Business Context and Reporting Period
Annaly Capital Management, Inc. is an externally managed REIT investing in residential and commercial real estate assets and middle-market loans. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2019; balance-sheet comparisons are to December 31, 2018 unless noted.
Financial Results and Position
- Quarterly earnings: Interest income was $927.6 million and interest expense was $750.2 million, leaving net interest income of $177.4 million, down from $334.1 million in Q2 2018. GAAP net loss was $1.776 billion, or $1.24 per common share, versus net income of $595.9 million, or $0.49 per share, a year earlier. The loss was driven principally by derivative and swap fair-value losses.
- Six-month results: Net interest income was $395.9 million versus $846.2 million in H1 2018. Net loss was $2.626 billion, or $1.88 per common share, versus net income of $1.924 billion, or $1.60 per share.
- Core earnings (non-GAAP): Q2 core earnings were $251.4 million ($0.15 per share); excluding the premium amortization adjustment (PAA), they were $391.2 million ($0.25 per share), compared with $382.8 million ($0.30 per share) excluding PAA in Q2 2018. H1 core earnings excluding PAA were $824.3 million ($0.53 per share), versus $768.1 million ($0.61 per share).
- Margins and costs: Q2 net interest margin was 0.87%, or 1.28% excluding PAA, versus 1.53% and 1.56%, respectively, in Q2 2018. Average cost of interest-bearing liabilities rose to 2.41% from 1.89%; excluding PAA, net interest spread was 1.07% versus 1.18%.
- Assets, equity and portfolio: Total assets rose to $131.8 billion from $105.8 billion at year-end, primarily as Agency MBS increased by $27.4 billion. Securities totaled $119.9 billion, including $118.2 billion of Agency MBS. Total equity was $15.7 billion, compared with $14.1 billion. Common book value per share was $9.33, versus $10.35 at June 30, 2018.
- Debt and leverage: Repurchase agreements increased to $105.2 billion from $81.1 billion; total liabilities were $116.1 billion. Debt-to-equity leverage was 7.2:1 and economic leverage 7.6:1, versus 6.3:1 and 7.0:1 at year-end. Repurchase agreements had a 70-day weighted-average remaining maturity.
- Liquidity and cash flows: Cash and equivalents were $2.0 billion; unencumbered financial assets were $7.8 billion. The company reported $124.3 billion of liquid assets under its stated measure, which includes assets pledged as collateral. For H1, operating cash flow was negative $1.7 billion, investing cash flow negative $23.0 billion, and financing cash flow positive $24.9 billion.
- Dividends and capital: The common dividend declared for Q2 was $0.25 per share, down from $0.30 in Q2 2018. The company issued common and Series I preferred shares during H1 and authorized up to $1.5 billion of common-share repurchases through December 31, 2020; none had been repurchased by quarter-end.
Material Changes Versus Comparable Periods
- The sharp decline in market interest rates drove substantial derivative losses: Q2 unrealized interest-rate-swap losses were $1.276 billion, while other derivatives recorded a $506.4 million loss. H1 included $1.667 billion of unrealized swap losses, $755.7 million of realized swap termination or maturity losses, and $621.6 million of losses on other derivatives.
- Available-for-sale securities recorded $3.345 billion of H1 other comprehensive income, moving accumulated other comprehensive loss of $2.0 billion at year-end to income of $1.4 billion at June 30. This did not offset the derivative losses recognized in earnings.
- Agency MBS holdings expanded significantly, while commercial real estate debt and preferred equity investments declined from year-end. Rising refinancing activity lifted projected long-term Agency CPR to 14.5%, from 9.1% at June 30, 2018.
- Common shares outstanding increased to 1.456 billion from 1.314 billion at year-end, reflecting equity issuance. Total G&A expense also increased, partly due to securitization costs and reimbursed management services.
Outlook, Commentary and Risks
- Management described Q2’s rate rally, increased mortgage refinancing and higher Agency MBS supply as challenging for Agency spreads, but said the resulting market conditions made the Agency MBS outlook more attractive. It expected refinancing-related supply effects to fade absent another significant rate rally, and said it would add credit exposure selectively and defensively rather than reach for yield.
- The filing gives no quantified earnings or dividend guidance. Management expected to continue financing residential securities largely through repurchase agreements and generally aimed to keep economic leverage below 10:1. The Federal Reserve cut its target rate by 25 basis points in July, after quarter-end.
- Principal risks include interest-rate, yield-curve, spread and prepayment changes; repo funding availability, collateral calls and refinancing risk; credit exposure in non-Agency, commercial and corporate assets; counterparty failure; and changes affecting REIT or Investment Company Act status. Management’s sensitivity analysis estimated that a 25-basis-point rate decline would reduce projected economic net interest income by 18.5%; a 25-basis-point increase would raise it by 14.1%. Results are model estimates and assume no management response.
- The company recorded a $5.7 million H1 loan-loss provision; its allowance was $9.2 million at June 30. It reported no material pending legal proceedings or material contingencies, and no material changes to previously disclosed risk factors. Management concluded disclosure controls were effective.
- Subsequent events included the July redemption of Series C preferred shares, a $463.4 million residential-loan securitization, and additional Series I preferred issuance of $42.5 million gross.
Important Facts for Investors to Verify
- How much of the GAAP loss reflects derivative valuation and termination effects versus recurring portfolio performance, and how should non-GAAP core earnings be interpreted?
- Whether higher projected prepayments, premium amortization and Agency MBS spread movements pressure future yields and book value.
- Repo funding, collateral and margin-call capacity, including the amount and availability of unencumbered assets during market stress.
- The trajectory of leverage, common book value per share, dividend coverage and share issuance or repurchases.
- Credit quality and reserve adequacy in commercial real estate, residential credit and middle-market lending portfolios.