Q1 2021 Annaly Capital Management Inc Earnings Call
Good day and welcome to the Q1, 2021 and the lead capital Management earnings Conference call and webcast.
All participants will be in a listen only mode.
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After today's presentation, the will be an opportunity to ask questions.
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Please note this event is being recorded.
I would now like to turn the conference call about the Mr. Sean Kensal, Vice President Investor Relations Mr. Cancel the floor is yours Sir.
Good morning, and welcome to the first quarter 2021 earnings call our annual capital management.
Any forward looking statements made during today's call are subject to certain risks and uncertainties Inc.
<unk> with respect to COVID-19 impacts which are outlined in the risk factors section in our most recent annual and quarterly SEC filings.
Actual events and results may differ materially from these forward looking statements.
Cause you to read the disclaimer in our earnings release in addition to our quarterly and annual filings.
Additionally, the content of this conference call may contain time sensitive information that is accurate only as of the date hereof.
We do not undertake and specifically disclaim any obligation to update or revise this information.
During this call we may present, the GAAP to non-GAAP financial measure.
Conciliation of GAAP to non-GAAP measures is included in our earnings release.
As a reminder annually routinely post important information for investors from the Companys website.
W. W Dot dot com.
Content referenced in today's call can be found in our first quarter 2021, investor presentation, and first quarter of 2021 financial supplement.
Both found under the presentation section of our website.
And we intend to use our web page of the means of disclosing material nonpublic information for complying with the company's disclosure obligations under regulation FD and to post an updated investor presentation and similar materials on a regular basis.
And I encourage you as investors analysts the media and other interested parties to monitor the company's website. In addition to following and all of these press releases SEC filings public conference call price.
Limitations webcast and other information of close from time to time on its website.
Please also note this event is being recorded.
Participants on this morning's call include David Finkelstein, Chief Executive Officer, and Chief Investment Officer Serena.
Serena Wolfe Chief Financial Officer.
Okay.
Had a preacher and types of products, Tim Coffey, Chief Credit Officer, Nick Junior head of residential credit and other members of the management and with that I'll turn the call over to David.
Good morning, everyone and thank you for joining us today.
Back on our first quarter 2020 earnings call I discussed the conceptual three phase process for how our portfolio of strategy would evolve coming out of COVID-19 to review briefly the first phase was about preserving capital and shoring up liquidity, which we did successfully as the crisis unfolded positioning us with the healthiest liquidity and capital.
Position this company as exhibited in the year's base.
Phase II, which characterize the majority of last year was about deploying capital in the agency sector, which I referred to as the shelter in the storm, while making opportunistic investments within credit while the fed in fiscal intervention provided strong support for both of our assets and liabilities. We then outline the phase three which.
Involved more transformative and strategic reallocation of capital the best position the company in the new environment.
We were prepared to utilize our liquidity benefit from the dislocations across markets and sharpen our strategic focus today I will provide an update on our progress on this third phase, which reflects our macro views and the vision for the company going forward.
Following changes to the senior leadership team, including my appointment as CEO last March was an opportune time to reevaluate certain businesses and revisit our expense structure, while also aggressively building out the necessary infrastructure and personnel to broaden our operational capabilities within residential housing finance.
Now before I go too far down that path I'll begin with the commentary on the rates market as the price action. This past quarter was notable.
First quarter was marked by a meaningful sell off in interest rates as the 10 year note rose over 80 basis points signifying one of the largest quarterly sell off in the past five years. The sharp REIT pricing was driven by a meaningful boost in economic growth expectations best seen in the federal Reserve's economic forecast for 2021.
Non GDP growth.
While epilepsy members had forecasted the strong four 2% growth this year at the December meeting the revised their projections up to six 5% by the March meeting if realized annual growth would be the strongest in nearly 40 years is the significant progress made on vaccinations appears to be paving the path out of the pit.
Demick.
And at the same time substantial government stimulus and very healthy consumer balance sheets are also boosting the U S economy.
The longer dated rates also reflect the anticipation of higher inflation base effects and consumers' willingness to pay elevated prices given the receipt of stimulus checks are noticeably lifting prices inflation is like likely to temporarily rise above the fed's, 2% target in the near term, but it remains uncertain as to.
The weather persistent higher inflation will take hold until we see meaningfully higher wages for consumers. In addition, all the factors that have been associated with lower inflation over the past three decades, changing demographics automation and increased globalization to name a few remain in place, which does reduce the risk.
The continued sharp selloff the.
That being said volatility in rates markets suggest that investors are not yet efficient in pricing the economic response to consumer enthusiasm.
Volatility should therefore remains somewhat higher as investors learn how much inflation will rise how much fiscal support the government will offer and how rapidly the U S exits of the pandemic. However, any turbulence should be dampened by the federal reserve that continues to signal patience when it comes to its monetary policy decisions. Despite the.
The strong improvement in the outlook in recent months.
Further down the road the fed will face difficulties extricating, the sizable monetary policy footprint markets, necessitating any withdrawal of the be gradual and well communicate it.
While we still see strong tail winds for agency MBS, which yoga will expand upon following my commentary the forecasted strong economy and the interest rate landscape tilts, the relative value equation modestly in favor of certain pockets of credit.
Our capital allocation to credit rose from 22% to 27% this past quarter, primarily driven by $1 4 billion of gross residential credit investments I'll also note that the nominal increase in the percentage was in part due to capital optimization decisions for certain credit products made possible by our excess of.
Liquidity cushion.
