Business context and reporting period
Annaly Capital Management, Inc. is a REIT that primarily invests in agency mortgage-backed securities (MBS) and agency debentures, financed largely through repurchase agreements. It also earns advisory and broker-dealer income through subsidiaries. This unaudited Form 10-Q covers the quarter and nine months ended September 30, 2010; comparisons below are to the corresponding 2009 periods unless noted.
Financial performance and position
- Third-quarter results: Interest income was $703.0 million and net interest income was $400.4 million, down from $744.5 million and $436.7 million, respectively. Net loss was $14.1 million, or $0.03 per common share, versus net income of $285.2 million, or $0.51 per share.
- Nine-month results: Interest income was $2.00 billion and net interest income was $1.14 billion. Net income was $48.8 million, or $0.06 per common share, compared with $1.23 billion, or $2.24 per share, in 2009.
- Key earnings driver: Interest-rate swaps generated unrealized losses of $448.3 million in Q3 and $1.16 billion in the first nine months of 2010; the comparable 2009 nine-month period had an unrealized gain of $137.1 million. These mark-to-market losses were a primary reason for the earnings decline.
- Margins: Q3 average asset yield was 4.06%, average cost of funds 1.95%, and net interest spread 2.11%, versus 4.89%, 2.24%, and 2.65% in Q3 2009. Nine-month spread was 2.16%, versus 2.42%.
- Balance sheet at September 30: Total assets were $82.6 billion, including $76.2 billion of MBS and $2.0 billion of agency debentures. Total liabilities were $72.9 billion; stockholders’ equity was $9.59 billion. Cash and cash equivalents were $289.5 million.
- Debt and liquidity: Repurchase agreements totaled $61.0 billion, up from $54.6 billion at December 31, 2009. Reported debt-to-equity was 6.4:1, versus 5.7:1 at year-end. The company reported 30 uncommitted repo lenders and no unsatisfied margin calls through September 30; it had no committed liquidity facility.
- Cash flow: Net cash provided by operating activities was $6.72 billion for the first nine months, investing activities used $9.47 billion, and financing activities provided $1.54 billion. Cash declined by $1.22 billion from year-end. Operating cash flow includes substantial matched-book and repo-related activity.
- Shareholder capital and distributions: Annaly raised approximately $1.0 billion net from a July offering of 60 million common shares and issued $600 million of 4% convertible notes due 2015. Common dividends declared were $0.68 per share for Q3 and $2.01 per share for the first nine months.
Material changes versus prior periods
- Average earning assets grew to $69.2 billion in Q3 from $60.9 billion a year earlier, but lower asset yields reduced interest income and spread.
- MBS and agency debentures at fair value increased to $78.2 billion from $65.7 billion at December 31, 2009. Portfolio mix shifted toward fixed-rate securities; adjustable-rate securities were 15.7% of principal at September 30, versus 25.9% at year-end.
- Net MBS purchase premiums rose to $2.27 billion, or 3.1% of current par value, from $1.25 billion at year-end, increasing exposure to premium amortization if prepayments accelerate.
- Common shares outstanding increased, including from the 60-million-share offering. General and administrative expense rose to $43.4 million in Q3 from $33.3 million, mainly reflecting higher compensation and staff growth.
Outlook, risks and unusual items
- No specific earnings, spread, dividend, or balance-sheet guidance is provided. Management says results depend on interest rates, yield curves, prepayment speeds, funding availability and asset values; it expects prepayments to vary with market rates.
- Management’s modeled parallel-rate scenarios estimate net interest income changes of +7.12% at a 75-basis-point decline and −6.78% at a 75-basis-point increase. Estimated portfolio-value changes, including swaps, are +0.44% and −0.84%, respectively; actual outcomes may differ materially.
- Principal risks include repo refinancing and margin calls, declines in collateral values, interest-rate and prepayment risk, swap counterparty exposure, and possible forced asset sales. Management notes that much of the portfolio is agency-guaranteed or rated/implied AAA, but this does not remove market, funding, or liquidity risk.
- The $1.60 billion negative fair value of interest-rate swaps is material. Swaps had $25.9 billion notional; the weighted-average pay and receive rates were 3.34% and 0.31%.
- Recovery of assets associated with Lehman Brothers International (Europe) remains uncertain; $3.3 million of assets believed held by affiliates was valued at an 80% discount, and the company cannot assure recovery.
- Management expected to pay approximately $14.1 million of Merganser acquisition earn-out in Q4 2010; additional 2012 consideration depends on performance goals. Ordinary-course legal matters were not expected to have a material effect, and no material change to previously disclosed risk factors was reported.
- Management described financial markets as recovering but noted continued uncertainty around regulatory changes, including the Dodd-Frank Act, and potential policy and Federal Reserve actions.
Important facts for investors to verify
- How much of reported earnings volatility is attributable to swap mark-to-market accounting versus recurring net interest income, and how swap fair values may evolve.
- Whether asset yields, funding costs, and net interest spread continue to compress, and how portfolio growth and mix affect those trends.
- Repo maturity, lender concentration, collateral requirements, unused borrowing capacity, and liquidity under adverse market conditions.
- Prepayment speeds and premium amortization: Q3 CPR was 20%, after 32% in Q2 and 34% in Q1 2010.
- Dividend sustainability relative to taxable income and cash generation, alongside the effects of equity issuance and convertible-note dilution.
- Actual recoveries from the Lehman-related investment and the final amount and timing of Merganser earn-out payments.