Q2 2021 Annaly Capital Management Inc Earnings Call
[music].
Good day and welcome to the <unk> Capital Management second quarter 2021 earnings Conference call.
Good day, all participants will be in a listen only mode should you need assistance during.
During today's call. Please signal for a conference specialist by pressing the Starkey followed by zero.
After todays presentation, there will be an opportunity to ask questions to ask a question you May Press Star then 1 on your Touchtone phone. She would draw. Your question. Please press Star then 2 please note.
Today's event is being recorded.
At this time I would like to turn the conference over to Sean Kensal, Vice President Investor Relations. Please go ahead Sir.
Good morning, and welcome to the second quarter 2021 earnings call for <unk> capital management.
Any forward looking statements made during today's call.
<unk> are subject to certain risks and uncertainties, including with respect to COVID-19 impacts which are outlined on the risk factors section in our most recent annual and quarterly SEC filings.
Actual events and results may differ materially from these forward looking statements.
We encourage you to read 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, both GAAP and non-GAAP financial measures are.
A reconciliation of GAAP to non-GAAP.
This is included in our earnings release.
As a reminder, we routinely post important information for investors on the company's website at Www Dot <unk> Dot com.
Content referenced in today's call can be found on our second quarter 2021, investor presentation on second quarter of 2021 financial supplement both.
Measured under the presentations section of our website.
And on the intends to use our webpage as a means of disclosing material nonpublic information for complying with the company's disclosure obligations under regulation, FD and to post and update investor presentations and similar materials on a regular basis.
And on the encourages investors analysts.
Both found yet and other interested parties to monitor the company's website. In addition to following the <unk> press releases SEC filings public conference calls presentations and Webcasts and other information it posts from time to time on its website.
Please also note this event is being recorded.
Participants on this morning's call include David Finkelstein.
The media Chief Executive Officer, and Chief Investment Officer, Serena Wolfe, Chief Financial Officer, <unk> <unk> head of securitized products.
Tim Coffey, Chief Credit Officer, and Mike <unk> head of residential credit.
And with that I'll turn the call over to David.
Thank you Sean good morning, everyone and thanks for.
<unk> for our second quarter earnings call today, I will provide an overview of the macro environment and current market dynamics briefly discuss our performance and capital allocation trends during the quarter and lastly, I'll highlight our progress on the various strategic initiatives that I outlined on last quarter's call. The OCA, who will provide a more.
Joining us here with commentary on our agency and residential credit portfolio activity and Serena will review our financial results. Finally, as Sean noted we are joined by our other business leaders today, who can provide additional context during Q&A as needed.
No economic momentum accelerated in the second quarter as.
More data driven restrictions were lifted in the U S economy reopened strong consumption was closely followed by rising prices as several goods, most notably cars and services were in short supply relative to surge in consumer demand. These price pressures are expected to cool from June levels, whereas core CPI rose 4.
5% year over year, yet it remains unclear as to how entrenched higher prices will be going forward.
The surprise to many longer term interest rates deviated from these positive economic fundamentals and rallied nearly 30 basis points during the quarter.
Right markets seem to suggest that peak growth momentum.
As co behind Us and narrative that has been fueled in recent weeks by a resurgence in COVID-19 cases, as well as the growing realization that elevated valuations require a sustained low interest rate environment.
The other meaningful economic event during the quarter was the subtle shift in communication from the fed at.
The Juniper UMC meeting in light of the high inflation readings, the fed signaled rate hikes might occur as early as 2023. Additionally, the momentum in growth and continued progress in labor markets led the committee to begin discussions around tapering their asset purchases.
This pulled forward expectations.
For a tightening in monetary policy and implies a taper announcement could occur in the coming months.
Although there is plenty of attention on the potential taper timeline and options right now the fed will be deliberate and transparent around any announcement as it wants to continue to minimize any potential market disruptions.
Turning.
Turning to our portfolio, we experienced a negative economic return of 4% in the second quarter amidst a challenging operating environment for agency MBS.
Rising volatility and persistent elevated prepayment speeds drove much of the deterioration in agency zilkha will discuss in more detail.
We continue to prudently.
As the portfolio, reducing leverage and hedging incremental moves in interest rates, while allocating capital towards credit investments with more attractive risk adjusted returns.
Consequently, our total portfolio decreased by approximately $7 billion to 93 billion contributing to a reduction in economic leverage.
We managed to 6.1% to 5.8 times and an increase in unencumbered assets from $8.9 billion to $9.6 billion quarter over quarter.
In light of relatively tight asset spreads on the end of easy monetary policies policy in sight, we expect to continue to maintain our leverage profile at the low.
Lower end of the range that we've historically operated in.
Despite the decline in our portfolio, we were able to generate earnings available for distribution exceeding our dividend by <unk>.
Although earnings have been in the proximity of <unk> for the past several quarters. We view this effectively to represent the high watermark.
Average and anticipate earnings will likely moderate going forward on.
On the financing front, we continue to take advantage of the historically attractive funding markets with sustained record low financing costs, which Serena will expand upon further we amended terms and credit facilities for our residential credit and middle market lending businesses.