Now turning to our strategic activity in the quarter, we announced the sale of our commercial real estate business. The slate asset management for a purchase price of $2 $3 3 billion and.
And we feel the transaction achieves great execution of our shareholders and as validation of the quality of the portfolio that has been on balance sheets since 2013, and the experience of our team.
The rationale for the transaction is best illustrated by briefly revisiting history, turning back to the environment. When we acquired Craigslist, bringing commercial assets onto our balance sheet. The fed was a few months in the QE three in agency MBS look rich on a risk adjusted basis relative to credit given the first order impacts of the.
The MBS bond buying program.
Moreover, we were still in the somewhat early stages of the economic cycle and could therefore pick up 200, 300 basis points of excess spread senior transitional light loans with strong visibility of business plans in top markets.
That relationship has sharply reversed over time as the commercial market has seen strong investor interest in record levels of capital raised which subsequently eroded the compatibility of the commercial platform with our core agency strategy.
We had embarked upon an evaluation of the optimal size and structure of the commercial business pre COVID-19, but the pandemic required CRE participants to confront the fundamental structural changes in the industry that we expect to occur over time.
With the unprecedented support injected in the economy, we had certainty the recovery would prevail and win the data began to turn we were well prepared and confident that the sale of our commercial platform will provide the strongest outcome for the company and our shareholders.
After a comprehensive exploration of the process to find firms that would represent strong fits for the business going forward, we identified a potential buyer to acquire the platform, including its assets and the majority of the people. In addition to the fixed the economics to the buyer, we will maintain a favorable carry profile on the assets until close.
The mitigating our reinvestment risk.
With respect to use of proceeds while agency may serve as a placeholder for capital return considerate of spreads over time, we will rotate the capital across our other investment strategies as opportunities arise given the customary closing conditions and regulatory approvals, we're still multiple months away from receiving the caps.
The back from the sale, which will be approximately $650 million.
The transaction will give us additional capacity to further expand our leadership and operational capabilities across all aspects of the residential mortgage finance market, which has been the cornerstone of annually strategy since our founding the.
The current environment reaffirms the strength of the housing sector and we continue to be excited about the growing synergies between our agency residential credit businesses.
Now the first area in which we're expanding our capabilities as the MSR sector. Previously we owned MSR via the servicer that we acquired in connection with our Hatteras acquisition and later sold but our portfolio has been in runoff mode for the past year and therefore, we've employed a multifaceted approach to investing in the asset class today.
We have committed third party partnerships that we've developed as part of our build out to own and oversee servicing of MSR in house and we have made several key hires with decades of industry experience to lead. This effort. Additionally, we've witnessed significant progress with licensing our envelope based subsidiary <unk>.
Stablish of satellite office and have begun to grow our portfolio again.
We are complementary strategic partner to originators because of the breadth of products, we can acquire from them and the certainty of our capital is of takeout. This has become particularly useful as the primary secondary spread has contracted reducing originated profitability and leading the increase secondary MSR volumes and the <unk>.
<unk> is highly additive to our prospective returns as a positive yielding hedged to our core agency strategy, while also modestly reducing our agency basis exposure. However, as we have said in the past in the absence of the severe pricing dislocation, we do not see capital allocated to the sector much above 10% on a run rate base.
Just given the implied structural leverage and liquidity of the asset. Our view is that MSR is a very attractive ingredient in the portfolio, but the measurements of the recipe require precision in light of potential volatility in risks.
Now. Additionally, we continue to add to a third party and in house sourcing capabilities on the residential credit front, which drove the over $450 million of whole loan purchases, we saw in the quarter and our pipeline continues to grow.
We also continue to believe the diversified platform beyond residential as a key differentiator for us, including the Optionality embedded in our alternative strategies like our middle market lending platform through that business, which has been on balance sheet. Since 2010, we generate leading returns with cycle agnostic investments.
And we will also retain of $500 million commercial mortgage backed securities portfolio, which we expect to grow over time, depending on pricing and our outlook.
And now with that I'll turn it over to the investment teams to go over our markets and portfolio activity beginning with Ilker to go through the agency sector in hedging activity.
Thank you David the portfolio delivered another solid quarter. Despite the video volatile interest rate environment characterized by sharp selloff in the intermediate and long end of the curve.
MBS performance was mixed with lower coupon price of the foremost legging higher coupons due to expansion of the cash flows and the resulting delta hedging costs. Although the spreads generally continued their trend tighter as the Mr demand outpaced the issuance, which the amaze near record levels.
Most notably the bank the month, we discussed last quarter remains robust as the expansionary monetary and fiscal policies continue to drive the level of deposits all yes, well the commercial and industrial loan growth has been muted.
The size of all of the agency portfolio remained stable as we reinvest the runoff primarily into TBA, which benefited from negative the implied financing rates over the quarter.
We do know TBA position the shifted exposure of into two announced in threes well the reduced lower coupons as we expect fed the bank Butch system migrate higher in coupon following the rise in rates.
In specified pools are average portfolio payoff declined by approximately three quarters of the point due to higher rates hover. They have good prepayments and resulting comex. The profile contributed the specified pools outperforming both tpa and duration hedges over the quarters.
Well, the selloff growth mortgage rates of about 3% the remaining high prepayment the environment due to technological efficiencies and increase capacity in the originated community and therefore, we expect core protection to continue to prove valuable, particularly in the heart of coupons specified pools.
Now shifting to old hedges.
