Q4 2022 Annaly Capital Management Inc Earnings Call

Okay.

Good day and welcome to the <unk> Capital Management fourth quarter 2022 earnings Conference call.

All participants will be in listen only mode.

Should you need assistance. Please signal conference specialist by pressing the star key followed by zero.

After todays presentation, there will be an opportunity to ask questions.

I ask a question you May press Star then the one already touched on furlough.

To withdraw your question. Please press Star then two.

Please note today's event is being recorded.

I would now like to turn the conference over to Sean Kensal Director Investor Relations. Please go ahead Sir.

And welcome to the fourth quarter 2022 earnings call for <unk> capital management.

Any forward looking statements made during today's call are subject to certain risks and uncertainties, 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.

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.

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.

Conciliation of GAAP to non-GAAP measures is included in our earnings release.

Content referenced in today's call can be found in our fourth quarter 2022, investor presentation, and fourth quarter of 2022 financial supplement.

Both found under the presentations section of our 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 Wolfe Chief Financial Officer, Mike Fannia, Deputy Chief investment Officer, and head of residential credit and Ken Adler head of mortgage servicing rights and with that I'll turn the call over to David.

Thank you Sean good morning, and thank you all for joining us on our fourth quarter earnings call today, I'll provide an update on the market and how it impacted our performance then discuss the macro landscape our portfolio activity this past quarter and conclude with our outlook for each business as we begin the new year.

Rina will then discuss our financial performance and we are also joined by our other business leaders to provide additional context during Q&A.

Starting with the market backdrop risk assets ended 2022 on a more constructive note driven by improved inflation data and a moderation in the size of federal reserve rate hikes, given the cumulative hikes delivered thus far inflation and wage growth are slowing in the decline in volatility as improved investor sentiment.

And led to fund flows into fixed income.

Mortgage and credit spreads tightened from the peak spreads exhibited in October with November representing the best month of excess returns in the history of the Bloomberg MBS index. The strong finish to 2022 helped drive our 8.7% economic return for the quarter and our economic leverage decreased from seven 1%.

Six three turns quarter over quarter attributable to a modest decline in portfolio size as well as book value appreciation.

Turning to the macro environment. Following the 25 basis point hike last week, the fed expects to hike a couple of more times and hold interest rates at elevated levels subject to inflation in labor market developments. This scenario should make for a more stable environment for fixed income in 2023, those certain risks out there.

Verizon remain but one that failure to resolve the debt ceiling has the potential to cause disruption in markets and Moreover, although inflation has cooled in recent months. These readings offer little information about the medium term run rate of inflation once base effects dissipate.

All considered we are optimistic still cautious on the outlook with.

With respect to the housing market activity declined meaningfully over the course of 2022 given the upward shock in mortgage rates and the resulting reduced affordability existing home sales. For example are now a third lower than at the end of 'twenty 'twenty. One however, the slowdown in activity has coincided with a reduction in available inventory.

Worries according to redfin, new home listings have decreased 28% year over year as borrowers opt to stay in their homes and the current higher rate environment and as long as the labor market remains robust. We proceed few forced sellers keeping inventories below historical averages as a result home prices.

Slower decline than initially expected with the case Shiller National home price index falling three 6% from its peak level in June .

Dynamic may change in the spring selling season. Nevertheless, we feel good about the state of the housing market as long as the labor market remains strong consumer balance sheets and lending standards are sound and the shortage of supply supports prices all else equal.

Now shifting to our portfolio activity during the quarter within agency, we continued to ship modestly up in coupon to take advantage of wider spreads and improved carry in production coupons. We grew our allocation of four and a half as in higher which now represent over 50% of our portfolio up from 40% last quarter.

We believe historically wide nominal spreads in these coupons provide more than adequate compensation for taking on the incremental convexity exposure relative to lower coupons. In addition, we reduced our exposure to T. B A's as roll Specialness dissipated over the quarter and were likely to favorite pools over TBA is going.

Forward given their better return profile.

