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Edited Transcript of NLY earnings conference call or presentation 31-Oct-19 2:00pm GMT

Q3 2019 Annaly Capital Management Inc Earnings Call

NEW YORK Nov 20, 2019 (Thomson StreetEvents) -- Edited Transcript of Annaly Capital Management Inc earnings conference call or presentation Thursday, October 31, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* David L. Finkelstein

Annaly Capital Management, Inc. - CIO

* Glenn A. Votek

Annaly Capital Management, Inc. - CFO

* Kevin G. Keyes

Annaly Capital Management, Inc. - Chairman, CEO & President

* Purvi Kamdar

Annaly Capital Management, Inc. - Head of IR

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Conference Call Participants

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* Douglas Michael Harter

Crédit Suisse AG, Research Division - Director

* Eric J. Hagen

Keefe, Bruyette, & Woods, Inc., Research Division - Analyst

* Kenneth S. Lee

RBC Capital Markets, Research Division - VP of Equity Research

* Matthew Philip Howlett

Nomura Securities Co. Ltd., Research Division - Research Analyst

* Richard Barry Shane

JP Morgan Chase & Co, Research Division - Senior Equity Analyst

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Presentation

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Operator [1]

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Good morning, and welcome to the Annaly Capital Management Quarterly Conference Call. (Operator Instructions) Please note, this event is being recorded. I would now like to turn the conference over to Purvi Kamdar, Head of Investor Relations. Please go ahead.

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Purvi Kamdar, Annaly Capital Management, Inc. - Head of IR [2]

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Thank you. Good morning, and welcome to the third quarter 2019 earnings call for Annaly Capital Management, Inc. 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 forward-looking statements disclaimer in our earnings release in addition to our quarterly and annual filings.

Additionally, the contents 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. A reconciliation of GAAP to non-GAAP measures is included in our earnings release.

As a reminder, Annaly routinely posts information for investors on the company's website at www.annaly.com. The content referenced in today's call can be found in our third quarter 2019 investor presentation and third quarter 2019 financial supplement, both found under the Presentation section of our website.

Annaly intends to use our web page as a means of disclosing material nonpublic information for complying with the company's disclosure obligations under regulation FD and to post an update investor presentations with similar materials on a regular basis.

Annaly encourages investors, analysts, the media and other interested parties to monitor the company's website in addition to following Annaly's press releases, SEC filings, public conference calls, presentations, webcasts and other information it posts from time to time on its website.

Please note, this event is being recorded. Participants on this morning's call include Kevin Keyes, Chairman, Chief Executive Officer and President; David Finkelstein, Chief Investment Officer; Glenn Votek, Chief Financial Officer; and other members of management. And with that, I'll turn the call over to Kevin Keyes.

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Kevin G. Keyes, Annaly Capital Management, Inc. - Chairman, CEO & President [3]

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Thank you, Purvi. Good morning, everyone, and welcome to our call. As we enter the final 2 months of this decade and approach the 2020s, I want to reiterate, update and provide commentary on some of the critical themes we highlighted at the start of this year.

To recap, on our fourth quarter 2018 earnings call in February, we stated that there was "An obvious combination of economic, fiscal, political and macro pressures that will contribute to a shift toward a more accommodative monetary policy than we've been able to project for a long time." On our call in May, I then remarked, "There has been a return of flashing red lights across markets, with the flattening yield curve and compressed credit spreads, resulting in little differentiation of risk." The volatile summer followed and on our second quarter call in July I commented, "Deteriorating economic data, weak inflation ratings and the unresolved global trade outlook, signaling growing possibility of an apparent earnings recession in corporate America."

This provoked the Fed to embark on its first rate cut later that day. Fast forward to today, following a challenging third quarter for which my prior commentary served to preview, we can now state that the market environment has certainly improved for Annaly for numerous reasons.

I'll give you the top 5: first, lower funding costs going lower still; number two, better outlook for asset yields; number three, the New York Fed's recent commitment and actions to stabilize the repo market; number four, the expected slowing of repayments by quarter end; and number five, the improving repo LIBOR spread as an additional tailwind. Because of this increased visibility, we reaffirm the fourth quarter dividend of $0.25.

Against this backdrop of more favorable market conditions and enhanced visibility into policy, there are 5 significant and expanding market, industry and corporate themes, which Annaly is uniquely positioned to capitalize on as we finish this year and enter the next decade.

The first theme is GSE shrinkage and the need for private capital in the U.S. housing market. We've discussed this theme over time but this past quarter, we gained additional clarity about the administration's view of the GSE evolution, which clearly necessitates a further shift to the private market.

With Fannie and Freddie -- while Fannie and Freddie will remain a critical component of housing finance, the treasury's 2019 housing finance reform plan published in September highlights how integral private capital will be to the future system in whatever form it may take.

