Annaly Capital Management [NLY] Conference call transcript for 2023 q1
2023-04-27 12:17:03
Fiscal: 2023 q1
Operator: Good morning, and welcome to the Q1 2023 Annaly Capital Management Earnings Conference Call. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Sean Kensil, Director of Investor Relations. Please go ahead.
Sean Kensil: Good morning, and welcome to the First Quarter 2023 Earnings Call for Annaly 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 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. Content referenced in today's call can be found in our first quarter 2023 Investor Presentation and First Quarter 2023 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 Fania, Deputy Chief Investment Officer and Head of Residential Credit; V S Srinivasan, Head of Agency; and Ken Adler, Head of Mortgage Servicing Rights. And with that, I'll turn the call over to David.
David Finkelstein: Thank you, Sean. Good morning, and thank you all for joining us on our first quarter earnings call. Today, I'll review our performance during the quarter, provide an update on the macro landscape and then discuss our portfolio activity and positioning within each business. Serena will then provide further detail on our financial performance, and we are also joined by our other business leaders who can provide additional perspective during Q&A. Now beginning with our performance. As we noted on our last call, our outlook was optimistic but cautious given the potential for further volatility over the near term. Our conservative approach was validated as we generated an economic return of 3% during what proved to be a very challenging quarter. We were deliberate with respect to our asset selection and hedging strategy, which I'll discuss in more detail, and we continue to maintain our defensive posture with economic leverage roughly unchanged on the quarter at 6.4 turns while outearning our rightsized dividend by $0.16. Now on the macro environment, few anticipated the bank liquidity management would be among the first victims of the Fed's rapid hiking cycle. The SVB induced turbulence led to questions about the outlook for the banking system, the economy and monetary policy. Moreover, it compromised the notion of calmer markets resulting in some of the highest levels of realized and implied fixed income volatility since the financial crisis. The situation remains fluid given events this week, and we view the main implication of the banking turmoil is creating an overhang of assets that need to be absorbed by private market participants. The SVB and Signature portfolios are currently being sold, adding to MBS supply. And even if other banks do not sell securities, most market participants had penciled in about $100 million in MBS demand coming from banks at the start of the year. However, instead of this demand, we will more likely see bank holdings of MBS decline. And with the Fed in continued runoff mode, in addition in net issuance, the market will be further reliant on money managers to absorb roughly $500 billion in aggregate supply. Now spreads are sufficiently attractive for this to occur, though the potential for spread tightening is more limited going forward. Now a second implication of this episode is that it illustrates the banks will likely opt to preserve capital in turn curbing lending activity. Credit availability was already reduced and lending standards were tight before March, but the events over the past few weeks suggest further contraction is possible in turn slowing economic growth. Now the U.S. economy remains on solid ground with the labor market still recording nearly 350,000 jobs per month this quarter, and U.S. inflation readings staying above the Federal Reserve's target measure. Although the banking situation increases risks of a meaningful slowdown, the Fed will likely hike 25 basis points next week and aim to keep interest rates unchanged for the rest of the year, in line with their forecasts. Now shifting to our portfolio activity during the quarter. Within agency, mortgage performance diverge meaningfully each month given interest rate and spread volatility. In January, MBS spreads tightened significantly driven by the decline in implied [indiscernible] and strong inflows into fixed income funds. Performance softened, however, in February, as yields rose despite manageable levels of MBS supply. And this ultimately gave way to a more meaningful cheapening in March on the news of SVB and Signature Bank entering FDIC receivership. In total, mortgage option-adjusted spreads widened approximately 5 to 15 basis points across coupons on the quarter. And we modestly grew our agency portfolio commensurate with the accretive common equity raised early in the quarter while maintaining prudent leverage. We continued our gravitation higher up the coupon stack. And at quarter end, only 5% of our portfolio was in 2s and 2.5s, down from 34% a year ago, and thus we were better protected from the widening that occurred in