Regarding prepayments the mortgage universe remains firmly out of the money and even with mortgage rates trending lower towards 6% only 1% of borrowers have an incentive to refinance leaving our convexity risk near the lowest levels. We've seen over the past five years, our portfolio paid seven five <unk>.

P R in the fourth quarter more than 30% faster than the 30 year universe, and our weighted average seasoning of 42 months and our WAC roughly 1% higher than the broader agency market positions us well for the current discount environment.

Our hedged portfolio kept as well insulated as interest rates reached a multi decade high in the fourth quarter and the notional balance of our hedges remains in excess of our liabilities as seen in our 107% hedge ratio within the portfolio, we rotated from treasury futures into soper swaps given the.

<unk> and swap spreads and going forward, we will remain defensively positioned on the rate front until the path. The policy becomes clear. Although we are encouraged by the lower rate volatility seen year to date.

Now moving on to residential credit our portfolio ended the fourth quarter at 5.1 billion in market value essentially unchanged quarter over quarter and the strategy currently represents approximately 19% of the firms capital.

Non agency credit participated in the broader risk gone rally with benchmark below investment grade Stacker, and two's 125 basis points tighter and AAA non QM spreads 20 basis points tighter whole.

Whole loan spreads did lagged the tightening in securities However, resulting in our transactional activity being predominantly focused on residential loans, where we settled $685 million in loans during the quarter and.

In the current decelerating housing market our loan business represents our preferred approach to investing in the resi credit market given our ability to control our credit strategy our partners the diligence process and pricing, we maintain a focus on preserving the credit quality of our portfolio with our fourth quarter whole loan.

Acquisitions exhibiting characteristics consistent with the quality of our GAAP consolidated residential whole loan portfolio.

Of note our underlying borrowers have seen their mark to market LTV improved to roughly 58% on average.

Our <unk> securitization platform had a record year of issuance supported by your correspondent channel acquiring nearly 2 billion in loans during the year since the beginning of 2022, we closed 17, securitizations totaling $6 6 billion and generated 760 million of proprietary assets with.

The low to mid double digit return profile utilizing minimal recourse leverage with credit spreads tightening post quarter end and capital markets execution improvement year to date, we expect to continue accessing the securitization market to efficiently fund our whole loan portfolio.

Now to discuss MSR as we noted during last quarter's earnings call. We were measured in our approach to further growing our holdings, resulting in muted activity in the fourth quarter over the course of 2022. However, we had significant growth in the strategy, increasing our portfolio by nearly three times to one 8 billion in market value.

And ending the year as the third largest buyer of bulk MSR in the market for 'twenty 'twenty. Two we added new originator partners expanded relationships with sub Servicers and put in place new dedicated financing is an additional source of liquidity to support future growth and our focus on very high credit quality low.

Loan rate MSR has proven to be valuable the portfolio paid three CPR for the quarter and experienced minimal delinquencies generating stable cash flows while providing a hedge to current dynamics in the housing market.

Now shifting to our outlook, we are encouraged by the support of investing environment for each of our three strategies that we remain deliberate with respect to our leverage profile and capital allocation strategy, considering the aforementioned risks to the operating environment.

Within our core agency business, we see a strong set up for the year with historically attractive nominal and risk adjusted spreads coinciding with declining interest rate volatility a more predictable prepayment environment and healthy financing conditions.

It relates to the supply and demand picture higher rates should mitigate fed run off in agency MBS supply while demand expectations appear more mixed buying.

Buying from banks and overseas investors is likely to be subdued. This further spread tightening will be reliant on inflows from the money manager community.

Also to note you shouldn't recessionary risks increase agency MBS have typically outperformed other fixed income sectors in times of economic weakness.

Accordingly, we plan to maintain our overweight positioning in agency relative to our long term capital allocation target, though we remain committed to expanding our housing finance footprint and are proud of the considerable progress we have made to date.

In residential credit as the leading nonbank issuer of prime Jumbo and expanded credit M. B S. We anticipate maintaining our market leadership, given our capital and certainty of execution and we believe our portfolio should remain relatively well insulated from a further deterioration in housing fundamentals as a result of our robust.