Today, private capital has absorbed 67% of risk transferred on $3.5 trillion of unpaid principal balance in the GSE's residential credit exposure. CRT market issuance is now in excess of $75 billion since the program's infancy in 2013 and Annaly has been an active participant in the market, purchasing roughly $2.5 billion since that time period.

The CRT market is a good prototype for the FHFA, which is now leading efforts to align regulatory treatment to level the playing field for private capital and assess which products are consistent with the GSE's statutory mission. In order to ensure the U.S. housing market continues to evolve and remains robust, we anticipate private level market volumes to increase over time in several asset classes we finance. Our residential credit business has doubled over the last 3 years, and we expect to match that growth rate over the next year by taking advantage of upcoming supply and potential new structures in a growing market.

What has also become more clear recently are the secondary effects that further GSE shrinkage could have on the market, as Fannie and Freddie reduce their collective footprint, while homeownership is already unaffordable for many Americans.

35% of homeowners have had to move into affordable housing this year, an increase of 35% since last year. And surprisingly in this country, 82% of renters now view renting as more affordable than homeownership. This is an all-time high and a 22% increase since just last year. The government needs to enable private capital to help fulfill the GSE's void and to avoid further worsening of affordability, especially given that housing is a proven powerful driver of our economy.

Annaly is focused on expanding our role here. Our business is now built to finance housing across the country, while supporting several related pillars of the economy. We have extended over 200,000 loans, totaling over $16 billion, to borrowers with lower loan balance mortgages in the country, financing homes that are typically less than half the nation's average price.

We've also financed over 4,200 loans totaling over $2.8 billion to credit-worthy borrowers who may not have access to traditional bank channels, including self-employed borrowers.

Lastly, we have invested nearly $2 billion into areas of economic opportunity, such as affordable housing, education, healthcare, retail groceries and other sectors of low income and low access areas through our portfolio investments and our JVs with Capital Impact Partners.

With or without legislative reform, the footprint of the GSE is undoubtedly shrinking in the next decade, and Annaly is poised to continue its growth as a significant contributor to -- of private capital to maintain the affordability and liquidity of the U.S. housing finance system.

The second long-term opportunity for Annaly is the product of bank shrinking their mortgage businesses. Parallel trends to the GSEs hold true in the banking sector, which has also experienced significant transformation due to regulatory reform. Leverage and liquidity constraints have altered banks' business models and shifted various residential and commercial lending activity to other players.

As an example, banks have decreased their GSE footprint and now originate only 1 out of every 3 GSE-eligible loans compared to twice that share just 6 years ago. Anecdotally, certain large U.S. banks today, once dominant in the mortgage markets, characterize the business now under other income in their financial statements. As banks' mortgage-related exposure trends lower, nonbanks and other originators have stepped in to fill the void. Since 2014, nonbanks' share of total agency mortgage origination is up from 29% to 53% of the market. These nonbank originators are in growing need of strategic and capital partners, such as Annaly.

Our third theme for the 2020s, private equity needs new partners. The growth of private equity has played a huge role in balancing out the redistribution of corporate leverage out of the banks. And with the amount of leverage growing in the market, structural terms depreciating and a system lack of differentiation and risk, I wanted to provide some real-time examples of how we are partnering with sponsors to invest and lend safely in credit in this environment.

Within our diversified strategies, we're simply focused on selecting the right credit, the right sponsor, the right place in the capital structure and sourcing larger, less competitive deals given our strong established relationships, scale and liquidity.

Within our Commercial Real Estate Group, Annaly has participated in financings over -- of several large portfolios for major private equity firms, including approximately $300 million for Blackstone just this month, contributing to deal volume for the group of nearly $800 million year-to-date.

Our middle market lending team has originated approximately $700 million of assets this year, of which 90% was repeat business with existing top-tier sponsors.

Notably, our average deal size in that business is up nearly 2x in the past 2 years. And lastly, our Residential Credit team is officially competing through proprietary partnerships. With these strategic partners, we have access to asset flow from a network of over 100 originators, and we're on pace to produce $1.7 billion of home loans in 2019, a 2x increase over the past 12 months.

Finally, we are producing very competitive returns using conservative leverage across all 3 of our credit businesses. For the third quarter, over our $1 billion of credit investments, generated a weighted average levered return of 12.6% using only 2.3x leverage.

The fourth theme is a combination of our focus on operating efficiency, financing expertise and capital optimization. For the next decade and beyond, Annaly is already built with operational efficiency. We have paid it forward, the investment in the company's infrastructure to efficiently invest in the redistribution of assets in the future as I just outlined, out of the Fed, the GSEs and the banks while investing alongside the growth of private equity. Now that our 4 businesses have successfully reached scale, we've reduced our management fee to 75 basis points for additional capital raise and have added a total of 25 institutional partnerships in lieu of paying for additional infrastructure.

We have incomparable operating leverage in our 4 businesses. Our operating expense as a percent of equity is only 2% compared to 25% on average for the nearly 300 mortgage REITs, banks, insurance companies and asset management companies that have an aggregate market cap of $3.8 trillion. With these ratios, we are over 12x more efficient on average across all our asset classes than these other investment models we compete against.