Mark increasing capacity and extending the term on facilities, notably.
<unk> pricing for financing on non QM loans by nearly 50 basis points. During the quarter. We also expanded collateral eligibility to meet the evolving needs of the residential credit business, including newly offered products such as agency eligible.
And non agency second homes.
Capital allocation continued to shift in favor of credit increasing modestly from 27% to 29% during the quarter. Despite our exit from the commercial real estate business, our residential credit business experienced another active quarter as we took.
Took advantage of opportunities its shorter spread duration securities as well as the non QM low market, which was bolstered by enhancements to our product sourcing capabilities that I will discuss further shortly.
Due to the more than 1 billion on purchases that were largely unlevered capital allocation to the business increased 6 percentage points.
19%.
Now shifting to middle market lending, we saw considerable portfolio activity during the quarter, while maintaining our targeted investment approach closing approximately $450 million on originations across 6 deals with an average commitment size $75 million our ability to.
And then underwrite deals in size as demonstrated this past quarter further differentiates our business, making us a preferred lender partner to our private equity sponsors.
Our syndication capabilities. We're also evidenced through seamless execution of 1 of our larger position subsequent to quarter end the portfolio continues.
To lead to exhibit healthy performance and we remain constructive on our outlook and positioning.
Now the previously announced sale of our commercial real estate business remains on track to be completed by the end of the third quarter as planned subsequent to this past quarter and the bulk of the platform, including a number of <unk> employees.
Who supported the business was successfully transitioned as part of the first closing of the transaction a significant majority of the assets were settled during the first close and we have received nearly 85% of the capital thus far.
On behalf of the entire annually team I'd like to thank our departing colleagues for their numerous.
<unk> solution and wish them continued success as they embark on this new chapter.
Now as I discussed on last quarter's call our commercial real estate divestiture gives us additional capacity and strategic flexibility to further expand our leadership and operational capabilities across all aspects of.
Continental housing finance market.
I would like to now provide an update on key milestones related to our top 2 initiatives building, our mortgage servicing rights business and portfolio and expanding our residential credit platform first with respect to our MSR business. We have 2 avenues for investment in the.
This sector burst through a set of committed third party partnerships and second by means of a build out of our own capabilities to own and oversee servicing of MSR in house through our Onslow Bay subsidiary.
We continue to make key hires in this area with decades of industry expertise to lead the effort we began.
This process over a year ago and have now build it to critical critical mass with over $400 million of exposure to MSR nearly doubling our portfolio during the second quarter as.
As expected diminished originator profitability in the first half of 2021 has led to elevated secondary MSR volumes from originators providing.
Simple supply we.
We expect this dynamic to continue in Italy is a synergistic partner to originators, given our deep capital base and ability to acquire a wide array of products.
Timidly MSR is an efficient hedge to our core agency portfolio, given its negative duration and positive yield and we.
And it will significantly enhance the long term sustainability of our returns however, given the inherent structural leverage of MSR. We are not currently employing financing for this strategy and do not foresee our capital allocation to MSR to exceed 10%.
As such given the size and scale of our balance sheet.
We believe it to be able to sufficiently scale, the MSR business and maintain a strong industry presence within these parameters. However, as we have noted previously we expect to grow our portfolio responsibly highly consider it valuations.
Now expanding on residential credit as I noted earlier we.
We deliberately increased our exposure to the sector during the quarter and we remain positive on housing fundamentals, given the monetary and fiscal stimulus and the under supply of single family homes in the U S.
<unk> has expanded its residential whole loan acquisition channels by initiating in house aggregation through on low base.
<unk> correspondent channel launched in April This channel offers a broad and diversified program suite to purchase residential mortgage loans on a best efforts flow basis that adhere to our rigorous credit standards and we continue to expand our network with new partners.
So a big picture view.
Is that the further development of these 2 initiatives combined with our best in class agency business and our size and liquidity increases our presence throughout the spectrum of residential housing finance and allows optionality to allocate capital where it is most attractive based on where we are on the cycle.
And lastly, before turning.
Over day Ilker I do want to highlight that we published our second corporate responsibility report earlier. This month. The 2020 report titled leading with purpose demonstrates our continued focus on high quality disclosure with respect to our ESG endeavors and provides an update on our ESG goals and commitments.
Turning it on this year's report we included additional SaaS be disclosures under the mortgage finance standards for our residential credit business and made a new commitment to further assess climate change risks and opportunities through the consideration of the task force on climate related financial disclosures and annually, we are constantly striving to improve.
<unk> of our corporate responsibility practices and to further integrate ESG considerations into our overall strategy to benefit all stakeholders.
Now with that I'll hand, it over day ochre to provide a detailed overview of our agency and residential credit portfolio activity and outlook for each sector.
Thank you David.
Improve as you noted MBS underperformed trade into the bulk flattening rally and our hockey shipped by deferred debt pulled forward rate hike on taper timelines.
Although the quarter MBS widened across the stack with lower coupons impacted by heavy supply and accelerated tapered outlook on higher coupons.