Credit standards.

Furthermore, our securities portfolio provides an additional lever for opportunistic growth when returns are accretive.

And an MSR, we expect there to be significant supply in the market given sustained monetization efforts by originators, while we're comfortable with the scale and quality of our current portfolio. We have capacity to Opportunistically add MSR should this elevated supply lead to more attractive returns.

Now before handing it off to Serena I wanted to make one last point as it relates to earnings available for distribution, while we generated a D that covered our dividend this quarter, we witnessed the moderation discussed in recent quarters and we anticipate some further pressure on a D going forward as a result subject to deter.

Termination by our board, we expect to reduce our quarterly dividend in the first quarter of 2023 to a level closer to analysts historical yield on book value of 11% to 12%, which compares to the approximately 16% yield on book were paying today. We believe this decision allows us to appropriately manage the portfolio with.

Conservative risk parameters, while also delivering a more sustainable yield that is competitive with the peer set and broader fixed income benchmarks, which has always been our objective overall, we were constructive on each of our businesses and we are enthusiastic about the multi pronged platform that we've built out over recent years, but we.

We remain vigilant and careful stewards of our shareholders' capital now with that I'll hand, it over to Serena to discuss the financials.

Thank you David today, I will provide brief financial highlights for the quarter ended December 31st 2022, and discuss selected year to date metrics.

Consistent with prior quarters, while earnings release, discloses GAAP and non-GAAP earnings metrics. My comments will focus on our non-GAAP AAD and related key performance metrics, which exclude P. I E.

Our book value per share was $20.79 to people, which increased by 85 cents per share for the quarter, primarily due to basis tightening it means all that rate volatility.

Strong gains on agency investments of approximately $1 61 per share contributed significantly to the book value appreciation for the quarter.

These gains were partially offset by losses on our derivative positions of approximately 60 cents per share and lower valuations on residential and other investments of approximately 14% primarily related to our MSR portfolio.

I think combining our book value performance at our fourth quarter dividend of 88 cents, a quarterly economic return was eight 7% compared to negative $11 seven in Q3.

We generated earnings available for distribution of <unk> 89 cents per share for the fourth quarter.

The 17% reduction in <unk> compared to last quarter is attributable to the continued rise in repo expense and lower TBA dollar roll income due to less specialness.

Partially offsetting these factors, however will be approximately $146 million increase in swap income quarter over quarter and instead, the rotation into higher yielding agency MBS.

Given the continued increase in financing costs, one off of swaps and the mismatch between the economics in earnings related to future is all things equal. We currently expect further pressure on EBIT in the near term.

Average yields ex PAA with 58 basis points higher than the prior quarter at 3.8 cheapest Chi. The previously mentioned acquisition of high yielding assets and a further decline in amortization.

The factors that impacted the idea also Australia and NIM for the quarter.

With a portfolio generating 190 basis points of NIM ex PAA, an eight basis point decrease from key training.

Net interest spread does not include dollar all income therefore that needs was comparable quarter over quarter at one point you said, 1%. That's just one 7% in Q3.

Turning to financing despite market volatility throughout 2022, and the Reits market funding market for agency and non agency security portfolio has remained resilient and ample.

Our expectation that the federal reserve is in the final innings of the hiking cycle liquidity and agency funding market should extend out the Kevin teach Cortez.

However, we currently continue to see liquidity concentrated in overnight and 10 market out to the fed meeting date.

With this landscape in our mind, a Q4 weighted average repo days were 27 days down from 57 days in Q3.

Our sustained S. S. M Park hearing dedicated financing for outgrowing whole line and MSR businesses continue to enhance the fed's liquidity profile, while generating capacity to foster growth in these respective businesses.

As David mentioned previously we continued to be a programmatic sponsorship that'd be X securitization pricing and secondly, an additional three transactions from the end of Q3.

As of the end of Q4 and disciplined approach has resulted in 90% about GAAP consolidated whole land portfolio currently being funded through securitization at a weighted average cost of funds of 3.38% approximately 260 basis points below the current non QM cost of funds.

