Business context and reporting period
Annaly Capital Management, Inc. is an externally managed mortgage REIT that invests primarily in Agency mortgage-backed securities (MBS), uses repurchase-agreement financing and derivatives to manage risk, and also operates commercial real estate and other lending businesses. This Form 10-Q covers the quarter and six months ended June 30, 2014; balance-sheet comparisons are with December 31, 2013. Amounts below are in U.S. dollars.
Financial performance and position
- Profit and per-share results: Q2 2014 net loss was $335.5 million, or $0.37 per basic common share, compared with net income of $1.64 billion, or $1.71 per share, in Q2 2013. First-half net loss was $538.9 million, or $0.61 per share, versus net income of $2.51 billion, or $2.61 per share, in first-half 2013.
- Interest income and spread: Q2 interest income was $684.0 million and net interest income was $557.9 million, up from $548.7 million a year earlier. Non-GAAP economic net interest income was $336.9 million versus $336.0 million; the company cited a 25-basis-point increase in net interest spread. First-half net interest income was $1.089 billion versus $1.108 billion; economic net interest income was $607.4 million versus $670.1 million.
- Core earnings: Non-GAAP core earnings were $300.4 million, or $0.30 per average basic share, in Q2, versus $294.2 million, or $0.29, a year earlier. First-half core earnings were $540.2 million, or $0.53 per share, versus $590.6 million, or $0.59.
- Drivers of GAAP loss: Q2 other income was a loss of $842.0 million, including $772.5 million of realized losses on swap terminations and $220.9 million of realized swap losses, partly offset by $175.1 million of unrealized swap gains. First-half other income was a loss of $1.525 billion. Management attributed the year-over-year deterioration mainly to changes in swap valuations and swap terminations, as well as weaker trading-asset and investment-disposal results.
- Assets, equity and book value: Total assets were $87.15 billion, up from $81.92 billion; Agency MBS were $81.06 billion. Stockholders’ equity was $13.45 billion, compared with $12.41 billion. Common book value per share rose to $13.23 from $12.13. Accumulated other comprehensive loss narrowed to $572.3 million from $2.749 billion, primarily reflecting higher fair values of available-for-sale securities.
- Debt, leverage and liquidity: Repurchase agreements were $70.37 billion, up from $61.78 billion. Reported leverage was 5.3:1 versus 5.0:1, and the capital ratio was 15.4% versus 15.1%. Cash and cash equivalents were $1.321 billion, including $1.155 billion pledged as collateral. The company reported $9.63 billion of unencumbered financial assets; 96.1% of total assets were classified as liquid assets, including pledged assets.
- Cash flow: First-half operating cash flow was $5.877 billion, compared with cash used of $7.703 billion in first-half 2013; investing cash flow was negative $6.821 billion and financing cash flow positive $1.712 billion. Operating cash flow includes substantial broker-dealer financing flows and should not be read as a simple measure of recurring earnings.
- Dividends: Common dividends declared were $0.30 per share for Q2 and $0.60 for the first half, versus $0.40 and $0.85 in the comparable 2013 periods. Preferred dividends continued to be declared.
Material changes versus the prior comparable period
- GAAP earnings swung from substantial profits in 2013 to losses in 2014, while quarterly core earnings and economic net interest income were comparatively stable. The prior-year results included large unrealized swap gains; 2014 results included significant swap-termination losses.
- The Agency MBS portfolio increased, while the company reported a lower average earning-asset balance for the first half: $83.7 billion versus $118.4 billion. First-half asset yield improved to 3.20% from 2.45%, but economic funding cost rose to 2.12% from 1.49%.
- Repurchase-agreement balances increased and weighted-average remaining maturity shortened to 173 days from 204 days. The reported weighted-average repo rate was 0.59% at June 30, 2014, compared with 0.68% at year-end; rates including specified financing and swap effects differ.
- Annaly ceased RCap’s trading activity in U.S. Treasury securities, derivatives, and certain securities-borrowed-and-loaned transactions during the first quarter. The filing attributes part of the asset-balance movement to this change.
- Common dividends declined year over year. The company also completed a $399.5 million commercial mortgage securitization in January 2014, issuing $260.7 million of investment-grade bonds.
Outlook, risks and unusual items
- Outlook: No earnings or dividend guidance is provided. Management said it expected to continue financing Agency MBS largely through repurchase agreements and to use FHLB advances, securitizations, or other term financing for certain assets. It remained cautious as the Federal Reserve reduced asset purchases and noted uncertainty around future rate increases and financial and housing regulation.
- Interest-rate and market exposure: The company identifies liquidity and investment/market risk as primary risks. It relies heavily on secured funding, which can require same-day collateral for margin calls. Its sensitivity scenarios estimate that a parallel 75-basis-point rate increase would reduce portfolio value by 1.8% and NAV by 11.9%; a 75-basis-point decrease would reduce projected economic net interest income by 14.5%. A 25-basis-point widening in MBS spreads was estimated to reduce NAV by 8.6%. These are modeled estimates, not forecasts.
- Hedges and collateral: Interest-rate swaps had a net negative fair value of approximately $758 million. Certain ISDA agreements permit termination following specified events; the aggregate net-liability amount subject to these provisions was approximately $757 million and was fully collateralized. The swap portfolio’s notional amount was $30.8 billion at quarter-end, down from $52.4 billion at year-end.
- Portfolio marks and credit: Agency MBS had $1.409 billion of gross unrealized losses at June 30, 2014. Management attributed these to market conditions, cited agency guarantees and AAA or implied-AAA ratings, and recorded no other-than-temporary impairment. In commercial real estate debt and preferred equity, $31.5 million was on the watch list, including approximately $13 million associated with one nonaccrual loan; no investments were rated workout and no loan-loss allowance was recorded.
- Debt maturities and other matters: The company’s $857.5 million of convertible-note principal was shown as due within one year; the 4% and 5% notes mature in 2015 unless repurchased or converted. Management said ordinary-course legal matters were not expected to have a material effect and no contingency accrual was required. It reported no material change to the risk factors in its latest Form 10-K and concluded disclosure controls were effective.
Most important facts for investors to verify
- Reconcile GAAP losses with core earnings and economic net interest income, including the treatment and timing of swap-termination losses and unrealized marks.
- Review repo funding concentration, maturity schedule, collateral haircuts, margin-call exposure, and the company’s available unencumbered liquidity.
- Assess the sustainability of the $0.30 quarterly common dividend against taxable income, core earnings, and future funding costs.
- Examine the 2015 convertible-note maturities and potential cash, share, or refinancing requirements.
- Check subsequent interest-rate and MBS-spread movements against the filing’s modeled sensitivity scenarios, and monitor CRE watch-list and nonaccrual exposures.