Influenced by persistence of fast speeds, which further delays the essential burn out the expectations.
In anticipation of market volatility by mid May.
<unk> reduced our agency portfolio by nearly 9 billion ahead of the most of the spread widening across a mix of outright sales and portfolio.
Folio runoff.
We manage the size of our portfolio, we maintained our barbell strategy, consisting of lower coupon TBA and high quality prepay protected specified pools in our coupons.
We continue to believe this strategy best positions us for the current environment low.
Lower coupon Kevin.
So on and Russia remains special well into 2022.
And our higher coupons specified pools provide defensive positioning ahead of any supply induced widening or further volatility in interest rates.
Turning to our hedge portfolio on aggregate, our hedge position declined during the quarter in.
With the lower leverage and rally in interest rates.
Is yieldco flattened, we reduced price you the future stages at the long end of the curve to actively manage our duration profile the.
Disruption portfolio declined as we exercise 2 billion of in the mining payer swaption effectively lacking in the negative duration from positions that we scheduled to expire in the quarters.
So options have been a crucial comics the hedge for us with the reversal in the yields for example, with much deeper Kevin early April the opportunistically edit or receiver position at very attractive levels.
The last 2 quarters have highlighted the importance of the liquidity on Optionality Nowadays profiles and we remained poised to adjust swiftly across the yield curve if needed.
Is David discussed we have also been actively growing out MSR portfolio in queue to be committed to purchase approximately $220 million in market value across for bulk purchases, bringing our economic exposure over $400 million.
MSR provides an additional tool for hedging MBS spread on interest rate risk, while earning high single digits.
More importantly, our expertise managing prepayment risk and in house modeling capabilities in the context of our MBS business provide us unique perspective on MSR speeds on valuations supporting the reasonable growth David mentioned.
Turning to residential credit business, we continue to grow the portfolio true purchase of expanded credit or loans and predominant the short duration on rated Mpls PL securities.
Total economic risk of the residential Covid portfolio now stands at 4.2 billion, a 6% to 7% increase from the beginning of the year.
Older credit spreads tightened on the quarters monetary stimulus and subsequent available to balance sheets had led to more attractive financing into on supporting level returns in the sectors.
Our securities portfolio increased by approximately 200 million over the quarter driven by 330 million of Mpls PL purchases as the previous day stated Mpls Pier Securities on high quality short duration assets with expansion protection debt provide attractive net interest margin and tables.
Low correlation to a longer duration Fixate agency MBS portfolio.
In residential hall loans, we settled approximately $1 billion of assets in queue too and price 3 rated Securitizations tossing approximately 1.1 billion since March.
The securitization swear comprised of 376 million non QM transaction, which generated approximately 35 million of retained assets at the projected leveled return into low to mid teens.
The remaining 2 securitisations were opportunistic prime jumbled transactions that we retain subordinates securities generating approximately $27 million of assets at high single digit are always.
As we look ahead agents MBS valuations on a healthier place following the widening into second quarters with Levered are always in the high to single low double digits.
However, technical headwinds persist out the horizon and therefore, we remain focused on diversifying the portfolio across various opportunities within housing finance, we continue to see attractive opportunities MSR Andres vessel credit and with low overall leverage on high levels of liquidity, we are well positioned to take advantage of the Patel.
Shall price look dislocations across all of our investable assets classes.
With that I will turn to call over to Serena.
Thank you and good morning, everyone.
This morning, I'll provide brief financial highlights the quarter ended June 30th 2021.
As noted in our earnings material in line with evolving industry practices. The company is reliable core earnings excluding PAA at earnings available for distribution or a day.
I wanted to be very clear that this is a name change only and a competition on the non-GAAP metrics core earnings excluding PAA and.
Precisely the same.
Consistent with prior quarters, while earnings release, discloses that gap and non-GAAP earnings metric.
My comments will focus on a non-GAAP.
And related key performance metrics, all excluding PAA.
The general theme to this quarter's earnings are consistent with cute 1.
As we generated strong results from the portfolio.
Benefiting from the continued low interest rates on the funding market Martin another quarter, a record low cost a fan.
And sustained special on it and dollars roll financing.
To set the stage with some summary information at book value per share with $8.37 a key to a decrease of 6.5% from Q1 and.
And we generated earnings available for distribution per share of steady fan and.
An increase of 3% on 1 cent per share from the price for App.
As David and <unk> have both touched on the second quarter was a challenging environment agency MBS book value decreased primarily due to the common and preferred dividend declaration of 345 million or 20% for sure at GAAP net loss and low or other comprehensive income of 222 million.
Or 16 cents per share.
Alpha value reflects the challenges outlined by my colleagues whereby the decline was driven by agency mortgage spread widening as.
As treasury rates rallied reflected in reductions in on derivative market values.
<unk> changes were muted.
As a result, our agency portfolio did not see book value gain to offset the derivative losses.
Combining our book value performance with the 22 common dividend we declared during Q2.
Our quarterly economic and tangible economic return with both negative 4%.
Economic return and tangible economic returned to Q1 with 2.8% and 3.6% respectively.