In addition to that below market financing right about securitized debt, 95% of the debt is locked in at a fixed rate.

Shortly after quarter end. Our team also took advantage of the robust liquidity and the financing markets to upsize one of our existing facilities by approximately 200 million chips 400 million entitled we remain well positioned with ample liquidity and our residential whole loan business with 2 billion in financing capacity across several diverse I'd provide is.

White House utilization remains low as we finished the quarter with approximately 720 million drawn against the whole land position.

Shifting to MSR financing with the addition of our newest committed warehouse facility recently closed we currently have $750 million and dedicated financing for MSR business amongst diversify counterparties with additional capacity available subject to customary conditions.

As reported in Q3 outstanding advances on this isn't stand at 250 million, leaving us with $500 million of additional capacity and I'll just stays home to draw against our MSR position.

The continued rise in repo rates and higher average balances impacted our total cost of funds for the quarter rising by 57 basis points to 211 basis points and keep Paul.

Meanwhile, our average repo rate for the quarter was 372 basis points compared to 225 basis points in the prior quarter.

We ended the quarter with a repo rate of full plane, two 9% compared to 3.13% as of September 32022.

And as previously mentioned swaps positively impacted cost of funds during the quarter by approximately 76 basis points.

We ended the year with an opex to equity ratio of one 4%, which is at the low end of the range discussed on previous earning calls reflecting cost savings from the disposition of L. M. M L.

Yes.

Lastly, we modestly increased our liquidity profile was $6 3 billion in unencumbered assets compared to the prior quarter of $6 1 billion, including cash and unencumbered agency MBS of approximately $4 billion.

The increase in unencumbered assets, primarily came from the reduction in leverage I'm ready credit and a settlement of an MSR packaging type.

That concludes our prepared remarks, and we will now open the line for questions. Thank you operator.

Thank you we will now begin the question and answer session to ask a question you May Press Star then one on your Touchtone phone.

Use of the speaker phone, we ask you. Please pickup your handset before pressing the keys to a charter. Your question. Please press Star then two.

Today's first question comes from Bose George became UW. Please go ahead.

Everyone. Good morning.

Could I get an update on book value quarter to date.

Sure Bose good morning, so as of weeks in book was up roughly 8% to 9% post payrolls, we'd come up just a touch and as of last night up roughly 7%.

Okay, great. Thanks, a lot.

And then you bet.

Talk about you know.

Normalized leverages, the current level of leverage kind of where you're comfortable.

Unless or until things change.

But it is for this capital allocation that is going to be dependent upon how we allocate our capital but was 67% agency.

Third allocated between <unk> and MSR, we feel good about the level of leverage we do have the capacity to take it up given our liquidity, but we're very comfortable with the right ear buds, okay great. Thanks.

You bet Bose.

Thank you and our next question today comes from Doug Harter with Credit Suisse. Please go ahead.

Thanks.

A little bit more about the dividend I'm, obviously book Value's been been incredibly volatile and just how you kind of think about kind of setting and targeting that 11% to 12% yield on Bakken in an environment like this where our book is moving around.

Sure Good morning, Doug and look it's a function of where where asset yields are and the leverage we apply in just to run through it you know in the agency market.

Current mark to market Levered returns range between 13% to 15% depending on what collateral we're buying in residential credit looking at obs securitization and routine holdings with very modest leverage we're talking 12% to 15% and then in the MSR market.

Unlevered returns around 10%.

No.

Get to an average yield in the market today of around call it 14%, 13% to 14% across the assets and a 135 to 145 basis points to run the business, which we think is incredibly FID decision brings you down to that to that level of 11%, 12% roughly.

You want to add something yeah, and you know that we've always been really clear that our dividend policy is to set a dividend that is.

Consistent with our historical yields, but also something that we can consistently achieve and so we do you know as David mentioned in his remarks that we believe that what we've looked at it two ways a very sustainable level will give me any money with tens of David just won't trade.

Great and then just one follow up on the returns that you just mentioned there.