Regarding financing and capital optimization, we refined our capital structure through Capital Markets activities, additional financing alternatives and securitizations. We have repeatedly demonstrated diligent allocation of capital. Beginning in late August and into the fourth quarter, we repurchased over $220 million of shares, taking advantage of a valuation or in our stock. These repurchases resulted in immediate book value accretion and created real economic return for shareholders.

Our repurchase program emphasizes our differentiated approach to the Capital Markets. We are buying back stock at similar valuation levels that others are issuing stock below book value. Believe it or not, 60% of the equity offerings completed in the mortgage REIT sector in the third quarter were dilutive to shareholders.

Finally, I want to highlight another significant theme in today's market and for the next decade where Annaly continues to be a market leader, corporate responsibility and ESG. Specifically, our focus on diversity and inclusion has fostered a culture, which has opened a healthy debate, enriched by broad experiences and made up of talent from all over the world. Savita Subramanian, a leading voice in ESG research from Merrill Lynch, whom we invited to present to our board just this year, validates that through an extensive study, businesses with at least 30% women in leadership positions have higher returns on equity and lower future price and earnings volatility.

With 50% of our additions to leadership represented by women since I became CEO and more than half of our firm identifying as female or racially diverse, we have illustrated our commitments to diversity across our organization in an effort to outperform over the long term.

While we are always striving to improve, a few additional data points illustrated Annaly's employee diversity: 33% of our operating committee are women; 45% of our Board of Directors are women; and finally, 69% of the 26 new hires we've made in 2019 identify as female or racially diverse.

Shareholders have validated our efforts in these areas of corporate responsibility. As demonstrated by the 79 ESG-oriented funds that now on Annaly, which is an increase of almost 70% since 2015.

Finally, we are encouraged by the direction the market is heading, which helps make our opportunities more visible and tangible today. As a private capital solution for the U.S. housing market, the commercial real estate industry and business owners across the country, we look forward to the opportunities that will be provided in this next phase of monetary policy and asset redistribution in the next decade and beyond.

Now I'll turn the call over to David Finkelstein.

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David L. Finkelstein, Annaly Capital Management, Inc. - CIO [4]

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Thank you, Kevin. While the market environment at the onset of the third quarter was relatively calm and increasing trade tensions and the prospect of a further slowdown in the global economy resulted in volatility picking up meaningfully in August. Longer-term interest rates rallied sharply to levels close to their all-time lows, which led to a considerable flattening of the yield curve and Agency MBS exhibited one of their worst months of relative performance in the postcrisis period on rising concerns over prepayments and hedging costs.

Although September brought some relief as rates retraced partially and the spreads grew modestly, we did end the quarter with materially lower rates and wider agency spreads. Amidst this challenging environment, we were able to generate a positive economic return of 1.4% and we ended the quarter at 7.7 turns of leverage.

Turning to portfolio activity and beginning with Agency sector, performance was highly directional with interest rates, prepayments increased, driven by a combination of lower mortgage rates and summer seasonals, and while our portfolio has considerable protection we were not immune to higher speeds as portfolio prepayments increased to just over 14 CPR, but did remain somewhat contained relative to the prepayment increase in the broader MBS universe. We took a relatively conservative trading approach during the quarter as we opted to protect book value by reducing assets in the volatility and managing leverage coincident with our stock buyback program that we commenced in August.

Also on the asset side, we modestly gravitated down in coupon, specifically in TBAs. Our activity was more focused on the hedging side as we shifted roughly 10% of our swap position to the front end of the yield curve, which we began prior to the curve flattening and the adjustment also helped to reduce our weighted average pay rate by 24 basis points in the quarter.

Some of these front-end swaps were subsequently rotated into overnight index swaps, linked to Fed funds, when the spread between LIBOR and OIS reached year-to-date wides. In a declining rate environment like the third quarter, those swaps provided an immediate benefit to our cost of hedging, particularly because they reset daily versus our LIBOR-based swaps that reset quarterly.

These conventions do balance out over the longer horizon, so looking at one single quarter doesn't give a complete picture and we will never manage the near term. As the market ultimately transitions away from LIBOR, we will look to continue to opportunistically gravitate toward OIS, or SOFR-linked swaps, at prudent market levels and considerate of the liquidity of those products. While OIS is a good short-term repo hedge, it doesn't provide the same credit and liquidity hedge as LIBOR. And to note, the vast majority of our swaps remain LIBOR-based, and we anticipate the wider LIBOR-OIS spread that prevailed at the end of the quarter to be a benefit relative to peers in the fourth quarter as over half of our LIBOR swaps reset in September.

Additionally, on the hedging side, we added out of the money payer and receiver swaptions to help manage tail risk and we were also compelled to add duration to the portfolio primarily in the form of covering futures hedges as the decline in interest rates shortened MBS durations. Agency repo rates remained elevated throughout the quarter, which culminated in a sharp increase in overnight rates in mid-September.