lower coupons as a result of the FDIC portfolio [indiscernible]. Also to note, over 50% of our portfolio is in what we define as intermediate coupons, 3.5s to 4.5s, which remain more insulated from potential bank sales while avoiding the supply pressure higher up the coupon stack. This dynamic drove investors to shift into these coupons, leading to marginally positive hedge performance within this portion of our portfolio despite headline MBS spreads widening over the quarter. Looking forward, we continue to favor these intermediate coupons, and we'll also opportunistically invest up the stack into 5s and higher as these assets provide historically attractive nominal spreads. In addition to our balanced positioning across the agency market, our duration management and hedging decisions were critical in helping us navigate the volatility in March. Over consecutive trading sessions beginning on March 9, the 2-year note moved in excess of 20 basis points per day. And throughout this period, our portfolio was well positioned and we were able to take advantage of the outside moves by adding short-end hedges at attractive levels, which replaced swap runoff experienced over the quarter. And furthermore, we continue to rotate hedges out of treasury futures in the SOFR swaps, which we see as a more efficient hedge and more closely tracks our repo funding costs. Shifting to residential credit, performance was mixed across products, both benchmark credit risk transfer securities and expanded credit whole loans were 10 to 15 basis points tighter on the quarter, while AAA non-QM securities were 30 to 40 basis points wider from year-end. Our resi portfolio ended Q1 at $5.2 billion in market value, up approximately $200 million quarter-over-quarter, currently representing 18% of capital. This increase in market value was driven by retention of OpEx assets generated through securitization and opportunistic purchases predominantly investment-grade CRT -- we remained active in expanded credit whole loans, purchasing $645 million in loans in the quarter, of which 80% was sourced directly through our correspondent channel. Our loan quality remains high as Q1 settlements had a 743 weighted average FICO, 70 LTV with an aggregate mortgage rate of 8.79%. And despite challenging market conditions, we ended the quarter with a robust loan pipeline of $555 million. Our excess warehouse capacity and liquidity management allowed us to be selective in accessing the capital markets via our OBX securitization platform. We conducted 3 transactions in the first quarter, totaling $1.1 billion, including 2 non-QM transactions and a jumbo partnership deal, all completed in the first 2 months of the quarter prior to the onset of spread volatility in March. And also to note, as volatility subsided to begin the second quarter, we priced our third non-QM securitization of the year just last week. Now lastly, within our MSR portfolio, consisting with recent quarters, we were disciplined adding just 1 whole package, and our portfolio is currently comprised of $1.8 billion in market value and $130 billion UPB, a very low-note-rate high-credit quality MSR with an attractive risk profile and stable cash flows. And this is evidenced by recent portfolio prepayment speeds, trending below 3 CPR, and serious delinquencies remain less than 50 basis points. Now in terms of the sector more broadly, despite widely publicized supply introduced into the market and interest rates declining roughly 40 basis points during the quarter, the strong performance of low WAC MSR drove an increase in valuations, which is reflected in a modest expansion of our portfolio multiple. Now to briefly touch on our outlook, we feel good about our positioning across our 3 businesses and believe we are appropriately levered for the current environment. And our careful approach to leverage and liquidity has been beneficial where fundamentals have improved, but technical headwinds persist. That being said, as outlined in our investor presentation, we do see attractive new money returns for each of our businesses with Agency remaining our preferred avenue for incremental capital deployment over the near term. Residential credit and MSR do offer appealing low to mid-double-digit returns and provide a diversification benefit to enhance the stability of our risk-adjusted returns. And out the horizon, we will look to grow these strategies to represent roughly 50% of our dedicated capital collectively, but we continue to be patient and measured with respect to further diversification. Now finally, before I hand it off to Serena, I wanted to welcome back V.S. Srinivasan, who we're very pleased to have with us on the call this morning. Srini has returned to lead our agency effort and having worked with him extensively over the years, I am fully confident in his ability to navigate the agency market, and we're very happy to have him back on the team. Now with that, I will hand it over to Serena to discuss the financials.