You know I guess are those sort of returns do you see that your current leverage.

Yeah.

And is there flexibility you know or.

No risk or opportunity to kind of move leverage up or down over time.

And obviously, it's how how that impacts returns.

Sure. There is so there is flexibility to move it up or down but that is using the agency market roughly eight turns of leverage which is approximately where we're currently levered in the agency portfolio just to break it down a little bit in terms of what we're buying generally we're buying production coupons and were somewhat barbell between.

Really low pay up but.

What we think to be good quality pools for example, new production retail bank serviced pools with low wax you don't.

Coming to pay up or just a few ticks and that's going to get you on a levered basis, a little over 15%, but we're obviously considerate of the possibility of a rally in the sensitivity of our production coupons to prepay and a rally and so we are kind of barbell ing that with higher quality pools for example high loan balance collateral in the <unk>.

<unk> coupon comes at a cost of about two points roughly and the Levered return on that is around 13%. So you take the average and you get to 14% in resi and Mike's done obviously, a number of securitizations over the recent past and the retained bonds.

With around one five turns of leverage and up to that low to mid teens type returns.

In MSR, we currently applied very very minimal leverage to the portfolio simply and liquidity.

A source, but the fact of the matter is we do have the capacity to lever that portfolio and when you look at the composition of our MSR and the loan rate given how deep out of the money. It is.

It's very different than production coupon MSR from a variability of cash flow standpoint as rates move.

The matter is you know it's raised.

<unk> can move a meaningful amount and youre not going to change the cash flows on that MSR that much and so all else equal youre not going to see a lot of price volatility, we expect and so as a consequence, you do have the ability to apply leverage to that but we currently don't.

Does that help.

Okay.

You bet Doug.

And our next question today comes.

From Trevor Cranston with JMP Securities.

Hey, thanks.

A question on the MSR market it.

It seems like there's the potential for you know a fairly large amount of MSR is to maybe come to market over the next few months.

Can you talk about like how you how you think that'll impact.

The MSR market and valuations overall.

You know if you think theres going to potentially be an opportunity to deploy a significant amount of capital, but the bulk of the source.

Sure I'll start it off and good morning, Trevor and then I'll hand, it off to Ken. So yes. There is we as I mentioned in my prepared remarks, we do expect a fair amount of supply to come to market last year was obviously quite a heavy year and we took advantage of it.

But.

The the supply will continue in terms of how it can impact the market in pricing. We do think there's a lot of capital that is ready including ourselves, but if you look at our Mark for for Q4, we did mark our MSR down.

Honestly in that was a function of that pending supply and Ken do you want elaborate yeah, Justin Thank you very much.

Last year was record supply for the industry and the flows worst somewhat balanced as you can see where much of their went including ourselves and.

2023 ish is certainly shaping up to be a higher amount of supply than the 2022, and we're evaluating several opportunities and we're opportunistically.

To participate in those.

So, yes, we're ready and as Dave mentioned that was the reason for.

Yeah, exactly and also why we remain relatively quiet last quarter. You know is currently 15% of our capital which is lower than than we'd like but we're going to remain patient and wait for the opportunities come to us Yeah, and just one last thing I mean, this markdown I mean, it's just a pure technical the cash flows or our hiring.

Quality uncertainty than they've ever been because of the money.

Collateral.

You're certainly looking as.

That's a great opportunity.

Right, Okay that makes sense. Thank you.

You bet and Trevor.

And our next question today comes from kind of RBC capital markets. Please go ahead.

Hi, Good morning, Thanks for taking my question just one on the on the potential dividend change is the assumption there that the underlying economic earnings over the near term it is not going to.

Change much in other words, you're assuming that that is not going to get a lot more aggressive in terms of our investment or our leverage over the near term even if the if the rate volatility for example were to settle down somewhere in the middle of the year. Thanks.

Well, we certainly could get more aggressive in.

The market is cooperative, but the way we look at it again is based on our current leverage and what returns are 10, and that's where we feel the market is offering returns for this business model.

