Business context and reporting period
Annaly Capital Management, Inc. filed this unaudited Form 10-Q for the quarter ended March 31, 2014. Annaly is an externally managed mortgage REIT investing primarily in Agency mortgage-backed securities (MBS) and related hedges, with additional commercial real estate, corporate lending, advisory and broker-dealer businesses. Its investment strategy uses borrowing to finance assets and seeks to earn the spread between asset yields and funding and hedging costs.
Financial performance and condition
| Metric | Q1 2014 | Q1 2013 or comparison |
|---|---|---|
| Interest income | $655.9 million | $737.2 million |
| Interest expense | $125.0 million | $177.6 million |
| Net interest income | $530.9 million | $559.6 million |
| Economic net interest income (non-GAAP) | $270.5 million | $334.2 million |
| Net income (loss) | $(203.4) million | $870.3 million |
| Net income (loss) available to common shareholders | $(221.3) million; $(0.23) per basic share | $852.3 million; $0.90 per basic share |
| Core earnings (non-GAAP) | $239.7 million; $0.23 per basic share | $296.4 million; $0.29 per basic share |
| Return on average equity | (6.52%) | 22.29% |
Other income was a loss of $682.9 million, versus income of $368.4 million a year earlier. The quarter included $616.2 million of aggregate interest-rate-swap losses, including $348.9 million of unrealized losses, and $146.2 million of trading-asset losses. Other comprehensive income was $660.5 million, principally reflecting a $741.2 million unrealized gain on available-for-sale securities, partly offset by reclassification adjustments. Consequently, comprehensive income was $457.1 million despite the GAAP net loss.
At March 31, 2014, total assets were $82.4 billion, total liabilities $69.9 billion and stockholders’ equity $12.6 billion. Common book value was $12.30 per share, up from $12.13 at year-end 2013. Leverage was 5.2:1, compared with 5.0:1, and the capital ratio was 15.2%, compared with 15.1%. Cash and cash equivalents were $924.2 million. The filing reports $8.9 billion of unencumbered financial assets and liquid assets equal to 95.47% of total assets.
Repurchase agreements totaled $64.5 billion, up from $61.8 billion; their reported weighted-average rate was 0.65%, with a 187-day weighted-average remaining maturity. Including swap costs, the quarter’s average cost of interest-bearing liabilities was 2.31%, while average asset yield was 3.21%, producing a 0.90% net interest-rate spread. Operating cash flow was $4.3 billion, investing cash flow was $(1.6) billion and financing cash flow was $(2.3) billion; cash increased $371.8 million to $924.2 million. Operating cash flows include substantial matched-book financing activity.
Material changes versus the prior comparable period
- GAAP earnings moved from substantial profit to loss, mainly as swap valuation results changed from a $325.7 million unrealized gain to a $348.9 million unrealized loss. Trading-asset results also shifted from a $1.5 million gain to a $146.2 million loss.
- Economic net interest income declined $63.7 million. Average interest-earning assets fell to $81.9 billion from $124.4 billion, while their yield rose to 3.21% from 2.37%. Average funding costs, including swaps, increased to 2.31% from 1.46%; the net interest-rate spread was nearly unchanged.
- Common dividends declared fell to $0.30 per share from $0.45. Preferred dividends were unchanged.
- Agency MBS fair value increased to $75.4 billion from $70.4 billion. Annaly said it had begun selectively adding Agency MBS during the quarter. Mortgage prepayment speed fell to 6% from 19% a year earlier.
- RCap ceased trading U.S. Treasury securities, derivatives and certain securities-borrowed-and-loaned transactions in January 2014. In January, Annaly also completed a $399.5 million commercial mortgage securitization, issuing $260.7 million of investment-grade bonds.
Outlook, management commentary and risks
Management described its stance as cautious amid the Federal Reserve’s reduction of asset purchases and uncertainty about financial and housing regulation. The filing provides no specific earnings, dividend or portfolio-growth guidance. Management expects to continue financing Agency MBS largely through repurchase agreements, while considering Federal Home Loan Bank advances, securitizations and other term financing. FHLB borrowing capacity is discretionary and subject to conditions.
Key risks include interest-rate, yield-curve, MBS-spread and prepayment changes; repo funding availability, margin calls and collateral requirements; and credit and counterparty risks in commercial real estate and corporate debt. Management reported $2.45 billion of gross unrealized losses on Agency MBS at quarter-end, attributed to market conditions rather than asset quality, and said it had the intent and ability to hold the securities through recovery. Its sensitivity scenarios estimate that a parallel 75-basis-point rate increase would raise projected economic net interest income 14.7% but reduce portfolio value by 7.5% of NAV; a 25-basis-point MBS-spread widening would reduce NAV by 8.8%. These are model estimates, not forecasts.
The net fair value of interest-rate swaps was negative $931.7 million. Certain derivative agreements allow counterparties to terminate upon specified events; the filing estimates approximately $898 million of net-liability derivatives subject to such provisions and states that this amount was fully collateralized. Two convertible note issues mature in 2015, with $857.5 million aggregate principal outstanding at quarter-end. Management said ordinary-course legal matters were not expected to have a material effect and reported no material change in disclosed annual-report risk factors.
Most important facts for investors to verify
- Whether core earnings and the economic net interest spread can be sustained as funding costs, hedge expense, portfolio size and asset yields change; core earnings and economic interest income are non-GAAP measures.
- The sensitivity of book value, liquidity and margin requirements to rate and MBS-spread movements, and the assumptions underlying management’s scenario analysis.
- The amount, terms, maturities, collateral and counterparty concentration of repo funding, and the availability of unencumbered assets during stressed markets.
- Performance and credit quality of the commercial real estate portfolio, including the $31.5 million of watch-list loans and the approximately $13 million non-accrual loan noted in the filing.
- The ability to meet or refinance the 2015 convertible-note maturities and the sustainability of the reduced $0.30 common dividend.