As we take a closer look at the gap results the challenges in the interest rate environment is further illustrated here as we generated a gap net loss of 295 million or 23 cents per share down from GAAP net income of $1.8 billion or 1 dollar and 23 cents per common share in the prior quarter.
This quarter slip many of the gap drivers I discussed in Q1 that is in queue to GAAP net income decreased primarily on higher unrealized losses on our interest rate swaps on derivatives portfolio.
Specifically declining interest rates impacted GAAP net income reflected unrealized losses on interest rate swaps of 141 million, which was $772 million of unrealized gains in the prior quarter.
Other derivatives led by futures at 578 million, which was $517 million of unrealized gains in the prior quarter.
Swaptions of $233 million, which is $306 million of unrealized gains on the prior quarter.
On a positive note GAAP net income benefited from low interest expense on lower average repo rate and slightly lower average repay balances at roughly $662 billion vs $65 billion in the preceding quarter.
Now for a federal look at earnings available for distribution.
The most significant factors that impacted.
Quarter over quarter included.
Consistent with my commentary around GAAP drivers interest expense of 61 million with lower than $76 million in the prior quarter due to low average repo rates imbalances.
We had slightly increased expenses related to the net interest component of interest rate swaps of $83 million relative to $80 million on the prior quarter as a swap portfolio national balance increased by $2.2 billion.
Higher TBA dollar rolling income of $110 million vs $99 million in Q1, as the desk was able to extract marginally greatest specialists in queue to relative to Q1, and finally, we had low interest income primarily driven by low average agency MBA balances.
The continued stability of the funding market was a bright spot in the quarter with Q2, marking 8 consecutive quarters of reduced cost of funds for the company.
We continue to Opportunistically target extended time that 6 to 12 months.
For a repo book without weighted average days to maturity consistent with the prior quarter at 88 days.
This strategy served as well during the quarter as the Feds increase in our R. P Io yah hazards.
Has resulted in approximately 3 to 4 basis point rise in overnight rates with a slight upward bias in 10 markets as well.
Additionally, the funding markets are continuing to improve on credit, particularly regarding structured products as we've seen tightening from both the spread and a haircut standpoint up and down the stack.
And while we expect funding markets out 1 year to remain relatively flat uncertainty around the debt ceiling infrastructure, bill and possible fed tape up could prove as headwinds and the funding market over the second half of the year.
Providing additional color regarding allergist interest expense for the quarter hour overall cost of funds decreased 4 basis points quarter over quarter from 87 basis points to 83 basis points.
Our average repo rate for the quarter was 18 basis points compared to 26 basis points on the prior quarter and we ended June with a repo rate of 16 basis points down from 32 basis points at the end of December 2020.
And my prepared remarks last quarter I referenced our efforts to fund credit assets selectively as I mentioned earlier deal of appetite for credit assets as strong however, given the conducive funding environment, we opted to optimize the use of liquidity and hold a portion of our credit assets with equity that's further reducing.
<unk> interest expense.
The portfolio generated 209 basis points of name up from 191 basis points out that Q1, driven by the 5 basis point increase in average yields and a decrease mentioned earlier and cost of funds.
Average yield increased due to an increase in agency yields of approximately 9 basis points during the quarter, mostly because of declines in projected CPR and the impact on amortization for the quarter and the change in portfolio mix 2 ready credit that is low or agency average on average balances in high ready credit Securities average balances on CRT and and.
<unk> purchases.
Moving that to our operating expenses efficiency ratios for the quota increase in comparison to Q1 ratio of 1.36% due to declines in equity during Q2 and timing differences in the true up of certain accruals.
Our opex to equity ratios were 155% on 1.46% for the quarter and year to date, respectively, which is within the revised range of 145216 provided in Q1.
And to wrap things up on only ended the quarter with an excellent liquidity profile with 9.6 billion of unencumbered assets up from the private quarters, $8.9 billion, including cash and unencumbered agency MBS a $4.7 billion.
The increase in unencumbered assets is associated with a low leverage in our approach to funding credit assets I mentioned earlier.
That concludes our prepared remarks, an operator, we can now open it up to Q&A.
We will now begin the question and answer session. As a reminder to ask a question you may prices Star then 1 on your Touchtone phone.
If you're using a speaker phone please pick up your handset before pressing the keys if at anytime. Your question has been addressed and you would like to withdraw it. Please.
Please press Star then too at this time, we will.
Today's first question it comes from.
Steve.
Delaney with J M. P Securities. Please proceed.
Good morning, everyone and thanks for taking my question, we noticed that you tap your a T M plan and the quarter for about 400 million was that specifically related to the 200 million plus MSR gross or or.
What other things.
Things did you have them on with that issuance. Thank you.
Well good morning, Steve and.
How are you so.
Well.
Q with respect to the ATM it actually had to do with a lot of factors I think when you look back to last year we.
We used our buyback program to buy back stock and an accretive fashion.
In December we called a preferred issue are 7 and a half which is about 460 million and also to your point in terms of growth of MSR, an expansion of resin credit.