The vote of vote position for the Steepening of the yield curve is the mentioned on our Q4 call. The additional tissue of the features of the swaption positions during Q3 and Q4 of last year.
These lower cost duration hedges, especially on the longer the end of the curve fruit instrumental to our portfolio of performance is the yields rose sharply on the back of fiscally induced inflation fears.
In particular, the payer swaption that we bought throughout 2020 at lower levels of implied volatility and lower forward rates proved to be an excellent core makes them duration hedge against the expense of the extended duration in agency MBS assets.
Although the act of the rebel installed portfolio to the rise in yields this quarter.
Due to all of price positioning.
Delta hedging needs for the minimal compared to the size and momentum of the selloff.
Neither of just about primarily the 10 treasury futures and interest rate swaps and all swaps executed the sulfur floating rate benchmark as we continue to decrease of our LIBOR footprints.
Finally, as you'll stabilize at the end of the quarter, we took the opportunity to add protection against the really as we were able to purchase the receiver swaption said attractive levels with the market commanding higher prices for protection against the subtle.
We expect to grow of disposition in coming quarters as it complements our planned growth in our MSR portfolio.
After the performance in Q1 split I think potential for MBS looks somewhat limited.
But the framework, we have been operating under still holds post of tailwind such as fed on bank day meant are likely to persist financing rates remain extremely attractive and nearly all of the as I said the clusters of trading so tied to the allegations.
So looking ahead, we anticipate maintaining our conservative leverage post year, well out of existing core portfolio of provides a solid income and enables us to grow out of higher margin businesses that David talked about now I turn the call over to Mike <unk> to cover our residential credit portfolio.
Thank you wilker, turning to our residential credit business. We continue to remain bullish on both consumer and housing fundamentals given considerable government stimulus and the accommodative monetary policy. In addition to of systemic under supply of one to four single family homes. The majority of the U S consumers have been able to success.
Fully navigate the COVID-19 pandemic with household net worth at all time highs personal savings rates in excess of 10% household debt to income at historical lows and year over year declines in credit card and auto delinquencies the health and resurgence of the consumer has also benefited the residential credit market without.
Standing forbearance plans declining to four 4% of the total market as of mid April down from five 2% as of year end and first lien delinquencies down over 100 basis points on the quarter coming in at five spot zero to 2%.
The housing market continues to exhibit strong momentum regarding both construction and home price appreciation as the result of low mortgage rates limited available inventory for sale strong household formation and changing homeowner preferences regarding both location and the desire for space.
National home prices were up 12% on a year over year basis in the most recent case shiller release and will most likely continue to see outsized depreciation at the supply demand imbalance is a long term structural issue that will not be resolved at the current pace of housing completions.
Regarding our residential credit portfolio consistent with our comments on our last earnings call surrounding attractive residential credit spreads and net interest margin. We were active in deploying capital by purchasing approximately $910 million of residential credit securities and settling $467 million of predominantly expanded.
Credit residential whole loans, the residential credit portfolio ended the quarter at $3 4 billion of economic risk, excluding our committed loan pipeline leverage across the residential credit portfolio has remained conservative with financial recourse leverage at one spot zero debt equity with where the ending the quarter.
Rising $1 8 billion of the firms capital.
Within securities greater than 95% of our purchases were concentrated in the unrated MPL RPM and seasoned CRT subsectors in the beginning of the year both of these products displayed attractive Roe per.
<unk> unit of spread duration and have benefited from continued improvement in the financing market.
The shorter duration par priced asset should yield high single digits to low double digit lifetime, rovs and serve as an excellent accretive hedge to our longer dated agency MBS portfolio.
Moving to residential whole loans, we continue to be proactive in sourcing accretive assets and had a robust pipeline of $410 million that we anticipate will settle over the next few months, we continue to see opportunities in the non QM market and have started to capitalize on opportunities in the agency investor market given recent changes to the GSE.
Preferred stock purchase agreement.
Turning to our <unk> securitization platform in March we securitized $257 million of expanded credit whole loans and of non QM transaction generating 15 million of term funded subordinate securities with an expected low to mid double digit Roe.
With minimal recourse leverage we also priced our inaugural Prime Jumbo securitization earlier this week of $354 million transaction, where we retained all of the subordinate securities approximately $14 million in market value of the.
The organic creation of non recourse term funded assets to our whole loan strategy, allowing us to control asset acquisitions oversee diligence and the selection of our preferred sub servicers with the ability to control of loss mitigation remains our team's primary focus.
With the reopening of the economy on the horizon of healthy consumer and the housing market poised for strength in 2021, the residential credit market should see continued positive performance I will now turn it over to Tim to talk about the <unk> portfolio.
Thanks, Mike.
One of the middle market lending growth was influenced by the combination of our portfolio of success through the pandemic as exhibited by the Euro and watch the decreasing by 41% versus the prior year.
Following by a very intense refi driven market and the absence of any meaningful new issue M&A throughout Q1, just the.
Resulted in the portfolio of modestly declining from two to three 9 billion at year end to 2.0 of seven 4 billion at quarter end of $3 31 <unk>.
Returns, both economic gain core increased meaningfully in the quarter versus year end as the team remained disciplined about new investment activity and will protect the existing portfolio of selectively.
As in 2020, we are very pleased with underlying portfolio performance with the continuation of zero non accrual of credits versus the cliff water direct lending index average of two 9% and of watch list, representing less than 4% of the handling of middle market total portfolio size.
In addition, the portfolio continues to migrate towards the first lien debt.