The spike in financing rates necessitated the Fed not only to intervene in the repo market for the first time in more than a decade, but also restarting their balance sheet growth beginning this month in an attempt to ensure sufficient liquidity in the banking system.

Following the Fed's measures, overnight shorter-term repo markets have largely normalized, however liquidity in longer-term contracts remain somewhat impaired through September and as a result, we opted to maintain a shorter repo duration profile through quarter end, which we have since begun to extend. While we do certainly utilize our broker-dealer, balances were limited to under 20% of our overall financing during the funding dislocation with just under half of those balances reliant on overnight FICC financing, which was the epicenter of the episode. The remainder being either termed out or financed through our direct repo counterparties, which did not experience funding volatility to the same extent.

Shifting to our residential credit businesses. As Kevin previewed, we increased the pace of our whole loan program as we acquired over $700 million of expanded prime and agency-eligible investor loans. We completed our seventh securitization in July with an additional transaction in October, both of which consisted of expanded prime loans. Organic creation of Residential Credit securities, such as through these 2 transactions remains a more efficient mechanism than the secondary market to add exposure within Residential Credit given result in low to mid-double-digit yields with modest leverage. And we are also encouraged by the growth of the expanded prime channel and the progression of the securitization market for these borrowers, where deals completed on non-QM thus far this year have eclipsed $18 billion, which has already doubled that of the market in 2018.

Also to note, the prospect of some form of administrative GSE reform, as Kevin touched on, would likely lead to further growth of alternative channels for mortgage borrowers.

Now with respect to our outlook, while the Agency market is experiencing elevated prepayments and higher convexity costs, valuations are reflective of these dynamics and we are more constructive on the Agency sector today given historically wide spreads. Moreover, a fundamental shift from a year ago, Agency assets will benefit as the Fed adds, rather than reduces liquidity within the broader system and financing should be more stable going forward.

However, despite the attractiveness of the Agency sector, as we have said consistently, we do remain committed to our diversification strategy given its inherent benefits of protecting book value and contributing to greater earnings stability. While we do expect to remain at the lower end of our allocation of credit with benchmark spreads close to postcrisis-type levels, we will continue to underwrite high-quality credit assets to ensure an appropriate balance between Agency and credit and our proprietary platforms will help to ensure we can accomplish this without meaningfully sacrificing returns.

Maintaining our capital allocation in the proximity of the current distribution should help to keep portfolio leverage in the recent range over the near term, and with the tailwind of accommodative monetary policy and persistently wider Agency spreads, we do expect an improved carry environment in the fourth quarter and beyond.

Now with that, I will hand it over to Glenn to discuss the financials.

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Glenn A. Votek, Annaly Capital Management, Inc. - CFO [5]

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Thanks, David. Beginning with the GAAP results, we reported a GAAP loss of $0.54 per share, driven by hedge portfolio losses, which improved sequentially, and offsetting mark-to-market gains in our Agency portfolio, which run through equity resulted in compressive income of $0.11 per share.

Book value declined modestly to $9.21 a share, and we generated core earnings ex PAA of $342 million or $0.21 a share. There are a number of factors contributed to our results this quarter beginning with interest income. While coupon income increased $0.04 on higher average earning assets, higher prepayments fees resulted in approximately $0.06 of additional PAA adjusted premium amortization. The higher amortization expense was due to projected CPRs increasing quarter-over-quarter as David had just noted a moment ago.

Additionally, [drop] income declined $0.01 sequentially and higher-average repo balances added another $0.01 to interest expense. Our operating efficiency metrics improved on declines of both management fees and other G&A. The dislocation between repo funding costs and LIBOR that we've discussed on prior calls remained a factor once again this quarter. While our average repo funding costs declined 13 basis points, LIBOR-based resets on the receiver leg of our swaps declined on an average basis by about 25 basis points. This dynamic also impacted NIM and net interest spread as lower rates, coupled with the higher premium amortization that I just mentioned, drove asset yields lower to a greater extent than the decline in our funding cost, which have lagged Fed's reduction in rates.

Looking forward, we expect CPRs to peak in early Q4 and anticipate lower funding costs and wider agency spreads to more than offset this impact contributing to NIM and net interest spread improvements of 10 to 15 basis points.

Turning to the balance sheet. Assets declined roughly $3 billion, primarily driven by a reduction of Agency MBS holdings. And our loan portfolio has experienced net growth of $400 million on originations, purchases of $1.3 billion, partially offset by securitizations and paydowns. During the quarter, we further lowered our preferred cost of capital by completing the previously announced redemption of the $175 million 7.625% Series C preferreds as well as the underwrite of partial allotment exercise of the 6.75% Series I preferreds that we previously issued at the end of the second quarter.

