Business context and reporting period
Annaly Capital Management, Inc. (NYSE: NLY) filed this unaudited Form 10-Q for the quarter ended September 30, 2019. Annaly is an externally managed REIT investing in residential and commercial real estate-related assets, financed substantially with borrowings. Its portfolio includes Agency and credit securities, mortgage loans, mortgage servicing rights, commercial real estate investments, and corporate debt.
Key financial results and condition
| Metric | Q3 2019 | Comparable period |
|---|---|---|
| Interest income | $919.3 million | $816.6 million in Q3 2018 |
| Interest expense | $766.9 million | $501.0 million in Q3 2018 |
| Net interest income | $152.4 million | $315.6 million in Q3 2018 |
| Net income (loss) | $(747.2) million; $(0.54) per diluted share | $385.4 million; $0.29 per diluted share in Q3 2018 |
| Core earnings excluding PAA (non-GAAP) | $341.9 million; $0.21 per average common share | $389.7 million; $0.30 in Q3 2018 |
| Net interest margin | 0.75% GAAP; 1.10% excluding PAA | 1.49% GAAP; 1.50% excluding PAA in Q3 2018 |
| Common book value per share | $9.21 | $10.03 at September 30, 2018 |
For the nine months ended September 30, 2019, net loss was $3.37 billion, or $2.42 per share, versus net income of $2.31 billion, or $1.88 per share, in the prior-year period. Net interest income was $548.3 million versus $1.16 billion.
The Q3 GAAP loss principally reflected interest-rate swap losses: $682.6 million realized on terminations or maturities and $326.3 million unrealized. Other derivative losses were $16.9 million. These market-value and termination effects contrast with non-GAAP core earnings, which exclude many realized and unrealized items; core earnings are not a substitute for GAAP results.
Q3 2019 other comprehensive income was $948.8 million, largely reflecting unrealized gains on available-for-sale securities. Total comprehensive income attributable to common stockholders was $165.6 million despite the GAAP net loss.
At September 30, 2019, total assets were $129.0 billion, up from $105.8 billion at December 31, 2018, primarily as Agency MBS holdings grew. Total equity was $15.2 billion. Repurchase agreements were $102.7 billion; total indebtedness, including other secured financing, securitized debt and mortgages payable, was approximately $111.5 billion. Reported leverage was 7.3:1 and economic leverage 7.7:1. Cash and cash equivalents were $1.79 billion; unencumbered financial assets were $7.15 billion. The company reported 98.95% of encumbered and unencumbered financial assets as liquid under its stated measure.
Operating cash flow for the first nine months was negative $2.40 billion and investing cash flow negative $19.77 billion, offset by $22.22 billion of financing cash flow; cash increased $58.2 million. These cash flows are affected by extensive securities trading, repo financing and collateral activity.
Material changes versus comparable periods
- Q3 net interest income fell about 52% year over year as interest expense rose faster than interest income. Average cost of interest-bearing liabilities increased to 2.28% from 2.08%; average asset yield excluding PAA rose to 3.26% from 3.22%.
- Q3 net interest spread excluding PAA declined to 0.98% from 1.14%. Core earnings excluding PAA fell to $341.9 million from $389.7 million.
- Q3 premium amortization adjustment cost was $117.2 million, versus $3.4 million a year earlier; management linked the pressure to higher projected prepayment speeds. Experienced CPR was 14.6% and projected long-term CPR 16.3%, compared with 10.3% and 9.1%, respectively, in the comparable prior-year measures.
- Agency MBS increased to $114.5 billion from $90.8 billion at year-end 2018. Repurchase agreements rose to $102.7 billion from $81.1 billion over the same dates.
- Common dividends declared were $0.25 per share for Q3, down from $0.30 in Q3 2018. The company also issued common and preferred equity, redeemed Series C and H preferred shares, and repurchased 18.3 million common shares for $155.0 million through September 30.
Outlook, management commentary and risks
The filing provides no company earnings or dividend guidance. Management described Agency MBS valuations as attractive but noted that near-term carry had been reduced by rapid prepayments and elevated financing rates. It expected Federal Reserve liquidity measures and lower short-term rates following rate cuts to improve MBS carry in coming quarters, while anticipating refinancing activity may moderate if rates do not fall further. Management reported generally healthy economic fundamentals supporting credit-sector investments, but noted volatility in markets and spreads during the quarter.
Key exposures include interest-rate and yield-curve movements, mortgage spreads, borrower prepayments, financing availability and repo margin calls, leverage, credit quality in non-Agency, commercial and corporate exposures, and counterparty performance. Repo funding had a 45-day weighted-average maturity; the company noted that margin calls may require same-day cash or collateral. Truman’s FHLB membership is scheduled to expire in February 2021 under the applicable sunset provision. The filing also discusses the transition away from LIBOR.
Management expected adoption of the credit-loss standard (CECL) on January 1, 2020 to increase the allowance, but did not expect a significant increase; the ultimate effect remained dependent on portfolio and economic conditions. The company reported no material contingencies and no pending material legal proceedings. Disclosure controls were deemed effective, with no material change in internal control over financial reporting reported for the quarter.
Subsequent events: in October 2019, Annaly closed a $465.5 million residential loan securitization and repurchased 7.9 million common shares for $68.2 million, excluding commissions.
Important facts for investors to verify
- Review the reconciliation and definition of non-GAAP core earnings, including PAA, and compare it with GAAP losses and the sizable swap and other derivative results.
- Assess whether asset yields and net interest margins can withstand funding costs, faster prepayments, spread widening and changes in the yield curve.
- Verify liquidity and collateral resilience against short repo maturities, leverage, margin calls and the concentration of pledged assets.
- Examine commercial loan risk ratings, the $12.7 million loan-loss provision, and credit concentrations in residential loans and non-Agency assets.
- Track the common dividend relative to recurring earnings, share issuance and repurchases, and book value per share.
- Monitor the LIBOR transition, Truman’s FHLB membership expiry, CECL adoption, and the terms and economics of subsequent securitizations.