Moving three full percentage points from 66% at year end to 69% at $2 31.
As we have reiterated over the past 10 years annually of middle market significant outperformance during periods of intense turbulence as a function of staying true to the industries in which we wanted to invest the forecasted ability of underlying credits to survive tumult.
And partnering with private equity owners that exhibit Likeminded Mis and track records consistent with all of low inside the very industries in which we want to be active.
Consistent with our behavior since joining in 2010, we have historically countered market periods dominated by refinancing the pipelines of wage it alongside sponsors.
Acquire businesses differently.
We anticipate 2021 will be no different in that respect and investing in concert with partially contributed equity from sponsors will continue to dominate our thinking when putting money to work.
Reignited convergence in the fixed income market and more specifically the loan markets makes us wary of leverage multiples more so than pricing.
With the refi driven markets coming out of the pandemic the broad array of issues capturing contracting spreads for last year's performance seems to be an acute contradiction, but nonetheless all of reality.
Inside of Emily Middle market lending is very aware of the current credit risk versus interest rate risk equation and with today's yield terms, we are comfortable with the middle markets current allocation.
As always middle market's growth or contraction for the balance of the year will remain subject to the underlying credit and our perception of adequate unlevered compensation for the risk both absolute and relative with that I'll turn it over the summer.
Thank you, Tim and good morning, everyone.
This morning, I'll provide brief financial highlights for the quarter ended March 31 2021.
Consistent with prior quarters, well earnings release discloses, both GAAP and non-GAAP core results My comments will focus on our non-GAAP core results and related metrics all excluding P. I E.
We continued to generate strong core results from the portfolio for the first quarter of 2021 benefiting.
Benefiting from the continued low interest rates in the funding market and sustained specialness and dollar roll.
The set the stage with some summary information on book.
Value per share was $8.95 for Q1 of flight.
The increase from Q4 2020.
Book value increased on GAAP net income of $1 75 billion or $1.25 per share.
Partially offset by the common and preferred dividends of 335 million 20 per cent per share and lower other comprehensive income of 1.37 billion or 98 cents per share.
A significant impact of GAAP net income and therefore of book value for the quarter was the held for sale of accounting entries recorded in association with the announcement of the sale of our commercial real estate platform, particularly.
Particularly the impairment of goodwill of $71 8 million of five cents per share.
I will expand on the details of these entries later in my prepared remarks.
We generated core earnings per share excluding PAA of <unk> 29.
A decrease of 3% or one cent per share from the prior quarter.
Combining our book value performance with the 22% common dividend we declared during Q1.
Our quarterly economic return with two 8%.
As I noted earlier, our book value increase reflected a five cent impairment of goodwill.
Excluding this impairment of Tan.
The economic return for the quarter was three six per cent.
Economic return and tangible economic return of Q4 with five 1% of five 2% respectively.
Taking a closer look at the GAAP results, we generated GAAP net income of $1 8 billion of one dollar and 23 cents per common share up from 879 million or <unk> 60 per common share in the prior quarter.
GAAP net income increased primarily on higher unrealized gains on our interest rate swaps and derivatives portfolio.
Typically GAAP net income benefited from rising interest rates reflected in unrealized gains on it.
Interest rate swaps of $772 million, which was 258 million and the price quota.
Of the derivatives led by features of 517 million, which was 12 million of the unrealized losses in the price quota.
And so options of $306 million, which was $4 million of unrealized losses in the prior quarter.
GAAP net income also benefited from lower interest expense on lower average repo rate and slightly lower average repo balances at roughly 65 billion I will kind of more details on interest expense later on.
Now to provide more color on the impact of the bulk of the commercial real estate divestiture.
As David mentioned in his remarks during Q1, we issued a press release, stating our intention to exit the commercial real estate business, including selling substantially all of the commercial real estate business the slight asset management.
The transaction is expected to close in the second or third quarter, following receipt of customary consents and approvals from regulators and joint venture partners.
As a result as of March 31, 2021.
We met the criteria to help the sale accounting, including the small number of commercial real estate assets excluded from the transaction given our intent to exit those positions.
The held for sale criteria require all asset from the disposal group can be recorded at the lower of cost of fair value.
Therefore under help the Sal accounting asset the written down but not up with gains recognized at closing.
This evaluation resulted in recognition of valuation allowances and impairments of approximately of $157 4 million.
All of its real estate in the securities.
Net by unrealized gains are C N b S available for sale of $16 8 million.
As the various closings of the transaction.
We will realize gains that more than offset the net valuation allowances and impairments recorded on the portfolio.
As the portfolio is now held for sale. It is no longer in the Skype of Cecil and in Q1, we reverse the previously reported reserve of 135 million through earnings.
In aggregate the divestitures of our commercial real estate platform through the sale of a slight asset management and our opportunistic sale of a portion of our skilled nursing facilities in the fourth quarter of 2020 will result in a true portfolio of benefit to tangible book value at closing, which will be fully recognized overtime due to GAAP accounting.
In conjunction with the acquisition of practice in 2013.
We recognized an intangible asset of goodwill.
Given our intention to exit the commercial real estate business, we have impaired the carrying value of the goodwill again 71 8 million of five cents per share Inc.
Q1.
Moving on now to see sort of is that consistent.
Consistent with the prior quarter, we continue to see of general improvement in market sentiment and the economic models. We use in this price is.
And given the commercial real estate disposition, the seasonal reserve now relates solely to our middle market lending.
We recorded a decrease in reserves of $6 2 million unfunded commitments during Q1.