As a result, in the past roughly 2 years with these additional actions, we've cumulatively reduced the cost of our preferred capital by approximately 70 basis points or 9%. In terms of our common dividend, we have reaffirmed our prior guidance for $0.25 for the fourth quarter dividend, subject, of course, to our Board's review and approval. So to wrap up as we alluded to in our prior call, the third quarter proved to be a challenging one, driven by compressed asset yields and resistant financing costs. We expect Q3 will have an earnings trough and under the current conditions, we'd anticipate core earnings trending higher into the fourth quarter. We believe our business model is well positioned and offers us capital deployment choices to drive shareholder value whether that be in the form of asset allocation options or further share repurchases.

And with that, operator, we will open it up to questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Rick Shane with JPMorgan.

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Richard Barry Shane, JP Morgan Chase & Co, Research Division - Senior Equity Analyst [2]

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Look, as you head into Q4 and then into 2020, you make a compelling case that margins are going to improve, that this is a trough in earnings. And we definitely see that in the trends as well. I'm curious when you think about this not on a pure return basis but on a risk-adjusted return basis, and I know that's more qualitative in terms of thinking about risk, but when you think about things on a risk-adjusted basis how do you feel about the operating environment?

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Kevin G. Keyes, Annaly Capital Management, Inc. - Chairman, CEO & President [3]

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Rick, I think our comments are meant to be constructive and positive, but measured. First of all, I think the way I would answer that in a Reader's Digest version of a risk-adjusted basis, and it's a very good way as to how we look at our capital allocation models across the 4 businesses. I think it's fair to say, we anticipated what was going to happen, and it happened. And I think going forward, pursuant to our commentary, risks are lower, and returns can be higher, predominantly in the Agency business. I think in the credit businesses, what we've demonstrated is we've done about $4 billion of credit in the last couple years across the businesses. On a risk-adjusted basis, that I think has been demonstrably better than the market, albeit it's not necessarily reflected in the numbers yet because there hasn't been a credit contraction or a credit -- sorry, a credit hiccup or a sell-off. So all that being said, we are a bit different because we have these 4 businesses that are complementary and combined.

So credit, I think, to David's point still is quite tight. But we're finding 12%, 13% returns at 2x leverage, which is very attractive, even versus the Agency business, which has become a lot more favorable.

So I think going into the fourth quarter, the reason we're maintaining the dividend and the reason why we're constructive on the outlook is that we see the portfolio's long-term earnings potential, not just stabilizing, but returning really to the levels that we anticipated earlier this year. And I think the bogey for us, the attractive kind of call option for us, is what happens in credit because I think we basically have been firing on 2 of our 4 cylinders here and if there is a corruption or if there is a disconnect in any of the credit businesses, we are capable of capitalizing like nobody else. And so -- and that's on top of, again, the Agency business, that we think is, a lot more attractive today certainly than it was over the summer.

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Richard Barry Shane, JP Morgan Chase & Co, Research Division - Senior Equity Analyst [4]

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Got it. And in that spirit, if you look at the leverage -- the economic leverage on a headline basis, it's ticked up a turn year-over-year. But if you -- in the idea of sort of risk-adjusted, if you look at the allocation to equity -- to credit going down, I would argue that there's actually less risk in terms of the increased leverage than the number would suggest. Headed into this sort of environment in Q4 and into 2020, are you comfortable taking leverage up given the current allocation to credit?

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David L. Finkelstein, Annaly Capital Management, Inc. - CIO [5]

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Rick, this is David. So to your point about leverage ticking of as a consequence of shift further towards Agency, that is correct. Agency is obviously more levered. So as we make that shift, you'll see more leverage in the portfolio as you have. Another point to note over the past year is to my comments in my script, the Fed has shifted to a more accommodative approach, not just in terms of short rates, but also very recently as we've seen, their intervention in the repo market and the Agency being a balance-sheet-intensive product does give us more comfort with respect to having a higher-levered portfolio.

Going forward, we think we can generate the returns that we feel is practical and prudent with the current level of leverage. But should things change or should we shift our capital allocation back towards credit if things cheapen and then it may go down or if there is an opportunity that we really think Agency leverage could go up -- the leverage could go up by increasing our Agency exposure, we would do so. But we're not there right now.

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Kevin G. Keyes, Annaly Capital Management, Inc. - Chairman, CEO & President [6]

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Rick, what I would just also offer what it ties to your first question, risk-adjusted returns. We also -- what we really look at is core ROE per unit of leverage. And if you look at our -- if you just take a look at our numbers, if you analyze our core earnings year-to-date per unit of leverage, we have a higher return than the sector by far by using less leverage. So that the output of this model is designed to produce better or higher returns of lower leverage. And to me, that's part of the risk-adjusted equation. And over time really the last 5 years, we've been -- if you look at that measure, historically, our core ROE per unit leverage is about 30%, 35% higher return with 30% or 35% lower leverage. So there is -- that's a big part of how we balance out where we put our capital.

