Business context and reporting period
Annaly Capital Management, Inc. is an externally managed mortgage REIT that primarily invests in Agency mortgage-backed securities (MBS), financed largely with repurchase agreements and hedged with derivatives. It has also expanded into commercial real estate debt and related businesses. This Form 10-Q covers the quarter and nine months ended September 30, 2013; comparisons are to the corresponding 2012 periods unless otherwise noted. Dollar figures below are in U.S. dollars.
Key financial metrics
| Metric | Q3 2013 | Q3 2012 | Nine months 2013 | Nine months 2012 |
|---|---|---|---|---|
| Interest income | $697.2 million | $761.3 million | $2.147 billion | $2.502 billion |
| Net interest income | $551.7 million | $579.4 million | $1.660 billion | $2.021 billion |
| Net income | $192.5 million | $224.8 million | $2.701 billion | $1.035 billion |
| Net income available to common shareholders | $174.5 million | $215.4 million | $2.647 billion | $1.016 billion |
| Basic EPS | $0.18 | $0.22 | $2.79 | $1.04 |
| Core earnings, a non-GAAP measure | $282.3 million; $0.28 per basic share | $306.3 million; $0.30 per basic share | $872.9 million; $0.86 per basic share | $1.203 billion; $1.21 per basic share |
Q3 economic net interest income, which deducts interest paid on swaps from GAAP net interest income, was $323.8 million versus $355.1 million. The economic net interest spread was 1.01% versus 1.02%. The company reported a 5.87% annualized return on average equity for Q3 and 25.08% for the first nine months; the nine-month result was substantially affected by derivative fair-value gains.
At September 30, 2013, total assets were $93.4 billion and stockholders’ equity was $12.9 billion, compared with $133.5 billion and $15.9 billion at December 31, 2012. Agency MBS fair value was $79.9 billion, down from $124.0 billion. Cash and cash equivalents were $1.123 billion. Repurchase agreements were $69.2 billion, down from $102.8 billion; debt-to-equity was 5.4:1 versus 6.5:1. The company reported a $1.455 billion accumulated other comprehensive loss, compared with $3.053 billion of accumulated other comprehensive income at year-end 2012.
For the first nine months, operating cash flow was negative $6.892 billion, investing cash flow was positive $31.665 billion, and financing cash flow was negative $24.266 billion; cash increased $506.9 million to $1.123 billion. These cash-flow totals include substantial activity from financing and broker-dealer transactions and should be read with the cash-flow statement’s detailed classifications.
Material changes versus prior periods
- Q3 net income and core earnings declined year over year, primarily reflecting lower net interest income as average interest-earning assets fell. Average interest-earning assets were $99.1 billion, down $20.8 billion year over year; the reported yield rose to 2.82% from 2.54%.
- Nine-month GAAP net income rose sharply, but the increase chiefly reflected a $1.441 billion unrealized gain on interest rate swaps, compared with a $373.8 million unrealized loss in the prior-year period. Core earnings fell year over year, primarily due to a 44-basis-point decline in the nine-month economic net interest spread.
- The company continued to shrink its Agency MBS portfolio and repurchase-agreement borrowings. Net unrealized losses on available-for-sale securities drove accumulated other comprehensive income (loss) from positive $3.053 billion at year-end to negative $1.455 billion at September 30.
- Annaly acquired control of CreXus on April 17, 2013, adding a commercial real estate platform; commercial real estate debt and preferred equity totaled $1.227 billion at quarter-end. In July, management was externalized to Annaly Management Company LLC under a fee of 1.05% per year of defined stockholders’ equity, subject to the agreement’s terms and employee-cost adjustments.
- The common dividend declared per share for the first nine months was $1.20, versus $1.60 in the prior-year period. The Q3 declared dividend was $0.35 per share versus $0.50.
Outlook, management commentary, risks and unusual items
- No specific earnings or dividend guidance is provided. Management said it expected to continue financing Agency MBS primarily through repurchase agreements and to consider securitization or other term financing for certain commercial mortgage loans. It generally expected leverage to remain below 12:1 and cited continued market volatility as a reason for maintaining lower leverage.
- Management described higher long-term interest rates and elevated volatility during 2013. The 10-year Treasury yield rose from 1.63% on May 2 to 2.49% on September 30. The Federal Reserve maintained its then-current asset-purchase program in September. Annaly reported slower MBS prepayments: the portfolio’s average CPR was 13% in Q3 2013 versus 20% in Q3 2012.
- Interest-rate and mortgage-spread movements, prepayments, premium amortization, funding availability, collateral values, margin calls, counterparty performance, and regulatory changes are key risks. Management’s modeled instantaneous +75-basis-point rate shock projected a 19.2% increase in annual economic net interest income but a 1.0% decline in portfolio value; a -75-basis-point shock projected a 26.7% decrease in economic net interest income and a 0.3% increase in portfolio value. These are model estimates, not forecasts, and depend on assumptions.
- At quarter-end, repurchase agreements totaled $69.2 billion, with a 200-day weighted-average remaining maturity. The company reported approximately $7.4 billion of excess collateral cushion and no repurchase-agreement margin calls it could not meet. It also disclosed approximately $1.3 billion of net-liability derivative contracts subject to specified termination events; that amount was fully collateralized.
- Unusual items included a $24.0 million goodwill impairment related to Merganser and an $18.9 million loss on remeasurement of the previously held CreXus equity interest. In October 2013, Annaly sold Merganser’s business and assets for an amount approximating book value.
- Commercial real estate credit exposure included $12.973 million of senior mortgage loans on a watch list, including a loan on non-accrual status; no workout loans were reported. Management reported no material unfunded loan commitments and believed ordinary-course legal matters would not materially affect the financial statements.
Important facts for investors to verify
- Review the drivers and durability of core earnings and economic net interest income, including portfolio runoff, funding costs, swap expense, and the lower year-over-year spread.
- Assess the scale and implications of the $4.508 billion nine-month decline in accumulated other comprehensive income, the Agency MBS unrealized losses, and potential effects on equity, borrowing capacity, and liquidity.
- Verify current leverage, repo maturity and counterparty concentration, collateral haircuts, available liquidity, and sensitivity to margin calls.
- Evaluate the commercial real estate portfolio’s underwriting, non-accrual exposure, credit performance, and integration following the CreXus acquisition.
- Review the external management agreement’s fee calculation, expense responsibilities, renewal and termination terms, and the implications of the Merganser sale.
- Confirm dividend coverage using recurring earnings rather than derivative fair-value movements, and monitor the company’s REIT qualification and related distribution requirements.