Driven by a reduction in the portfolio and improve the macroeconomic assumptions.
Over the net of charge offs comprise 1.58% of all ml line portfolio as of March 31, 2021.
We expect the seasonal where that will be an immaterial part of our financial statements in the future.
Turning back to earnings I wanted to provide more details surrounding the most significant factors that impacted core earnings quarter of quota.
First consistent with my commentary around GAAP drive is interest expense of 76 million with Aloha and 94 million in the prior quarter due to lower average repo rates and balances.
We had increased expenses related to the net interest component of interest rate swaps of 80 million relative to 67 million in the prior quarter as the swap portfolio of position increased by $5 5 billion.
Finally, we had lower interest income primarily driven by lower average agency balances and a reduction in average agency yield.
And while the amount of consistent with Q4 at 97 million dollar roll income and contributed meaningfully to core for the quarter given continued record levels.
Our treasury groups view on the funding market came to fruition in Q1 with continued tightening of rights and flattening in terms of pets.
Today, we see overnight rates and the low low single digits and 10 market north of six months at 12 to 14 basis points in the bilateral market.
As a result, we successfully executed our strategy to add duration to our repo book without weighted average days to maturity up compared with the prior quarter at 88 days versus 64.
Providing further color regarding our reduced interest expense for the quarter.
The overall cost of funds is consistent with the prior quarter at 87 basis points.
The composition of different from Q4.
With repo interest expense of lower the cost of funds associated with hedges, increasing due to the increase in national AD. It.
Our average repo rate for the quarter was 26 basis points compared to 35 basis point from the prior quarter and we ended March with of repo rate of 20 basis points down from 32 basis points at the end of December 2020.
We continue to actively manage our repo book and look for further opportunities to reduce the cost of funds and improved liquidity book.
Instance, we experienced lower head cuts across the board from agency book.
And considering our liquidity profile, we selected to find out most liquid credit assets and utilize capital for the remainder.
The portfolio of generated 191 bps of NIM down from 198 bps as of Q4.
Driven primarily by the decrease in average asset yields.
Moving now to our efficiency ratio is pretty.
Obviously, we've provided a range of opex targets associated with potential cost savings from our internalization of one six to 1.75 per cent and in the prior year, we incurred of G&A costs for the annual Opex ratio in this range of $1 six 2%.
We expect to realize cost savings due to the disposition of out of commercial real estate business and began to see these in Q1 with an opex the equity ratio of one four per cent.
Given consideration to the pivot in our strategy from commercial real estate to read the credit Amazon and all of MMO business. We believe that of revised estimated range of Opex to equity for 2021 would be 1.4 of 5% tier one 6%.
And to wrap things up and we ended the quarter with an excellent liquidity profile with $8 9 billion of unencumbered assets slightly up on prior quarters of $8 7 billion, including cash and unencumbered agency MBS of six 2 billion.
Now with that that concludes our prepared remarks, and operator, we can now open it up to Q&A.
Yes ma'am.
We will now begin the question and answer session.
Ask a question you May press Star then one of them, they're touchtone phone.
You're using a speaker phone please pick up the handset before pressing the keyes.
And the type of question has been the dress and you would like to draw. Your question. Please press Star then two.
Many of the Star then one to ask a question at this time of we'll just pause momentarily to assemble our roster.
Okay.
And the first question, we have will come from Steve Delaney of JMP Securities. Please go ahead good morning.
Thank you good morning.
I guess my first question out of dress to Mike Fannie Hum, Mike on the resi side of.
About two thirds of the new investment.
The RMB S and.
The other third in whole loans.
Explain that logic, and where their was that simply expedient and that obviously securities transactions can be executed more quickly.
And that balance between securities and whole loans going forward, how should we think about that thank you.
Sure Steve. Thanks for the question I think that we've always designed our platform to have the ability to buy and purchase both securities and whole loans, we'd never wanted to enter into the resi credit market as a mono line entity and I think.
This quarter shows that we do have the ability to flex in the products to the extent securities are showing high ROE per unit of spread duration per unit of leverage spread duration and then we do have an operating platform as well that allows us to express a view in the organic creation of those assets. So.
So I would say when we when we see the.
The ability to have attractive NIM, we can deploy capital in both securities and whole loans.
And we were able to be successful in doing that.
It looked like.
Oh I'm sorry go ahead, I would just add that.
As of quarter end or after quarter end, the the whole loan acquisition.
Part of the business has accelerated I think we're over 1 billion year to date.
Either loan settled or loans in the pipeline so.
We're enthusiastic about the growth of the loan business as well.
Got it and it looked like on the EQM deal you may be retained about 7% on the prime deal fiber or a little bit less and then the math not I don't have the exact math I'm just curious do you consider.
When youre doing the deal and I know these new issue, our MBS are extremely well bid and over the over the.
The bid if you will.
But do you look at the economics of retaining some bonds farther up the stack as well as the sort of the minimum amount.
And obviously some of those I know you can put a little bit of leverage on.
Yes, that's the that's a good point, Steve So we've always.
Ben been aligned with our investors and that we normally take greater than five per cent of the risk retention.
We usually target 6% to 8%.
Capital deployment per each securitization and that will include some nominal amount of recourse leverage as well and I would say historically, we've retained about 10% to 15% of the market value of our assets.
The answer to your question is yes.
We've been very active in terms of retaining more risk than some of our peers and we do think that the delevering of the asset upgrades.
And improvements in financing.