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Operator [7]

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Our next question comes from Kenneth Lee with RBC Capital Markets.

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Kenneth S. Lee, RBC Capital Markets, Research Division - VP of Equity Research [8]

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Just a follow-up on the equity capital allocation. You mentioned in your prepared remarks that allocation towards credit asset is closer to the lower end of the range right now and Agency is closer to that higher end. But just wondering looking forward in the near term given the current investment opportunities in the macro environment, how do you see that evolving? Could we see material shifts more allocated towards credit if pricing changes? I just wanted to get a little more thought about that?

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Kevin G. Keyes, Annaly Capital Management, Inc. - Chairman, CEO & President [9]

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Yes, Ken, it's really -- it's pretty basic right now on a relative value basis, risk-adjusted basis. Agency is cheaper than credit, full stop. So that's where you see our portfolio reflecting that in terms of our capital allocation being higher towards the Agency than it has been in the past few years. It will shift when credit gets relatively cheaper, relative to Agency. So that's part of our model, which is shared capital and by definition, risk management is that, we don't have to put our money to work in everything or in any one thing. So we measure it every day, every week. When credit is weaker or weakens or we find a deal in credit that is on a risk-adjusted basis more attractive than Agency than we will steer our money that way.

The way I would answer the question also is, what does it take for -- if there is a correction or a reset in credit, what would our mix look like? And the efficient frontier for this company given the efficiency of our operations is that we could be 50-50 credit/Agency in terms of capital allocation without really having to invest in the infrastructure here.

When I said in my comments, we've paid it forward. We've set this company up to grow in many different ways and especially in credit when we do see that retraction in the spreads.

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David L. Finkelstein, Annaly Capital Management, Inc. - CIO [10]

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I would just say to the point about being at lower end of the credit spectrum and capital allocation and efficient frontier, we do have the strike the balance between this smoothing book volatility and earnings. And we are late cycle in credit. Spreads are relatively tight. We do have enough organic origination through our 3 businesses to certainly maintain our credit exposure in quality assets, but we're not price takers in credit by any means. We'll do what we do and to the extent there is an opportunity to add through cheaper spreads we will, but we're not chasing anything.

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Kenneth S. Lee, RBC Capital Markets, Research Division - VP of Equity Research [11]

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Got it. Very helpful. And just one follow-up, if I may? Wondering -- I wanted to get some of your thoughts around our capital position and, specifically, available capacity for making investments going forward?

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David L. Finkelstein, Annaly Capital Management, Inc. - CIO [12]

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You're saying with respect to increasing leverage or making larger capital investments with our liquidity?

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Kenneth S. Lee, RBC Capital Markets, Research Division - VP of Equity Research [13]

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Yes. I guess, either potential to -- potential to increase leverage or utilize other, like, for example, the unencumbered assets, just wanted to see the interplay between them, and how do you view how much you could actually use to deploy capital in potential investment opportunities?

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Kevin G. Keyes, Annaly Capital Management, Inc. - Chairman, CEO & President [14]

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Ken, the headline answer to that is yes, yes, and yes. I mean we have, I would argue to this model, not just more -- there's 3 things: more options to invest in the 4 businesses; number two, more financing availability and options for the 4 businesses; and number three, our liquidity and capacity dwarfs most in the sector. So the reason we're not kind of a fully amped up across the businesses in terms of leverage is that it has been to the point of an earlier question about risk-adjusted returns. It's been a high-risk market across the board.

Now what we see going forward is, lower risk in Agency on a relative basis. And we're picking our spots in credit. But our liquidity really is our moat. It's our advantage. And frankly, the sources of that liquidity, we have 10 different ways, we finance our businesses nonrecourse, which nobody else has, and that's the reason we built this platform the way we did.

So going forward, you're going to see the lag effect catch up for us, meaning our weighted average cost of funds will continue to go down in the fourth quarter and beyond. So the cost of finance is going up, and yet, we still haven't drown down on a lot of our capacity in any one of the businesses. So we're -- we think we are paying a pretty good cash on cash return to wait for our capital appreciation event or the next big our event in terms of an acquisition or a portfolio lift or some other strategic direction that we are -- that's why we are -- that's why we maintained liquidity the low liquidity position that we do.

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Operator [15]

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Our next question comes from Matthew Howlett with Nomura.

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Matthew Philip Howlett, Nomura Securities Co. Ltd., Research Division - Research Analyst [16]

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Just to reiterate, did you say 10 to 15 basis point improvement in 4Q in the margin?

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Kevin G. Keyes, Annaly Capital Management, Inc. - Chairman, CEO & President [17]

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Yes, we did.

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Matthew Philip Howlett, Nomura Securities Co. Ltd., Research Division - Research Analyst [18]

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Okay. On that note, does that, when you look at -- further, is that something that's sustainable and when you look at sort of new purchase yields and where you can finance on at, how should we think about the stability? You did a good job for outlining what the headwinds were in the third quarter and things sort of normalize in the fourth quarter? Does that -- do you think things will stabilize on that route, could they get better, could they get worse? I know you don't have a perfect outlook on it, but I just wanted to hear your thoughts.

