ANNALY CAPITAL MANAGEMENT INC quarterly report, Q1 FY2016

Annaly Capital Management, Inc. — Q1 2016 Form 10-Q

Reporting period: Quarter ended March 31, 2016. Annaly is an externally managed mortgage REIT investing primarily in Agency mortgage-backed securities, with residential credit, commercial real estate and corporate lending businesses. Amounts below are U.S. dollars; figures are rounded.

Financial performance

Metric	Q1 2016	Q1 2015 or comparison
Interest income	$388.1 million	$519.1 million
Net interest income	$240.7 million	$389.7 million
Net loss attributable to Annaly	$867.9 million	$476.4 million loss
Loss available to common stockholders	$885.9 million; $0.96 per share	$494.4 million; $0.52 per share loss
Comprehensive income attributable to common stockholders	$132.1 million	$74.7 million
Core earnings, non-GAAP	$123.3 million; $0.11 per share	$254.1 million; $0.25 per share
Normalized core earnings, non-GAAP	$291.8 million; $0.30 per share	$342.0 million; $0.34 per share
Net interest margin, as defined by Annaly	0.79%	1.29%
Normalized net interest margin, non-GAAP	1.54%	1.68%

The GAAP loss primarily reflected $1.03 billion in unrealized interest-rate-swap losses, associated with lower forward rates, and lower interest income. Available-for-sale securities generated $1.02 billion of other comprehensive income; accumulated other comprehensive income consequently moved to $640.4 million from a $377.6 million deficit at December 31, 2015. Annaly cautions that its non-GAAP core measures are not substitutes for GAAP results and may not be comparable with other companies’ measures.

Cash flow, balance sheet and liquidity

Total assets were $77.4 billion at March 31, up from $75.2 billion at year-end. Cash and cash equivalents were $2.42 billion, including $2.22 billion pledged as collateral.
Operating cash flow was negative $133.5 million; investing cash flow was negative $663.2 million; financing cash flow was positive $1.44 billion. Cash increased $646.9 million during the quarter. These flows include substantial financing and investment turnover.
Repurchase agreements were $54.45 billion, down from $56.23 billion at year-end. Other secured financing rose to $3.59 billion from $1.85 billion; securitized debt of consolidated VIEs rose to $3.80 billion from $2.54 billion.
Total indebtedness was $62.21 billion. Debt-to-equity leverage was 5.3:1, versus 5.1:1 at year-end; economic leverage was 6.2:1 versus 6.0:1. The company’s stated internal ceiling for economic leverage is 10:1.
Repurchase agreements had a 1.87% weighted average borrowing cost after swaps and a 136-day weighted average remaining maturity. Approximately 12% had maturities over one year. The repurchase-agreement weighted average rate before the swap adjustment was 0.99%.
Unencumbered financial assets totaled $7.05 billion. Annaly reported liquid assets of $71.1 billion, or 91.77% of total assets, but noted that $64.9 billion of those assets were pledged as collateral.
Common book value per share was reported as $11.61, compared with $12.88 in the filing’s Q1 2015 comparison. Common dividends were $0.30 per share, unchanged from Q1 2015.

Material changes and portfolio developments

Net interest income declined 38% year over year. Interest income fell $131.0 million, mainly from lower average residential investment balances and yields and higher premium amortization; increased commercial-portfolio interest income partly offset the decline. Interest expense rose to $147.4 million from $129.4 million.
Normalized core earnings fell to $291.8 million from $342.0 million, primarily because of lower normalized interest income from residential securities, partly offset by growth in commercial investment income. Core earnings were lower in part because they include the quarter’s larger premium-amortization adjustment.
Interest-rate-swap fair-value liabilities rose to $2.78 billion from $1.68 billion. Total realized and unrealized swap losses were $1.18 billion, compared with $850.9 million in Q1 2015.
Annaly described early-2016 markets as volatile and said it remained cautious on portfolio positioning and leverage. The 10-year Treasury yield fell to 1.77% from 2.27% at year-end, while the mortgage basis widened to 80 basis points from 73.
Commercial real estate debt investments at fair value increased to $4.40 billion from $2.91 billion, largely reflecting consolidated securitization trusts. The held-for-investment CRE debt and preferred-equity portfolio declined to $1.18 billion from $1.35 billion. Of its $1.18 billion CRE debt and preferred-equity principal portfolio, $443 million was rated performing, $420 million closely monitored and $321 million special mention; none was rated substandard, doubtful or loss. No loan-loss allowance was recorded.
Projected long-term CPR on Agency mortgage-backed securities increased to 11.8% from 9.2% a year earlier. Annaly reported that this change increased premium amortization and reduced current-period interest income.

Outlook, risks and contingencies

Hatteras acquisition: On April 10, 2016, after quarter-end, Annaly agreed to acquire Hatteras Financial for consideration valued at approximately $1.5 billion based on Annaly’s April 8 share price. Approximately 65% was to be paid in Annaly common shares and 35% in cash. Hatteras preferred shares were to convert into a new Annaly preferred series. Closing was subject to conditions including regulatory approvals and was expected before the end of Q3 2016. Hatteras also agreed to pay its manager a $45.4 million termination fee upon completion.
Management’s outlook reflected a low-growth, low-inflation environment and uncertainty around interest rates, mortgage spreads, prepayments, financing availability and regulatory changes. The filing provides no specific company earnings or dividend guidance.
Key exposures include interest-rate and spread changes, prepayment speeds, repo funding and margin calls, collateral values, counterparty performance, credit losses in non-Agency and commercial assets, and maintaining REIT and Investment Company Act status. A sharp decline in asset values or reduced lender capacity could pressure liquidity or force asset sales.
Interest-rate sensitivity scenarios show projected economic net interest income declining 8.1% under a 25-basis-point rate decrease and increasing 7.1% under a 25-basis-point increase; estimated portfolio value moves in the opposite direction. These are model estimates assuming no management response, and actual results could differ materially.
Derivative agreements included termination provisions tied to events such as specified declines in equity, leverage-limit breaches, loss of REIT status or NYSE delisting. The maximum termination amount for affected derivatives in a net liability position was approximately $2.6 billion and was reported as fully collateralized.
Annaly reported no material pending legal proceedings, no material contingencies and no material unfunded loan commitments at quarter-end. Management said disclosure controls were effective and that no material change in internal control over financial reporting occurred during the quarter.

Important facts for investors to verify

Whether the Hatteras transaction closed on the expected terms and timetable, including regulatory approvals, cash funding, share issuance, integration costs and potential dilution to earnings or book value.
How sustainable the $0.30 common dividend is relative to taxable income and recurring earnings; reconcile GAAP losses, core earnings and normalized core earnings before relying on any one measure.
Repo funding capacity, collateral haircuts, unencumbered liquidity and exposure to margin calls, particularly given the large collateralized balance sheet and derivative liabilities.
How lower rates, mortgage-spread widening and faster prepayments affect swap valuations, premium amortization, net interest income and book value.
Developments in CRE loans rated closely monitored or special mention, and the performance and concentration risks of consolidated securitization trusts and other non-Agency credit assets.