Makes that a logical choice for us.
Thanks for the comments and congrats on the quarter.
Thanks, Steve.
And next we have Bose George of K B W.
Hey, everyone. Good morning.
Can you talk about where you see incremental returns on tools and on Ppas and then on the credit side. I think you gave some color on the Rps like where the returns where you can you just reiterate that and just talk about how that compares to what you're seeing on the agency side.
Sure.
The time.
On the need of investments on the TBA side even.
The.
And to add some specialness of the roll you are getting rid of low double digits escalation to unlock some higher coupon.
For the highest coupon the specs specified pools.
Expect drove high single digit cents for the rest of the mortgage universe, It's led to meet the high single digits.
And for the credit Mark came from 1% share.
Sure. Thanks, Alan So Rick on the on the NPL RPM purchases I would say in.
In Q1, we thought that they were high single digits very low double digits I would say if you fast forward to the to the current market. We have seen a good amount of tightening probably 40 basis points on the quarter in terms of any ones, which are the seniors close of 100 basis points of tightening on the H twos, which are the senior subordinates. So we think levered returns on the seniors now of <unk>.
The mid high single digits on the on the subordinate it's still probably you know very low double digits, but I don't think you'll see the growth of that portfolio.
On a go forward given given the tightening in the NIM, Yes book just to add.
Mike has been talking about that sector for the last couple of quarters. If you recall beginning last fall and we've slowly the accumulated of larger position and we've gotten to a point where it is.
It's not.
More attractive than agency currently but I think if you look back the last fall when we started buses or even prior to that and then there was a substitutable substitution away from agency marginally towards that sector.
Okay, great. Thanks, a lot and then actually I didn't know if he gave the said what's the book value quarter to date.
Sure as of yesterday were just about flat within a penny of where we ended the quarter.
Okay, great. Thanks, a lot.
Gross.
And next we have Rick Shane of J P. Morgan.
Hey, guys. Thanks for taking my questions. This morning.
David I did have one strategic question for you.
I understand the decision to exit the.
Commercial mortgage book.
But then you made the comment about continuing to invest and see MBS and when we think about it.
The loans the mortgages themselves bespoke risk.
Versus sort of more commoditized risk in the <unk> book and when we think back about either recent history or really back.
Pre TFC.
Some of the challenges folks it had with C. M B S.
Curious why to keep your foot.
You know sort of keep your nose under that tends to at this point.
Great question, Rick So first the first I'll say with respect of history I think of lot of the problems that were exhibited from our liquidity.
The endpoint existed with firms that were overly concentrated in.
The credit sectors and when you look at the end of Lee with.
And the assets in the agency sector, we do have capacity to have alternative products and not sacrifice liquidity as was the case with you saw last March now with respect to see MBS versus the commercial real estate platform.
It's largely about efficiency.
Look our commercial real estate business had been on balance sheet for eight years. It was a very solid contributor to the bottom line for annually. When we brought it on balance sheet as I've talked about in the prepared comments. It was of great decision on <unk> part because of the relative attractiveness of those assets.
<unk> two agency at the time and as the years went on more and more capital came into the sector, whether it be debt funds sovereign wealth insurance companies and it did become quite crowded and it became harder to compete for commercial to compete.
With the agency sector and as you know I'd say its a highly operational operationally intensive business.
In north of 20 people in our CRE.
Operation.
And it really has to be scaled to make sure you're generating the right returns and over the years 2017, 18, and 19 it did become harder to do that as spreads tightened and as a consequence of the compatibility with the agency was the key was a key driver of.
The decision notwithstanding the the considerable contribution that that business provided two annually over the years now with respect to see MBS, it's a very efficient.
Lean business.
And we see it within our securitized products framework, so we have resin credit and securitized products.
And CMS fits right in there.
We have good credit work.
Performed by the team.
And of great trading effort, but its lean and we can be very opportunistic in it and it's likely to be higher up.
The capital stack.
Relative to some of the things we were doing on the on the direct lending side.
Got it look I think it also highlights perhaps.
The challenge for companies that are associated.
Associated with particular products, which is that you probably don't get credit for the diversification.
But at the same time when there are challenges.
You get panelized, one of them so it almost feels like a one way risk.
<unk> exactly and with the relatively small footprint. When there is the dislocation within the MBS market or <unk> ex U can you can relatively quickly and efficiently add to the portfolio of if you think the fundamentals are are attractive relative to what's going on in the market.
Okay. That's very helpful. Thank you guys you bet Rick.
The next question, we have will come from Mark Devries of Barclays.
Yeah. Thanks, just a couple of follow up questions on the decision to exit the commercial loan business.
First of all is it fair to think that you know with some of the operating efficiencies youre going to generate from exiting that the that the.
The overall kind of blended return expectations for the business get a bit of a boost here.
You say just from an expense reduction standpoint, yes, yes, yes, just the kind of an all in return across the business without having to carry those expenses, yes at the margin we expect the Serena talked about the lower expense ratio. So yes.
Okay.
And then you know.
David I mean, one of the things you guys have highlighted with all the different.
Different asset classes as you invest in is there is there is some diversification benefit.
Returns being at least somewhat uncorrelated does it does it feel like what you give up here.
You know is in terms of the the added diversification.
You know kind of minimal when you think about the impact to kind of the broader returns for the business.
Yes, I would characterize as the Mark and when you think about substituting.
MSR for commercial I think you get you get.