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Glenn A. Votek, Annaly Capital Management, Inc. - CFO [19]

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Yes. I mean, obviously, we don't have a crystal ball as far as what's going to happen over time but we are very confident in what we are seeing in terms of trends with respect to our funding cost and the benefit it will have on both NIM as well as net interest revenue.

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Matthew Philip Howlett, Nomura Securities Co. Ltd., Research Division - Research Analyst [20]

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Great. Okay. And then, Kevin, I just want to follow up on your positioning and a lot of -- you've probably seen a lot of REITs moved into this operating model. I know you said you're not price takers here in this market. When you look at buying originator or becoming more of an originator, how to use see things playing out? Is Annaly looking at everything here?

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Kevin G. Keyes, Annaly Capital Management, Inc. - Chairman, CEO & President [21]

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It's a good question. We -- yes, Annaly looks at everything. And we have, I think, thankfully, we see a lot of mortgages because of the ecosystem of these businesses, right? In terms of origination, we do we see everybody. We have great relationships. Right now we have chosen to maintain our joint venture and partnerships that I described in my prepared comments. And we do the math. And the math is definitive for us. That we can produce x billion of assets from an origination partnership that -- at 20% to 25% of the cost, meaning 75% cheaper because we're not -- we don't have the people, the systems, the infrastructure needed to run a conduit or an originator and have all the bricks-and-mortar around it. So the math says that we are accessing these assets 75%, 80% more cheaply than those that are producing it on their own. So that's beneficial for incremental returns here.

And as we see that business grow, and it's been one of our higher growth businesses and will continue to be to my comments, the point here is, I want to grow, not necessarily just in size, but in -- obviously, in return on invested capital. So incremental business that will push through our residential platform should be higher-margin business for us the more we do.

So we're getting into that scale. We're at that threshold now where those returns, albeit -- all things being equal, in the market, those returns should even get better. Now that being said, if there is a partnership or a platform that we would like to lock off in terms of a proprietary relationship and have an investment to do that, by all means, we are open to that because we -- that's another way just to lock off flow and secure more tangible definitive flow on top of what we have. What we have is producing some really good growth as you've seen.

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Matthew Philip Howlett, Nomura Securities Co. Ltd., Research Division - Research Analyst [22]

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Well, I'll certainly say it's nice to see you're buying back stock and recognizing the value in the platform. Long-term, does it make sense? I mean, keeping those businesses combined, I know you like to sort of reference the shared capital model? Or do they need at some point to be segregated given the high returns and some of the premiums that are applied to other peers?

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Kevin G. Keyes, Annaly Capital Management, Inc. - Chairman, CEO & President [23]

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Yes. Some of the parts we think are undervalued today, but long-term, I think, especially in these markets where I don't think you get paid to take excessive risk or get paid to do quarterly trades or things can go sideways on you quite quickly. So we think the sum of the parts here, the value for our shareholders is really safety. These businesses together churning out the complementary cash flows that they churn out. It's more safe for them all to be collectively together. Now -- and it's easier to grow and it's more efficient and the liquidity and everything else, every business benefits from each other.

If there comes a time, and I mentioned it, I think, a couple of quarters ago, if the sum of the parts becomes more obvious and there's an arbitrage ability for us to take advantage of some arb whether we sell assets or spin-off a business or carve out a company, we're prepared to do that. All these businesses are run and accounted for independently under one very tight umbrella. So if the -- another call option in owning our shares is that potential, but I don't see anything coming down the road because we are, frankly, focused on efficient growth with returns on invested capital, which are higher as one company versus one of these companies was on a stand-alone basis.

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Operator [24]

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Our next question comes from Eric Hagen with KBW.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [25]

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I had a question on the originator as well, and I think you answered that really well. I'll just add that it's been exciting to watch you guys issue some securitizations and get those deals done. So congrats. Just a couple housekeeping items, I guess. I think this if for you, Glenn. Is there a sensitivity you can give us to the level of premium amortization that corresponds to a change in your CPR assumption in either direction?

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Glenn A. Votek, Annaly Capital Management, Inc. - CFO [26]

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Yes. It's a really complicated set of calculations in terms of how the whole PAA adjustment works, I think the simple way of looking at it is to look at what the prior quarter's projection was and how that compares against the future. In other words, we are trying to reset it back to that prior period. I can tell you that based on where we see prepayments trends correctly, we would expect on a PAA adjusted basis, amortization expense to be roughly equivalent next quarter as far as what we see or what we had experienced in Q3.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [27]

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Okay. That's helpful. And then where in the coupon stack are you guys reinvesting run-offs in the Agency portfolio? And on the dollar roll side, I see that you guys have a net long position in TBAs around $11 billion, but are you short any rolls? That's the question.

