Annaly Capital Management, Inc. — Form 10-Q Summary
Reporting period: Quarter and nine months ended September 30, 2011. Annaly is a REIT whose core business is investing in agency mortgage-backed securities (MBS) and agency debentures using repurchase-agreement financing; subsidiaries also provide investment advisory, broker-dealer, and other financial services. Amounts below are in U.S. dollars.
Financial performance and position
- Third-quarter results: Net loss was $921.8 million, or $0.98 per average common share, versus a $14.1 million loss, or $0.03 per share, in Q3 2010. Nine-month net loss was $101.1 million, or $0.14 per share, versus net income of $48.8 million, or $0.06 per share, in 2010.
- Interest income and spread: Q3 interest income was $930.8 million and reported net interest income was $809.4 million. Including swap payments, management’s economic net interest income was $577.5 million, up from $400.4 million in Q3 2010; the economic net interest spread was 2.08%, versus 2.11%. For the first nine months, economic net interest income was approximately $1.7 billion versus $1.1 billion, and the spread was 2.23% versus 2.16%.
- Yields and costs: Q3 average asset yield declined to 3.71% from 4.06% year over year; economic funding cost declined to 1.63% from 1.95%. Average interest-earning assets grew to $100.5 billion from $69.2 billion, supporting higher interest income despite lower yields.
- Primary earnings drag: Q3 interest-rate swap losses were $231.8 million realized and $1.505 billion unrealized. Nine-month losses were $654.8 million realized and $1.803 billion unrealized. The company attributed the GAAP loss primarily to the larger unrealized swap loss; it is distinct from the recurring economic interest-spread measure.
- Other income and expenses: Q3 gains on sales of agency MBS and debentures were $91.7 million; advisory and other fee income was $20.8 million; general and administrative expense was $65.2 million, up from $43.4 million. Management attributed the expense increase principally to higher compensation and staff growth, from 108 to 145 employees.
- Cash flow: For the first nine months, operating cash flow was $4.05 billion, investing cash flow was negative $25.07 billion, and financing cash flow was $24.21 billion. Cash and cash equivalents ended at $3.47 billion, versus $282.6 million at year-end 2010. Operating cash flow includes substantial financing-related dealer transactions and should not be read as a simple measure of earnings.
- Balance sheet and leverage: Total assets were $113.63 billion, including $106.59 billion of agency MBS, compared with $83.03 billion and $78.44 billion, respectively, at December 31, 2010. Repurchase agreements were $86.50 billion, up from $65.53 billion; convertible notes had a $557.0 million carrying value and $600 million principal amount. Stockholders’ equity was $15.91 billion, versus $9.86 billion. Debt-to-equity was 5.5:1, down from 6.7:1; management’s usual target range is 8:1 to 12:1, subject to market and liquidity conditions.
- Liquidity and collateral: Repurchase agreements had a 1.61% weighted-average borrowing rate after swaps and 122-day weighted-average remaining maturity. Securities pledged under repos and swaps had estimated fair value of $93.6 billion. The company reported no repo margin calls it could not meet through September 30, 2011.
- Book value and OCI: Accumulated other comprehensive income was $3.07 billion, compared with $1.16 billion at year-end 2010, reflecting substantial unrealized gains on available-for-sale securities. Q3 comprehensive income was $101.8 million despite the GAAP net loss.
- Dividends and capital: Annaly declared $0.60 per common share for Q3 and $1.87 per share for the first nine months. It raised approximately $5.35 billion net from follow-on offerings during the first nine months, including a July offering of 138 million shares for approximately $2.41 billion. Shares outstanding were approximately 970.1 million as of November 8, 2011.
Material changes versus comparable periods
- Q3 average interest-earning assets increased about $31.3 billion year over year, while their yield fell 35 basis points. Lower prepayment speeds (18% CPR versus 20%) partly supported interest income.
- Q3 economic funding cost fell 32 basis points, but the economic net interest spread narrowed 3 basis points. Economic net interest income rose with portfolio growth, yet the larger unrealized swap loss drove the much worse GAAP result.
- Agency MBS fair value rose to $106.6 billion from $78.4 billion at year-end 2010. Repo financing and common equity also expanded materially. The company issued 310.5 million shares through three follow-on offerings during the period.
- The filing reclassified swap interest expense from interest expense to realized swap losses within other income for comparative presentation. Economic net interest income includes those swap payments; reported net interest income does not.
Outlook, risks, contingencies, and unusual items
- No quantified earnings, dividend, or portfolio guidance was provided. Management expected to continue financing operations primarily through repurchase agreements and emphasized preserving unused borrowing capacity and liquidity.
- Interest-rate, yield-curve, prepayment, asset-valuation, and financing availability changes are principal risks. Higher mortgage prepayments can accelerate premium amortization and reduce income; falling collateral values can trigger margin calls or forced asset sales.
- Management’s modeled rate shocks estimated economic net interest income would increase 10.27% under a 75-basis-point decline and decrease 7.82% under a 75-basis-point increase. These are model estimates, not forecasts; actual results could differ materially.
- A significant regulatory uncertainty is the SEC’s August 2011 review of the Section 3(c)(5)(C) Investment Company Act exemption relied upon by mortgage REITs. An adverse interpretation could require asset sales or restructuring, reduce net interest income, and restrict leverage. Annaly stated it was compliant at September 30, 2011, but the SEC’s outcome and timing were unclear.
- Unrealized losses on interest-only agency MBS were $39.0 million. The company reported no other-than-temporary impairment on its agency MBS or affiliate equity investments. Affiliate holdings included approximately $124.6 million of Chimera and $84.6 million of CreXus at fair value.
- Ordinary-course legal matters were not expected by management to materially affect the financial statements. Additional Merganser earn-out consideration may be payable in 2012, depending on performance goals; the amount was not determinable. The filing reported no material capital expenditure commitments.
- Management identified a proposed accounting update concerning investment-company status that could materially change financial statement presentation and said it was evaluating the effect. Disclosure controls were assessed as effective, with no material quarterly change in internal control over financial reporting.
Important facts for investors to verify
- Reconcile GAAP losses with economic net interest income, focusing on the large swap mark-to-market losses, swap cash payments, and how these measures are presented.
- Track asset yields, funding costs, net interest spread, mortgage prepayment speeds, and premium amortization as rates and refinancing conditions change.
- Monitor repo leverage, collateral values, lender concentration, margin-call capacity, unused borrowing capacity, and the maturity and call features of financing.
- Assess the SEC’s review of the Section 3(c)(5)(C) exemption and any subsequent regulatory developments affecting the company’s ability to use leverage.
- Review the effect of substantial equity issuance and dilution, dividend levels relative to taxable income and cash generation, and changes in book value.
- Distinguish operating cash flow from portfolio and financing cash movements; verify liquidity against the company’s large secured funding obligations.