Much more complementary portfolio to the agency business and obviously as you know it fits the hedge profile of nicely. It is a modest basis hedge. So overall when you look at the portfolio Years' out Holistically I think we're going to have a better risk adjusted return profile for the overall portfolio.
Palio and we'll do it we'll still maintain that diversification just in the slightly different way.
Okay got it alright. Thank you thanks Mark.
Okay.
The next question, we have will come from Eric Hagen of V. P. I G.
Hey, how are you guys. A couple from me I think you noted about half of your Paydowns were reinvested in spec pools. The other half went into the TBA is just curious of your approach to reinvestment of what that could look like going forward. Maybe you can also describe your approach the.
The relative value approach between picking up higher quality.
Versus medium quality cohorts.
And then it looks like you guys picked up some of our agencies CRT in the quarter I'm just curious how you think about it.
Additional opportunities there and just the liquidity and the asset class considering Fannie Mae hasn't issued since the pandemic and can you also just share how conditions and availability for financing those.
Of those physicians with the repo it looks right now.
Sure, let me start with the Swiss watch versus TBA last quarter's pool. The addition slow.
Most of the TV TBA surrogates like video by the low pay up pools, which most likely will be delivered into the.
The roll into the in this quarter or depending on the roll side. So we see the pictures of.
Not much different than what we took last quarter. So the other barbell portfolio of high quality high of coupon specs and on the lower coupons. In this case <unk> Suisse. There are most of the lung in TBA and we intend to continue this.
And as I said in my prepared remarks, even though mortgage rates are high and we are still in the high prepayment environment. So we don't want to give up the core protection on that.
And Eric I'll pick up the CRT so.
I would characterize the purchases in CRT is very short durations season assets that offer attractive spreads relative to that.
Duration exposure, so, yes, Fannie mae's not back in the market Freddie has been <unk> been very active but the the.
Assets, we're buying are the more seasoned very short duration of.
One year type spread duration assets that fit nicely on the balance sheet and we were buying just north of LIBOR plus 200 late last year and that's subsequently tightened in so it's not quite as attractive now but for the relative for the spread duration of those assets were quite attractive and were just under $1 billion on the overall sector now we all.
So did substitute away from these in the more in tubes.
Got it maybe you can address.
The address of the leverage.
Part of the equation.
As it applies the CRT.
And just the availability of repo leverage that youre seeing from dealers and your comfort level in applying leverage to the CRT portfolio here, Yes, and again it goes back to my comments about about the overall portfolio liquidity.
Certainly CRT financing was dislocated last March.
It has come back quite strong very strongly.
Say in more and more dealers are providing financing and financing rates are coming in lower and lower now that being said as I mentioned in my prepared comments. Some of those assets are funded with capital simply because we're in an abundant liquidity position. So it's always a risk with respect of financing of credit assets, but when you're running liquidity.
As we are.
Comes less of a concern and the dealer balance sheets are opening up or have continued to open up and if you think about it from their standpoint with the with the abundant haircuts and the spread you're earning with just the amount of liquidity in the system, it's not a bad use of.
Our balance sheet on the part of the.
The banks.
Thanks for the kind of you bet.
The next question, we have will come from Doug Harter of credit Suisse.
Oh, Thanks, So just a little bit more on the strategy David.
Just give us a little bit more.
How you're thinking about the middle market lending and in the context of.
The decision to sell commercial real estate and you know kind of.
Just.
How in kind of that system.
To kind of the.
The other one is residential.
Sure Doug Good question and I have focused a lot of my commentary recently on the build out of the housing finance function and now.
With with our rebuilding of the MSR effort.
Across all aspects of housing finance, but middle market lending is a core part of the company. It's a core part of the portfolio.
And it has been very complementary to the agency business over the years.
It had very consistent returns that have been uncorrelated with the agency. It also happens to be a scaled business and it's very efficient.
And the cost structure as a standalone looks very very attractive relative to peers in the in the space.
Our middle market lending franchise.
Also is quite unique in that were largely of niche sectors, which are highly value of our participation is highly valued by our PE sponsors.
At Tims business interacts with on a daily basis, and also theres a bit of a symbiotic relationship with with the REIT because he's able to do things in that business, which are much more considerable than a lot of his peers given the amount of liquidity that the.
We can offer for example, large positions that we can subsequently syndicate and then that certainty of execution that the sponsors have had become accustomed to a core.
<unk> has also been beneficial so generally I'll say.
Some of it up it is complementary to the to the agency business. We haven't had a conflict with respect to relative returns on a risk adjusted basis and it's worked for us.
Great I appreciate that David and then just on the MSR do you imagine building that up kind of through flow programs are for you.
To be active in looking at book purchases sure and it's the combination of the two we do have a partnership which will likely be co issue flow of will be core to flow, but the way we view the business. It's not like when we owned pingo <unk> of where we had dozens of flow partners and it was very operationally intensive.
The core business that is being run out of Italy will be focused on partnering with large originators.
Originator, Servicers, where we will buy bulk packages.
And we're very confident that given the dynamics in.
In the servicing industry right now with the with the contraction in primary secondary spread and our ability to provide liquidity to that sector and not compete with.
Of those institutions that we're going to be a very very favorable participant in that market in the eyes of of Servicers.
Over time, we will grow the portfolio responsibly.
We do have a pipeline that.
It was about 130 $140 million in market value between three different packages that we have.
<unk> agreed to buy thus far which will be coming on balance sheet in the not too distant future.
We'll grow it over time responsibly and very considerate of the operational risk, which is why we want to partner with.