That influenced as well so the way I would look at it from 1 point, we improved our overall capital structure by somewhat lagging.
The call of the preferred to issuance of common but also to better growth of or alternative products in the build out of that infrastructure.
Alright.
Well.
Certainly you you certainly have indicated where are you going to be growing on the credit side and that that that certainly makes sense..1 follow up we heard last night on on a call that.
The non agency on M. B S. The new issue the new issue market was getting a bit crowded the comment was from an originator who would normally execute securitizations and it sounded like.
The economics of the securitization weren't as attractive because the just the buyers were maybe just getting too much on there on on their plate. So with that in mind can you talk about the ability of annalise balance sheet at your size can you pretty much acquire whole loans.
Without an immediate securitization execution and and just hold them with alternative short term financing until the securitization market appears appears optimal and and and if so if you have the flexibility to do that could you kind of size what.
You would be comfortable with in terms of unsecured Taj told lunch. Thank you.
That's a great question, Steve so.
First off I'll say that the securitization market has been quite robust and we've had a lot of success has recently this week issuing transactions with respect to capacity and availability of our own balance sheet warehouse loans and Mike can expand on this but I will say that we did settle roughly.
A little over 1 billion whole loans last quarter, we do have on.
Another $800 million in the pipeline and we have considerable warehouse loading capacity and we also have ample liquidity on the balance sheet as we discussed and so and so we feel good about where we're at and Mike can talk a little bit.
Securitization market and the dynamics associated with it thanks.
Sure Steven and thanks for the question I think.
In terms of the originator of that was claiming that the securitization market was quote on quote for a lot of that is the prime jumbo market and then also agency investor as you know because of the changes you've seen issuance. There. So if you look at that market. The beginning of July there was about $27 billion of issuance. If you look at last year.
In total there.
It was about 22 billion so year to day, you've already surpassed issuance last year. However, Steve most if not the majority of our purchases are in the non QM market and when you look at the non QM market.
It's actually the probably the most advantageous time to issue.
Given where spreads are so at the beginning of the year on non QM spreads on the AAA that makes up about 75% of what you sell was 85 to swaps to fast forward to today, that's 60 to swaps.
So I think that your point is valid in that there are certain components of the market that have why didn't given supply. However, the majority of our risks in our exposure is in a different market and different structure that is actually executing at what we would say the best economics, we've seen in the non QM deal.
That we did over over this quarter.
Issued at a 90% advance right.
80 to swap with a weighted average cost of 80 to swaps.
And lastly, we did have 2 prime jumbo securitization since the end of March and that is the market at which you have seen a lot of supply. However, those securitizations our partnership where we don't actually have any economic risk until the deal closes. So hopefully that's able to answer your question no that's extreme.
That level of detail with respect to different products is extremely helpful to clarify my mind as to as to what I heard last night. Thank everyone. I appreciate all the comments. Thank you.
Steve Thanks.
The next question comes from Doug harder with credit Suisse.
Please go ahead Sir.
Mr Heart of your lines.
Alright is that better.
Yep.
I'm, sorry, I'm sticking with residential credit can can you talk about what are the advantages that come from opening the conduit that you're talking about.
Yeah, largely price, but all of Mike expand on that.
Sure sure I think that we've shown over over the years since the inception of this business the ability to purchase residential loans inside without having exposure or direct investment with an originator we have a number of different.
Pricing avenues, and strategic relationships that allow us to be accretive outside of the bulk market. However, we have always participated in the bulk and many both markets and I think the launch of the correspondent channel really what that does is it.
Low you to face smaller originators and the ability to lock best efforts allows you to.
On the economics of the loan at a much more accretive price than it would if you would participate in the bulk or many bulk market and it's easy as just the fact that you have to have infrastructure personnel additions sales business development et cetera that.
Those developments.
Allow you to allow you to get entry into the into the market at a much more advantageous price. So that is that is the main reason and we also have the ability to control our own credit control pricing and control our partner so.
It's a multitude of factors.
And it's.
Providing certainty of execution to originators, which is a service that they value and were consistent with it.
And then.
Think about the the equity allocation capital allocation to to credit.
Picked up.
This quarter so.
The current thing over the next.
Next your and what's kind of a longer term range so you're shooting.
So is ilker discussed our our aspiration is to continue to grow or alternative products and we're certainly sensitive to relative value quarter over quarter. The growth saw in residential credit we were very happy with and as Serena noted that a lot of that capital allocation was.
Was big.
Because we didn't lever a lot of the assets and 1 thing I'll note is that when we when we're not as optimistic on agency and this sounds counterintuitive you will see leverage on our credit products actually go down and that's because typically we're going to have ample liquidity because we're reduced.
Agency and then we can look to use that liquidity to offset financing costs associated with with.
With credit products, but first and foremost it starts with our overall liquidity position and when we're in an abundant liquidity position that debt level of leverage is going to fluctuate.
Does that help.
It does thank you.
You bet.
The next question comes from Bose, George with K VW. Please proceed.
Hey, good morning.
Actually switching back to Ya.
