Business context and reporting period
Annaly Capital Management, Inc. is an externally managed mortgage REIT that primarily invests in Agency mortgage-backed securities (MBS), financed largely with repurchase agreements, and earns the spread between asset yields and funding costs. This Form 10-K covers the fiscal year ended December 31, 2014; quarterly figures below identify the fourth quarter where relevant.
Agency MBS represented 96.2% of the portfolio at year-end, up from 93.7% in 2013. Commercial real estate debt and equity were 2.0% of the portfolio. The company reported total assets of $88.4 billion.
Financial performance and position
| Metric | 2014 | 2013 |
|---|---|---|
| Interest income | $2.63 billion | $2.92 billion |
| GAAP net interest income | $2.12 billion | $2.29 billion |
| Net income (loss) attributable to Annaly | ($842 million) | $3.73 billion |
| Net income (loss) per basic common share | ($0.96) | $3.86 |
| Core earnings, non-GAAP | $1.15 billion; $1.14 per basic share | $1.22 billion; $1.21 per basic share |
| Economic net interest income, non-GAAP | $1.29 billion | $1.39 billion |
| Net interest spread / margin | 1.21% / 1.52% | 1.09% / 1.31% |
| Return on average equity | (6.49%) | 26.70% |
| Book value per common share | $13.10 | $12.13 |
Fourth-quarter 2014 net loss attributable to common stockholders was $676 million, or $0.71 per share; third-quarter net income attributable to common stockholders was $337 million, or $0.36 per share. Common dividends declared were $1.20 per share for 2014, down from $1.50 in 2013. The fourth-quarter dividend was $0.30 per share.
Operating cash flow was $6.13 billion; investing cash flow was a $7.80 billion outflow and financing cash flow was $2.86 billion. Cash and cash equivalents ended the year at $1.74 billion, up from $552 million. These cash-flow totals include substantial financing and securities activity.
At year-end, repurchase agreements were $71.36 billion, total liabilities $75.02 billion, and total equity $13.33 billion. Debt-to-equity was 5.4:1, compared with 5.0:1 in 2013; the capital ratio was 15.1% in both years. The weighted-average remaining repo maturity was 141 days. Unencumbered financial assets were $9.73 billion; $77.36 billion of financial assets were encumbered. Convertible senior notes with $857.5 million principal were due in 2015.
Material changes versus the prior comparable period
- GAAP results swung from $3.73 billion net income in 2013 to an $842 million net loss in 2014, principally reflecting a $2.55 billion net loss on interest-rate swaps in 2014 versus a $992 million gain in 2013.
- Core earnings declined 6% to $1.15 billion. Management attributed the decrease mainly to lower average interest-earning assets and interest income, partly offset by lower funding and swap costs.
- Average interest-earning assets fell to $85.2 billion from $105.4 billion. Average asset yield increased to 3.09% from 2.77%, while average funding cost, including swaps, rose to 1.88% from 1.68%.
- Portfolio MBS prepayment speed slowed to 8% from 14%; principal repayments fell to $8.3 billion from $21.7 billion.
- Net unrealized gains on available-for-sale investments improved to $205 million from a $2.75 billion net unrealized loss in 2013. This supported the increase in book value, while market-value changes were recorded in other comprehensive income.
Outlook, commentary, risks and unusual items
Management reported that the Federal Reserve ended QE3 asset purchases in October 2014 and expected increases in the federal funds target rate to begin in 2015. Falling longer-term rates had increased MBS prepayment risk. The filing provides no specific earnings, dividend, or balance-sheet guidance.
The principal risks include leverage and repo refinancing or margin-call risk; interest-rate, yield-curve, spread and prepayment movements; hedge effectiveness and derivative counterparty exposure; and credit and execution risks in commercial real estate and other diversification investments. The filing’s scenario analysis estimates that a parallel 75-basis-point rate increase would reduce portfolio value by 1.2% and NAV by 8.0%; a 25-basis-point MBS spread widening would reduce portfolio value by 1.1% and NAV by 7.4%. These are modeled estimates, not forecasts.
Unusual items include $779 million of realized swap termination losses and $949 million of unrealized swap losses. Management said the MBS fair-value declines were market-driven, not credit-related, and reported no other-than-temporary impairment. A $23.8 million one-time payment to Chimera to resolve derivative-demand issues was included in other expense. The company also completed a $399.5 million commercial mortgage securitization, issuing $260.7 million of investment-grade bonds.
Annaly intends to maintain REIT status and generally distribute 100% of REIT taxable income, subject to board discretion and cash availability. GAAP net income is not a direct measure of REIT taxable income or future dividends. Management stated that ordinary-course legal matters were not expected to materially affect the financial statements. The independent auditor gave unqualified opinions on the financial statements and internal control over financial reporting.
Key facts investors should verify
- Review the reconciliation and definition of non-GAAP core earnings, and distinguish it from GAAP net income and REIT taxable income.
- Assess the nature, cash costs, collateral requirements and future valuation sensitivity of the swap portfolio, including the $1.5 billion net negative fair value disclosed at year-end.
- Check the refinancing or settlement of the $857.5 million principal amount of convertible notes due in 2015 and the maturity profile and concentration of repo funding.
- Verify the sustainability of the $0.30 quarterly common dividend against taxable income, cash generation, capital needs and board discretion.
- Monitor MBS prepayments, premium amortization, rate and spread exposure, and whether unencumbered assets remain adequate under stressed conditions.
- Track credit performance and concentration in commercial real estate loans, securitized assets and owned properties, as well as compliance with REIT and Investment Company Act requirements.