Serena Wolfe: Thank you, David. Today, I will provide brief financial highlights for the quarter that ended March 31, 2023. Consistent with prior quarters, while earnings release disclosures GAAP and non-GAAP earnings metrics, my comments will focus on our non-GAAP EAD and related key performance metrics, which exclude PAA. Despite the challenging market David referred to earlier, our book value per share for Q1 was relatively unchanged from the prior quarter at $20.77. Our investments gained across the board with increases in valuation on our agency resi and MSR portfolios contributing $2.54 to book value for the quarter. These gains were offset by losses on our derivative positions of roughly $2.75, predominantly related to our swap portfolio, which comprised 82% of the losses on our hedging book. After combining our book value performance with our first quarter dividend of $0.65, our quarterly economic return was 3%. We generated earnings available for distribution of $0.81 per share for the first quarter. The $0.08 or 10% reduction in EAD compared to last quarter is primarily attributable to the continued rise in repo expense with interest expense up 20% or approximately $135 million compared to the prior quarter. Largely mitigating the increase in repo expense is a higher net interest component of swaps as the average receive rate climbed 66 basis points, resulting in a 35% or $99 million increase in swap income quarter-over-quarter. TBA dollar roll continued to decline, offsetting the benefit to EAD of higher yields on the spec pools experienced during the quarter. In previous earnings calls, we communicated our expectation that earnings would moderate as demonstrated this quarter. And the driving factors that we had referenced previously still hold. That is the continued increase in financing costs, swap runoff, the decline in the specialness of rolls and the mismatch between economics and earnings related to futures. Therefore, we expect some further moderation of EAD in the near term, but continue to be comfortable with our current dividend level, given the economic earnings of the portfolio, all things equal. Average yields ex PAA were 14 basis points higher than the prior quarter at 3.96% as we continue to rotate up in coupon this quarter, with 56% of our agency portfolio now in 4.5% coupons and higher. The factors that impacted EAD are also illustrated in NIM for the quarter with the portfolio generating 176 basis points of NIM ex PAA, a 14 basis point decrease from Q4. Net interest spread does not include dollar roll income. Therefore, the decline in NIS was less than NIM, 9 basis points down quarter-over-quarter at 1.62% versus 1.71% in Q4. The continued rise in repo rates and higher average balances impacted our total cost of funds for the quarter, rising by 23 basis points to 234 basis points in Q1, and our average repo rate for the quarter was 462 basis points compared to 372 basis points in the prior quarter. However, as previously mentioned, swaps positively impacted cost of funds during the quarter by approximately 58 basis points. Now turning to details on financing. Funding markets remain a bright spot amongst all the volatility in the financial markets with funding for our agency and nonagency security portfolios remaining resilient and ample. Consistent with most of 2022, liquidity is concentrated in shorter-term markets after Fed meeting dates. In saying that, a core tenet of our funding philosophy is diversification, both counterparty and term. And as such, we have sought to extend approximately 10% of our agency repo books. In this vein, during Q1, we opportunistically entered into 6- and 12-month floating rate trades at attractive rates. As a result of this positioning, our Q1 reported weighted average repo days were 59 days, up from 27 days in Q4. Since the beginning of the year, we increased our dedicated financing for our credit businesses, upsizing an existing resi credit facility by $200 million and adding $500 million in new warehouse facilities for resi credit and MSR combined. Our deliberate approach to diversifying financing for our credit businesses has resulted in a combined $3 billion of capacity with leverage levels substantially unchanged from Q4 and substantial unused capacity for both resi credit and MSR of over $2 billion. Our securitization platform continues to be a core part of our resi credit strategy. As of the end of Q1, 86% of our GAAP consolidated whole loan portfolio was funded through securitization at a weighted average cost of funds of 3.78%, approximately 215 basis points below the non-QM balance sheet cost of funds for the quarter. In addition to the below-market financing rate of our securitized debt, 96% of the debt is locked in at a fixed rate. Our OpEx to equity ratio for the quarter was unchanged from full year 2022 at 1.4% as we've realized most of the cost savings from our internalization and divestiture of MML and ACREG businesses. Operating expenses may rise modestly as we continue to invest in resources for growth in our resi credit and MSR platforms. Our liquidity profile remains robust with unencumbered assets of $5.7 billion, including cash and unencumbered agencies of $3.8 billion for the quarter. The approximately $600 million decrease in unencumbered assets primarily came from the pledging of assets to our new MSR facility in Q1, which remains undrawn and slightly higher leverage of agencies and whole loan positions at quarter end. Now that concludes our prepared remarks, and we will now open the line for questions. Thank you, operator.
Operator: [Operator Instructions]. Our first question will come from Bose George with KBW.
Operator: Our next question will come from Trevor Cranston with JMP Securities.
Operator: Our next question will come from Doug Harter with Credit Suisse.
Operator: Our next question will come from Vilas Abraham with UBS.
Operator: Our next question will come from Richard Shane with JPMorgan.
Operator: [Operator Instructions]. Our next question will come from Jason Stewart with Jones Trading.
Operator: This concludes our question-and-answer session. I would like to turn the conference back over to David Finkelstein for any closing remarks.
David Finkelstein: Thanks, Anthony, and thank you, everybody, for joining us today. Good luck, and we'll talk to you next quarter.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.