Agencies in terms of spread widening how much of the spread widening do you think Ah related to tape thing has already happened and is there a way to think about the spread level at which you guys get decided to get more aggressive side in terms of capital deployment.
Sure.
Ooh.
Let's basically look at the landscape of the mortgage universe, so roughly 50% of and tired mortgages on and help to make sure to portfolio banks on Fred So if you're available for sale Securities for Bank portfolios also you get this number to bid on 666% to 7%.
So given that this time it on paper will be much less impactful in the mortgage market than before.
In fact, I would argue that lots of luck.
Money managers and even look others.
<unk> ability investors are waiting on the sidelines for the temperature to relocate the agency MBS. So I would think that a good chunk of the tape lesbian price.
And.
Agencies zone, an unhealthier place right now and they will look as we said really tight at the end of July.
Okay, great. Thanks.
So yeah, great. Thanks, So it's helpful and actually just on the trend since quarter and can you just give them an update on book value called your day Turbos, We're we've moved around a little bit, but we're within a penny or 2 flat on the quarter as of last night.
Okay, and then actually just 1 clarification on the capital allocation you've mentioned for the MSR did you say about 10% of the capital is is what you would be with you okay.
That's what we would like to get 2 over time, but we're very patient about that we will certainly be responsible about the growth of that portfolio and and were okay to take our time, but we do do expect to grow it deliberately over the coming quarters in years.
Okay, and so just when you think about the size of debt MSR.
We should think overtime, 10% of capital whatever advanced range, you can get on that sort.
Sort of size the potential MSR down the road that way, Yeah, and you should think about it on Levered. There may be a case, where we get a warehouse line, but that's simply for liquidity purposes. How we look at MSR zone Unlevered basis, so from that standpoint, roughly $1 billion on a have it steady state peak at some point in the future.
Okay, great. Thanks, you bet bows.
Our next question comes from Rick Shane with J P. Morgan. Please proceed.
Hey, good morning, everybody and thanks.
Thanks for taking my questions.
This is actually kind of dovetails with the conversation you were having with Doug harder, but when you look at your comments related to the MSR on the fact that you plan to on that level that on on Levered basis.
Can you talk about the return profiled owning MSR unlevered and should we really think of that.
Has.
Consider that in the context of the Fungibility of your assets that you will increase and decrease the leverage on your other assets to fund Msr's Uhm.
Based upon sort of interest rate outlook and.
More efficient financing for those other assets.
Sure. So let me start with the last part of it the.
The funding decision will be based on the liquidity of the overall portfolio. So both of them be analyze them as well.
We analyze the returns on lillard, so right now you're getting.
Hi single digit returns on Msr's with the hedge benefit this coming from the TVA hedges on liver to transfer price single digits, which is good enough, but we expect MSR available to will be hired on the road and we probably can find opportunities to reflect double digit returns on level with the help of the hedges.
Okay and can you and can you explore the second part of that.
Which is that really you're looking at the fungibility of of the funding to support the MSR and the efficiency of for example, levering up the agency MBS, a little bit more as opposed to some of the risks associated with MSR financing.
Luckily look again, David David booked it automated on I. So that we never look at database. So we never say that Asia to funding you see here. So let me use the agency funding to other assets, including MSR. Other creative process, we never look at that that's a slippery slope, but what we're seeing is that when we have excess liquidity in.
Excess of what we will meet the on the rope with distress and others that we may not from some of our other assets. This includes MSR and then it was the easiest of funding on debt. So funding decision is based on the overall included the needs and then we try to optimize the funding portfolio.
But we will never let's look at the agency funding and then use that funding leverage to get to the charges on other asset classes that that must be done.
So then we are Analysing MSR for example, or any other instrument, we will always look at the funding of debt instead of the month venue or during the MLT convert when you are designing your hedges, but when it comes to funding it depends on how much access the glued to Europe.
In the box.
That does that's very helpful.
Thank you guys.
Rick Thanks.
The next question comes from Erik Hagen with B T. I G. Please proceed.
Hey, Thanks. Good morning Hope you guys are well the first 1 on specified pillows I'm in premiums Silverman I think well above their historical levels are low mortgage rates are of course low right now mainly wondering if you feel like the structure of the market has changed because of how much of the agency market. The fed on at this point, where maybe a new premium floor has been established for spectacles.
Even if we do get some back up in rates and mortgage rates et cetera.
Yes. This is with 1 victrola Europe like a big chunk look.
The cheapest of deliverable market has really been taken away both by banks.
And fit in debt makes spit.
Specified force a little between a unique place, but as you said blood levels are a little bit.
Elevated given the historical levels, but also speeds also suggest this right Smith.
Specify pools, especially on the lower lower coupons are paying much better for example on fainted 2 enough much better than the TVA true enough and Tba's are supporting debt with the special rules. So if you asked me what I expect I expect specified payouts moderate a little bit because this row.
Special sauce on the lower class group vs risk of the higher coupon specified booth pay.
Pay up really doesn't mean that much.
All along with that because there's very little CVT flow. So almost able to pool is a specified pool. When you are talking about force on foreigners.
So you look at it specifically on a cash flow basis irrespective of the TVA contract.
