ANNALY CAPITAL MANAGEMENT INC annual report, FY2013

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Annaly Capital Management, Inc. — 2013 Form 10-K

Business context and reporting period. This annual report covers the fiscal year ended December 31, 2013, not a standalone fourth quarter. Annaly is an externally managed mortgage REIT that primarily earns the spread between returns on mortgage-related investments and financing costs. It acquired CreXus in April 2013, adding commercial real estate lending and investments.

Financial performance and condition

  • Revenue and earnings: Interest income was $2.92 billion, down from $3.26 billion in 2012. Net interest income was $2.29 billion, down from $2.59 billion. Net income rose to $3.73 billion ($3.86 per basic common share) from $1.74 billion ($1.74 per share), primarily because of a $2.00 billion unrealized gain on interest rate swaps, compared with a $32 million unrealized loss in 2012.
  • Underlying earnings: Company-defined non-GAAP core earnings fell to $1.22 billion, or $1.21 per average basic common share, from $1.54 billion, or $1.54 per share. Economic net interest income declined to $1.39 billion from $1.70 billion; net interest spread narrowed to 1.09% from 1.27%.
  • Margins and returns: Yield on average interest-earning assets was 2.77%, versus 2.78% in 2012; average funding cost including swaps rose to 1.68% from 1.51%. Return on average equity was 26.7%, versus 10.7%, with the increase heavily affected by swap valuation gains.
  • Assets, equity, and book value: Total assets declined to $81.9 billion from $133.5 billion. Stockholders’ equity fell to $12.4 billion from $15.9 billion. Common book value per share declined to $12.13 from $15.85. The portfolio remained concentrated in Agency mortgage-backed securities (93.7% of portfolio value), with commercial real estate debt and equity at 2.1%.
  • Debt and liquidity: Repurchase agreements totaled $61.8 billion at year-end, down from $102.8 billion. Debt-to-equity declined to 5.0:1 from 6.5:1; the stated general ceiling is 12:1. Repo weighted-average remaining maturity was 204 days, and weighted-average repo borrowing rate was 0.68% before the effect of swaps. Cash and cash equivalents were $552 million; management reported $8.75 billion of unencumbered financial assets and liquid assets equal to 91.6% of total assets.
  • Cash flow: Operating activities used $12.9 billion, investing activities provided $37.5 billion, and financing activities used $24.7 billion. Cash declined by $63 million to $552 million. These cash flows reflect substantial portfolio and financing turnover; operating cash flow should not be read as a simple measure of recurring earnings.
  • Dividends: Common dividends declared fell to $1.50 per share from $2.05 in 2012. The board has not set a minimum dividend. Preferred dividends were paid in full through year-end.

Material changes and unusual items

  • Annaly reduced leverage and substantially shrank its Agency MBS portfolio amid 2013 interest-rate volatility and uncertainty around Federal Reserve asset purchases. Agency MBS principal repayments were $21.7 billion, compared with $35.1 billion in 2012; average prepayment speed declined to 14% from 20%.
  • Net unrealized losses on available-for-sale investments were $2.75 billion at year-end, versus net unrealized gains of $3.05 billion in 2012. The company attributed the decline to market conditions, not asset credit quality, and reported no other-than-temporary impairment.
  • The April CreXus acquisition added $1.58 billion of commercial real estate debt and preferred equity at year-end. Commercial investments included $31 million of watch-list loans and no workout loans; the filing reported no allowance for loan losses on this portfolio at year-end.
  • Management was externalized effective July 1, 2013. The Manager receives a monthly fee based on 1.05% annually of defined stockholders’ equity; management disclosed potential conflicts because the Manager is owned by members of Annaly management. Annaly also sold Merganser’s operations in October and recorded a $24 million goodwill impairment.

Outlook, risks, and contingencies

The filing provides no quantified earnings or dividend guidance. Management said it expected to continue financing Agency MBS primarily through repurchase agreements and to consider securitization or other term financing for certain mortgage loans. It described continued caution, lower leverage, and an emphasis on capital preservation and liquidity.

  • Federal Reserve tapering and changes in interest rates, yield spreads, and mortgage prepayments could affect portfolio values, book value, funding costs, and net interest income. The filing’s modeled scenarios show that a 75-basis-point rate increase could reduce portfolio value by 1.7% and increase projected economic net interest income by 13.0%; results are estimates based on stated assumptions, not forecasts.
  • Repo dependence exposes Annaly to refinancing, collateral haircut, margin-call, counterparty, and forced-sale risks. The company reported that it had met all repo margin calls through year-end 2013.
  • Expansion into commercial real estate and corporate lending adds borrower, collateral, concentration, and loss risk. Regulatory changes affecting Fannie Mae, Freddie Mac, derivatives, REIT qualification, or the Investment Company Act exemption could also materially affect operations.
  • Management stated that ordinary-course legal matters were not expected to have a material effect. No material unfunded loan commitments were reported. The independent auditor issued an unqualified opinion, and management and the auditor concluded internal control over financial reporting was effective.

Most important facts for investors to verify

  • Whether core earnings, economic net interest income, and the dividend remain sustainable as the portfolio contracts and spreads face pressure; distinguish these measures from GAAP net income, which was materially boosted by unrealized swap gains.
  • The drivers of the $3.72-per-share decline in common book value, the $2.75 billion net unrealized investment loss, and the sensitivity of book value to further rate or spread moves.
  • Repo maturity, counterparties, collateral haircuts, unencumbered assets, and liquidity under stressed conditions—not only headline cash and liquid-asset ratios.
  • Credit performance, underwriting, watch-list migration, and realized returns in the acquired commercial real estate portfolio, including the mezzanine and preferred-equity exposures.
  • The management agreement’s fee calculation, expense reimbursements, related-party conflicts, and the implications of the 2013 externalization.
  • Whether REIT qualification and the Investment Company Act exemption remain intact as the asset mix diversifies, and how Federal Reserve tapering and housing-finance reform may affect Agency MBS valuations and returns.