With large institutions.
Where we can we can buy bulk packages, but then we're still going to engage in that flow core issues flow business through another partnership.
Great. Thank you David.
Net.
The next question, we have will come from BRIC Vandervliet of UBS. Please go ahead.
Hey, good morning, everyone. This is of USA Abraham and for of Brock Most of my questions have been asked and answered maybe on the credit portfolio. Overall, how are you guys thinking about the target capital allocation. There I think you mentioned in the prepared remarks, there was around 27% so what's the target.
They're now and are you trying to hit that sooner rather than later or are you going to take maybe a more patient posture and.
And getting there, yes, Hy Vee list look I'll say there isn't a specific target. We have historically said the agency will be between 60, and 80% of our capital allocation and relative value is going to going to dictate that range. Now obviously, we're substituting away from commercial and <unk>.
MSR you can consider into that alternative outside of the pure agency capital allocation.
But overall that hasn't changed we think that the liquidity of the agency.
The portfolio.
Our footprint in that business and how well it's worked for us over the years.
Enable us to maintain that core capital allocation and we don't envision a meaningful shift from.
Our philosophy of that 60% to 80% range now.
Depending on relative value, it's going to fluctuate but.
It's all dependent on the state of the market at a particular time and what's attractive and the good thing about our credit businesses is that they're not force deploy use of capital we can be opportunistic there all scaled with the.
The exception of the MSR, which we'll get to scale.
But we're not where we are.
Not.
We're not forced to do anything.
We can pay attention of the market and do what's right for the portfolio.
Okay got it that's helpful. Just maybe quickly on just overall funding costs I appreciate the swap book.
The sizing up a bit and.
The cost kind of staying flat of about 87 bps.
Just moving forward given.
Given the mix is changing a little bit the know how should we think about that or we are we kind of trough.
Dropped here now or is there incremental fund.
Funding cost declined to be to be seen.
Thanks.
Yeah, the militants arena, so and we do actually contemplate a continued reduction in funding costs going through each of the second quarter.
And bill of so I'll, just add to that with respect to MSR. We have said in the past that it's an instrument that we that we do not lever that being said you could see a scenario, where we do have a warehouse line simply as an insurance policy, but again as I said in my prepared comments, we expect it to be.
At scale with 10% of capital business, and we're not going to look at it on a levered basis.
Great. Thank you.
You bet.
The next question, we have will come from Kevin Barker of Piper Sandler.
Thanks, most of my questions have been answered, but just can you give us the you know your view on.
The outlook for.
Rates in the economy as we move into the back half of the year and I realize you have Inc.
Greece and GDP within your forecast and various other.
Seems like your positioning for a steeper yield curve, but can you just lay out your expectations and then what are the biggest risks you see out there given your current strategy.
Sure sure. So look our view right now as rates could be slightly higher than where the right now but.
We don't expect the meaningful further selloff in the market and I think that was reaffirmed bye bye.
Sure Paolo yesterday, if you just think about the fed's posture.
There's been a lot of anxiety by when the taper will occur and how theyre going to.
Position the monetary policy, but if you just look at their forecast in March.
We have a six 5% GDP forecast four 5% unemployment at year end and the two 2%.
Core PCE forecast and Thats, obviously, very strong data, but theres still steadfast in their in their accommodative approach and a lot of that has to do with they will are willing to let the rough with the economy run a little bit hot over the near term, there's still eight odd million people unemployed.
And Theres also objectives that they want to achieve with respect to the marginal worker and in making sure that they don't take their foot off the gas too early.
Now they also when you look at their longer term forecasts.
<unk>.
You have effectively of long term unemployment rate of 4% GDP of one 8% long term inflation around 2% out the horizon if.
If you think about what that world looks like and then you look at the forwards in the rates markets five years out of twos tens is currently between $2 50, and $2 70, if you look at the forwards.
With the two 5% terminal on the.
With respect of fed policy.
Still a little bit low, but it's not unreasonable.
And what's the margin can be a little bit higher, but but we've got a very accommodative fed and we're respectful of that that being said there are risks to your point and we're obviously experiencing higher inflation over the period of near term. The fed does believe it to be transitory the market is kind of fighting them.
On that half of the rate increase in the first quarter was attributable the inflation breakeven with the other half.
Of real rates.
And there is the possibility that that does get a little bit out of hand in which case the.
<unk>.
The back on their heels, but but they are not overly concerned about it and they like to see a bit of inflation.
But generally speaking I think the margin could could.
The in a position to where.
Let's do get get a little bit elevated and theres further hedging and in the mortgage market.
There is still extension left in the agency market and Thats why were being very vigilant about managing our duration. We entered the year of the lesson of quarter year of duration, we actively managed it as you've seen our hedge profile and we're currently in that context as well.
Just very slightly long in the market.
It is expensive to be short.
But we hedge given given the steep yield curve, but you do have to be prudent about it and as a consequence, we're keeping we're keeping duration close to home and we expect that to continue foreseeable future.
Okay. Thank you. Thank you for the color.
The good talking to you.
Well showing no further questions at this time, we will go ahead and conclude our question and answer session I would now like to turn the call.
The call back over to Mr. David Finkelstein for any closing remarks, Sir thanks.
Thanks, Mike and thank you everybody for joining us today, and we'll talk to you next quarter.
All right. We thank you Sir also until the rest of the management team for your time today again. The conference call has now concluded at this time you may disconnect. Your line is thank you everyone take care of and have the wonderful and Blessed day.
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