4 high profile.
Got it I follow you.
1 on the head inside of you know a lot of swaps concentrated at the short end of the yield curve I just want to get a sense for how much duration you feel like your assets have that short on the curve and what you feel like the effectiveness of those hedges are in this environment.
Well I'll just back up and note that last year, we actually did put a lot of those swaps on it at close to negative rates are low single digit. So so they've been perfectly fine in terms of curb positioning we do have a modest deepener on so a lot of our duration is still concentrated in the front.
And notwithstanding shorter duration swaps and generally our views obviously rates are artificially low we think they are a little bit too low here.
And with respect to the curve, we do feel it should be a bit steeper the way we looked at it 1 metric.
Uses 5 year 5 years 5 year forward 5 year rates, which currently this morning or around 190.
At the beginning of Q2 was around 260 or thereabouts arguably it was it was a bit cheap then but.
But but.
Us.
Forward to look rich, which suggests higher rates and slightly steeper curve and so that's how we are positioned in a lot of a lot of the steepening that did occur did come through contraction of the assets in the rally, but we're perfectly content with the physician and we're not running a meaningful duration GAAP were slightly longer pretty cool.
The flat.
Thanks for the comments.
<unk>.
[laughter].
Our next question comes from Brock Vandervliet with UBS. Please proceed.
Hi, good morning.
Sorry, if you are covered this day had to bounce off the call for a minute but.
But.
The tapers kind of funny.
It's obviously.
Destabilising.
Impact as it is destabilizing impact I would assume on the market, but then again, it's probably the most widely anticipated thing that we've seen in years added to hit it to the market as well.
What would you need to see.
2.
Either during that process or on the back of it or in front of it to take up to.
To take up leverage.
Yeah, I'll start milk or can can add into your point about about the taper vs. Stabilizing I wouldn't characterize it at all as such we've been through this before and I think the market well in Mississippi.
The reduction in the fits footprint and is prepared for it and if you think about the technicals to <unk> point about about the stock effect with fed and bank portfolios held to maturity and also the fact that money managers are underweight reaps or less leveraged certainly so.
We feel like this time around it's going to be a much smoother transaction and in terms of what type of widening we'd need to add leverage it's not just about the headlines spreads on agency MBS. It's the quality of those spreads meeting what's it cost to hedge will kind of volatility do we expect.
And how how manageable is adding agency mbas and what's the relative value equation vs or alternative products. So I can't put an exact spread number on it for you it's going to be state specific but I will say that the market is an agency market is reasonably comfortable place where content with our leverage profile into.
The extent there was cheapening and we felt like that was a manageable proposition from a hedging balance sheet standpoint, we would add I just don't have an exact number because it does depend on what the rate landscape looks like and.
And the overall.
Right.
Okay.
You better.
And just just as a follow up.
David in your opening remarks, you mentioned 30 cents is kind of a high watermark.
Sort of.
Could you just break down the major components of of.
Yeah.
Lower lower numbers going forward with that would consist of.
Yeah.
I would say that we certainly expect the outer in the dividend in Q3 and beyond that I wouldn't I wouldn't comment but are TBA position was a little bit small smaller so roll income should moderate a little bit and there's other factors from amortization standpoint, and run off of of higher Boogie.
Building assets that are consideration, but we do expect a modest decline for.
For Q3, but nonetheless, well out earning the dividend.
Got it okay. Thank you you bet Brock.
The next question comes from tennis, Lee with RBC capital markets. Please proceed.
Hi, good morning, and thanks for taking my question I'm wondering if you could just further expand upon comments on what you could see in terms of funding costs for the second half of this year. Thanks.
Thanks, Ken Serena so as I mentioned in my prepared remarks.
Think that.
We continue to have obviously reduced cost of funds. We think we would probably hit a bit of a trough with regards to agency.
And saying that the average rate the quarter with 18 bits and we ended.
The quarter with 16 bit that you are going to see some sort of natural.
Benefit from that and the subsequent quota.
Some furtive.
Modest decline continued decline in that expense as well, we do see continue to see some level of tightening also in the credit side of things given the.
<unk> reported the majority of our expense I would say.
Little bit of.
Of the timing on a reduction in the polling quarters, but we do think we probably hit a bit of a trough when it comes to those types of rape.
Great that's very helpful and 1 follow up.
I made it sounds like there's a couple of opportunities between the msr's the residential hold on channel.
Uhm wondering from a high level, where do you see <unk>.
Investment leaning towards for the marginal dollar to incremental dollar.
Just wanted to talk about the the overall not skip that thanks.
Yeah, I would say I would say residential credit is the area, where we still feel very good about that marginal dollar also we haven't talked about tim's business in middle market lending on there is a lot of activity on that front and.
MSR you know a lot of the MSR, we purchase was earlier in the quarter when valuations were cheaper there's still okay, right now, but but they're not as cheap as where we added a lot of those assets early in the quarter and so I'd like to say, we are content with the agency portfolio and the alternative sectors, where we want to put him on.
To work, but we're not a force deployer in any sector and we can we can let the market come to us does that help.
