well, now, that’s helpful. And that’s what I understood it to be, and what you’re saying there is that if your lifetime prepayment expectation changes in any quarter, that will result in a lower yield to maturity. So in that particular quarter, if you had not changed your lifetime speed expectations from quarter to quarter, then it may more or less be proportional – the premium amortization may simply be proportional to principal received, whereas if there’s some change in the expectations, that could create higher amortization to get you to a lower yield to maturity.

Kathryn Fagan

Right, and with that being said, you don’t want to be too aggressive. You really have to support the CPRs you use in every single security. So you don’t want to over-amortize and be too, like I said, as Wellington pointed out, dire situation on one of the securities when that’s not the reality of how it’s going to perform.

But also, if you’re seeing a pickup and you expect that through the life of the security, you have to consider that. And it’s something that’s heavily scrutinized by the auditors and by the PTOB, anything that’s with income recognition. And so this is really a hot topic that is checked very thoroughly here and by our auditors.

Steve DeLaney – JMP Securities

Understood and that’s appreciated. Thank you, Kathryn. And just one final one for Jimmy, because he talked about the longer-term repo. There seems to be an increased availability on counterparties and you guys added $10 billion to your over-120-day bucket. I was just wondering, Jimmy, how far practically can you go out? And can you give us some sense for – if you’re going out one to two years, how that pricing compares to the current 40 basis point type rates we see on short repo?

James Fortescue

Yeah. I think with everything it’s relative. If you think of swaps and versus swaps, and certainly long-term repo, it is balance sheet and there’s a cost to balance sheet. So there is a pay-up to that. Again, we have done trades that I have never seen before in my career, being with Mike and Wellington 17 plus years, we did a $5 billion trade for five years that was – obviously fortifies pretty much everything that we need to do without seeing a lot of demand from the cash, because it’s all welled up on the sidelines.

Everyone is looking for different conduits out there because of the balance sheet regulation that’s coming in. What I will say is is with all the things going on in Europe, we were far ahead of this kind of for – in the second quarter and late second quarter, and we’ve added a lot of that protection going into the third quarter.

So, right now there’s not that need to add that stuff because that protection’s in the portfolio. But it’s a slight pay-up, but it definitely pays off in the long run. So, but guys are looking for returns for the cash. So, there is demand, but you have to be credible and you have to have the right assets for that.

Wellington Denahan-Norris

Yeah, and...

Steve DeLaney – JMP Securities

Understood.

Wellington Denahan-Norris

And Steve, we’ve actually been doing longer repo for some time now. It’s not a new phenomena on our balance sheet.

Steve DeLaney – JMP Securities

Well, thank each of you for the comments this morning.

Operator

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

Wellington Denahan-Norris

I want to thank you all again for the tremendous outpouring for Mike and he certainly will be missed. And we will continue to do all that he envisioned and more, and I look forward to speaking to everybody on the next earnings call. Thank you.

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 10019907.

This concludes our conference for today. Thank you for participating and have a nice day. All parties may now disconnect.

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