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David L. Finkelstein, Annaly Capital Management, Inc. - CIO [28]

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Sure. Eric, with respect to where on the coupon stack, we do have a tilt towards higher coupons, but that being said, I would say we still do think that in spite of elevated pay-ups, loan balance paper is still very attractive. The way we look at TBAs versus pools is, TBA is a benchmark and they are a relatively cheap benchmark and pay-ups have obviously increased quite a bit, but they're rich to achieve benchmark. So when you look at pools on a cash flow basis and the spread relative to financing and hedging costs, reasonably well-protected pools are still certainly attractive to us, and we are certainly maintaining our exposure in higher-quality pools.

But we are also sensitive to the value associated with lower pay-up pools. For example, you can distinguish between servicer and how much third-party origination and gross WACC can you actually can get real value relative to that very cheap benchmark where the pay-ups are somewhat low.

So your question about TBAs and rolls. In the third quarter, we did not have short positions as has been discussed. Higher coupon rolls did trade negative. Our view was that higher coupons were also relatively cheap and their performance -- TBA performance in the third quarter on a curve-adjusted basis was relatively strong. So we think that was a good decision not to be short TBAs in the third quarter. However, since higher coupons have performed reasonably well since August. We have entered into some short TBA positions in higher coupons given the fact that rolls do persist at a negative drop. So we do have a small amount of short positions in TBAs.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [29]

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Got it. That's helpful. And then just to kind of pin you down on the coupon question, just runoff is going into 3s and 3.5s or mostly 3s. I mean just give us a sense for...

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Glenn A. Votek, Annaly Capital Management, Inc. - CFO [30]

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Some 3s and 3.5s, I'd say. But we have 70% of coupon exposures in 4s and 4.5s, so we're not reallocating there.

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Operator [31]

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(Operator Instructions) Our next question comes from Douglas Harter with Crédit Suisse.

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Douglas Michael Harter, Crédit Suisse AG, Research Division - Director [32]

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I was hoping you could help me understand kind of the big drivers of kind of the earnings volatility last 2 quarters, almost 4 years of kind of stable earnings and kind of what the -- kind of what changed so much over the past 2 quarters to introduce more volatility into earnings?

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David L. Finkelstein, Annaly Capital Management, Inc. - CIO [33]

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Sure. This is David. I'd say there's a couple of factors heading into the spring and summer. We did have some swap runoff of some lower fixed-rate payers that did runoff in the second quarter, which caused earnings to go down somewhat in the second quarter. And in the third quarter, it was predominantly attributable to higher (inaudible) expense associated with prepayments.

With that being said, when you consider the third quarter versus the fourth quarter, I think, it's notable that we got essentially 80% of 1 Fed cut in the third quarter. If we look at the fourth quarter, we now had 3 cuts from July, September and October to where the weighted average is 2 and 2/3 rate cuts for the fourth quarter. And so we do think that will be the predominant tailwind that will equate the third quarter to a trough.

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Douglas Michael Harter, Crédit Suisse AG, Research Division - Director [34]

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Great. And then I was just looking forward kind of, as we get through the fourth quarter and you got does rate cut benefits, I guess, just how do you view your earnings stability going forward, are we likely to go back to kind of the prior 4 years of stable earnings? Or do we think we're in a period that this volatility in earnings is going to continue?

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Kevin G. Keyes, Annaly Capital Management, Inc. - Chairman, CEO & President [35]

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Look, my outlook right now is a lot more constructive, Doug. And when you look at our stability the last 4 years, our core earnings variability has been 24% versus the sector -- the REIT sector earnings variability was 111%. So we're -- which is 5x more volatile. The yield sector that I always quote in terms of the broader market for companies and other industries that produce income, their variability is about 60% or 3x more volatile than us. So we have proven over time that we're more stable. And there's no reason to believe with our outlook that we can't maintain that stability with this model. To David's point and to Glenn's points, protecting book value sometimes you sacrifice earnings in order to maintain the portfolio and the earnings potential going forward and that's what we have done. And outlook, I think, on a risk-adjusted basis to start the Q&A, I think, we feel a lot better, albeit we never feel good about anything because we're a defensive yield stock. So look, this model more than any other is built for stability and not again, for a quarterly trade or a short-term outlook. That's why I talk about the next decade and we talk about the big macro influences and GSE reform, banks retreating and PE needing Switzerland in terms of lending to them. So I think, we've not only made it through the trough of one quarter of earnings, I think, we're looking forward to, frankly, more volatility in different parts of the market that we're prepared to take advantage of than others are. And that's when we can start firing on all cylinders and that's what we're looking forward to.

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Operator [36]

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

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Kevin G. Keyes, Annaly Capital Management, Inc. - Chairman, CEO & President [37]

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I'd like to thank you, everyone, for their interest in Annaly and for joining the call, and we will speak to you next quarter. Thanks, everyone.

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Operator [38]

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The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.