Gotcha very helpful. There one follow up you touched upon this in the prepared remarks Ah why don't you just get your thoughts on what you think could be potential implications.

If the government does not resolve that ceiling. Thanks.

Yeah, So look it's very difficult to and handicap the implications.

Ken It is something that we should pay attention to you know on one hand, the market did rally in 2011.

But look it's a different world right now and you only have to look back to what occurred in September with the U K.

Situation on the trust tax cuts and you saw 10 year Guilds for example, sell off a 120 basis points based on.

Somewhat of a lack of confidence in it it is somewhat of a precarious circumstance in D. C. Right now I think we've all seen what's going on down there and it's a little bit disconcerting. Our base case is that this gets resolved and it is not going to lead to certainly passing the ex date without without a resolution but look.

We have a contingent down in D. C are currently that is larger than it was in 2011, and the freedom caucus and they're playing for a different outcome.

It's more of a base outcome and even mainstream members of both parties are thinking about the broader.

The broader country, but.

It's a little bit uncertain, we do think it's going to be resolved, but nevertheless, there is a lot of.

There is.

There's a lot of outcomes that could that could occur and so that's one of the reasons why we're being somewhat conservative.

Got you very helpful. There. Thanks again.

You bet Ken.

And ladies and gentlemen, as a reminder to ask a question. Please press Star then the one our next question comes from Delos Abraham with UBS. Please go ahead.

Hi, everybody. Thanks for the question just a follow up on the MSR conversation. So moving forward would you look to grow that book by.

Allocating more equity or increasing the leverage there.

The capacity how are you thinking about that.

Yes, we would expect more equity allocated to it certainly with the option to apply a modest amount of Leverages Serena talked about in our warehouse financing, we have in upwards of $1 billion with them.

Capacity and so that will remain an option, but generally speaking its liquidity.

So for us in the quiver.

And we do expect to add more equity to the sector.

Okay, and then in terms of capital allocation between agency MBS and and resi credit right. Now are you leaning one way or another.

Generally we're a little bit more fond of agency our base case, notwithstanding some of the risks out the horizon is that volatility does continue to come down which would favor.

Agency and while housing has outperformed our expectations over the past six months modestly there is a little bit of risk.

With the sector, particularly as we do get into the spring selling season, and we'll really see what kind of implications.

Mortgage rates and other factors have on on home prices, So, we're a little bit cautious but.

With mics.

Residential securitization business and the acquisition of whole loans.

Collateral, we're very comfortable adding particularly giving given his lending standards and the ability to control all aspects of.

The acquisition of alone So we'll add but generally were marginally favorable towards agency right now.

Okay. That's helpful and just lastly on the non QM securitization market.

Execution has gotten a lot better since Q4, just any color that you can kind of add there on.

What you're expecting and are these level of spreads that you're seeing there sustainable and just what can move it one way or the other moving forward here. Thanks.

Sure, but losses as Mike Daniel.

I'd say, yeah, I think a lot of what we saw in 2022 was gross issuance in non QM. It was at $39 40 billion. It was a record for the sector. So.

Insistent with risk off plus the technical landscape, it's certainly pressured the non QM market pressured non QM spreads I think what you've seen to start is that there is a high percentage of the market that seems to be pricing in a soft landing and youre seeing that in terms of risk on from you know probably late October November to where we sit today and then from a technical.

Well landscape.

Supply will certainly be significantly lower than what it was last year, we think supply and non QM, maybe 25 to 30 billion. This year. So with that I think investors have realized that there is a scarcity of the asset class and we have seen spreads now tightened to probably call. It 150 over on the AAA where at the y.

We're probably mid high two hundreds so we do think that it can be sustainable to the extent of the you know the macro environment.

Great. Thank you.

You bet.

Sure.

And ladies and gentlemen, this concludes our question and answer session I'd like to turn the conference back over to Mr. Michael Stein for any closing remarks.

Well. Thank you. Thank you everybody and we look forward to talking to you again after the first quarter.

Thank you Sir.

Today's conference call. Thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.