Very helpful. Thanks again.
You bet good talking to you can.
The next question comes from it Derek Hewitt with Bank of America. Please proceed.
Good good morning, everyone.
And my question relates to what was discussed on on the last question, but just just given that increased capital allocation towards residential credit and expectations to grow that MSR and correspondent on originations.
What is that the longer term plan for for for middle market lending Uhm.
Are there additional opportunities to grow the portfolio since it's been relatively flat for the last few years.
Could you just expand on that.
Yeah, Yeah, sure Derek and good to hear from you and we talked a little bit on on the last call about middle market lending.
That business remains a core part of the portfolio at nearly 10% of capital the returns of the business or.
Largely on correlated with agency so it's incredibly complimentary.
For us and it's a scaled business with a very efficient cost structure and a solid franchise given the.
Ah relationships and so we feel good about it but at the end of the day, we do certainly recognize that there are limits to growth given the fact that we're re.
But it's a steady state scale business and if there's if there's incremental opportunities to grow it from a return standpoint, we have certainly capacity to do so and we feel good about that and it's not nearly the conflict with the agency business somewhat like CRE was in terms of competition for capital.
And and the agency business, making up some of the shortfall from lower CRE returned to solid business.
Okay, and then would you be willing to add a little bit of leverage to bouchey returns even higher or.
Or is it still going to be funded basically with with equity at this point.
It depends on the composition between first lean and secondly, the portfolios to 2 thirds first lien a third second lien in less than a turn of leverage and if it if it works from the standpoint of adding leverage to the portfolio and we do more first lien then we will do so in this arena talked about financing.
He is improving and credit if there is any any potential upside the financing it's in our credit sectors and so it's going to be dependent on the composition of the portfolio and the cost of leverage.
Okay. Thank you you better.
The next question comes from Orion car with Jeffries. Please proceed.
Hi, good morning, and thanks for taking my question not to beat a dead horse here, but can you talk about the risk adjusted return profile in the in the credit book relative to agencies, given that prevailing environment and and how you're thinking about that going forward.
Sure so.
Obviously, it's specific to the to the type of transaction Ilker talked high single digits on MSR without any leverage Fannie his transactions is securitization transactions are well into double digits.
And with Tim's business, it's Paul writer on that double digit.
Level with incredibly low leverage so those are attractive propositions now granted the agency markets cheapened up and if we apply specialness too.
B as you do get into the double digits, but it dollar for dollar similar returns. The objective is to is to further diversify and and we expect to have opportunities to do it but it's it's product specific in episodic.
Got it thank you and then.
Turning to the distribution.
<unk> noted that 30 cents is kind of the high end.
A core earnings at this point in going forward, you are expecting that debt.
Drop a bit but when would you consider a potential increase in the distribution and what level with you.
Where would you be comfortable in making that decision.
Yeah. So obviously, that's a conversation with our board and what I'll say is we're not force to adjust the dividend notwithstanding out earning it.
And look at the end of the day, when we reset the dividend of 22 the considerations were.
We wanted it to be a competitive yield and consistent with our historical average.
And we wanted to make sure was consistent right now our dividend yield on book is 10, 5% in that proximity on the stock.
Thank you very much.
You bet. Thanks Ryan.
The next question is a follow up from Rick Shane with a J P. Morgan.
Police procedure.
Oh, sorry about that thanks, guys for letting me pop back in queue I just wanted to ask 1 follow up question on the MSR. When we think about the movement in book value. This quarter from a descriptive perspective. It was the underperforming of the hedge and that makes sense in light of what we saw for inter.
East rates.
I am curious if you had had a greater hedge position associated with MSR, if that would have in fact dampened the.
The book value compression, we saw this quarter.
Well to be clear.
We add MSR, we do adjust the hedge profile and yogurt talked a little bit about receivers swaptions, which were done in conjunction with MSR purchases. So the answer to your question is is no I think we effectively hedge the MSR on it contributed to overall book performance on on the quarter from a from a hedge.
Perspective.
Okay, but I understand the dynamic there, but what I'm, what I'm asking is that would the.
Theory should be MSR, which was better correlated to the assets.
All other things being equal without moving the swap position would it have been a more effective hedge this quarter in light of the environment. We're in because I'm just thinking about the uncertainty that we're facing going forward as we sort of transition through the right environment. If you think that will give you a more efficient hedge absolutely in Oakland can expand on.
Associate in this quarter, yes, because MSR have tightened and it will be reduced your spread duration to agency Mesma Zambia the wider for this quarter of your answer is definitely yes, but also lists not forget that when you are hitting MSR ending to negative comics.
This needs to be managed but yes, we had our city state if we if we.
Get get to Davis vision earlier, this would have different there'll be some underscore.
Got it okay. Thank you guys.
Alright, Thanks, Rick and I believe that.
Last question. So thank you everybody for joining us and we look forward to talking to you again next quarter.
The conference has now concluded. Thank you for attending today's presentation and you may now disconnect.
Okay.
[music].
Okay.
Okay.
[music].
Okay.
Okay.
[music].
Okay.
[music].