Annaly Capital Management, Inc. — Q2 2012 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2012. Annaly is a mortgage REIT focused principally on leveraged investments in agency mortgage-backed securities (MBS), financed largely through repurchase agreements. Its subsidiaries also provide investment-management, broker-dealer, warehouse-financing and other services. Figures below are in U.S. dollars; financial statement amounts are generally shown in billions unless stated otherwise.
Financial performance and position
| Metric | Q2 / June 30, 2012 | Comparison |
|---|---|---|
| Interest income | $886.3 million | Down from $957.1 million in Q2 2011 |
| GAAP net interest income | $719.9 million | Down from $843.7 million in Q2 2011 |
| Economic net interest income, including swap payments | $497.9 million | Down from $627.0 million in Q2 2011 |
| Net interest rate spread | 1.54% | 2.45% in Q2 2011 |
| Net income (loss) | $(91.2) million; $(0.10) basic and diluted per common share | $120.8 million; $0.14 per share in Q2 2011 |
| Comprehensive income | $555.7 million | $1.161 billion in Q2 2011 |
| Common dividend declared | $0.55 per share | $0.65 in Q2 2011 |
| Total assets / stockholders’ equity | $128.3 billion / $16.3 billion | $109.6 billion / $15.8 billion at Dec. 31, 2011 |
| Repurchase agreements | $96.8 billion | $84.1 billion at Dec. 31, 2011 |
- For the first half, net income was $810.6 million, or $0.82 basic EPS, versus $820.7 million, or $1.03, in the first half of 2011. Economic net interest income fell $149.3 million; higher realized securities-sale gains partly offset the decline.
- Q2 annualized return on average equity was negative 2.26% (versus positive 3.60%); first-half return was 10.13% (versus 13.39%).
- Average interest-earning asset yield fell to 3.04% from 4.04% year over year. The average cost of interest-bearing liabilities, including swaps, declined to 1.50% from 1.59%, but the lower asset yield drove spread compression.
- Agency MBS fair value was $118.5 billion, up from $104.3 billion at year-end. The portfolio’s weighted-average yield was 3.17%; its net premium was $4.46 billion. Average CPR was 19% in Q2, versus 11% a year earlier.
- Debt-to-equity was 6.0:1, up from 5.4:1 at year-end; management stated an expectation to keep the ratio below 12:1. Repurchase agreements had a 0.59% weighted-average stated rate and 205-day weighted-average remaining maturity; the reported all-in borrowing cost, including swaps and convertible notes, was 1.58%.
- Cash and cash equivalents were $924.4 million; reverse repurchase agreements were $2.0 billion. For the first half, operating cash flow was $3.69 billion, investing cash flow was $(12.12) billion, financing cash flow was $8.36 billion, and cash declined $69.8 million to $924.4 million. Operating cash flows include substantial securities-financing activity.
Material changes and unusual items
- Q2 net loss principally reflected unrealized losses on interest-rate swaps and interest-only Agency MBS. Swap unrealized losses were $611.2 million; interest-only MBS unrealized losses were $26.1 million. These fair-value movements are distinct from the recurring net interest spread.
- Annaly sold $5.7 billion of Agency MBS in Q2, recognizing a $94.8 million net gain; first-half sales were $10.9 billion with $175.1 million of gains.
- In May, the company issued $750 million principal amount of 5% convertible senior notes due 2015, receiving approximately $727.5 million net proceeds, and issued 12 million Series C preferred shares at a 7.625% dividend rate, receiving $290.5 million net proceeds. The notes increased convertible-note principal outstanding to $1.35 billion.
- All outstanding Series B convertible preferred shares were converted into common stock during the first half. Annaly also authorized an at-the-market program permitting sales of up to 125 million common shares; no shares were sold under it in Q2.
- Accumulated other comprehensive income was $3.41 billion at June 30. Agency MBS unrealized losses totaled $124.7 million; management attributed these to market conditions, said the securities were not other-than-temporarily impaired, and stated it intended and expected to be able to hold them for recovery.
Outlook, risks and contingencies
- No specific earnings, spread, dividend or balance-sheet guidance was provided. Management said spread compression could continue with declining asset coupons, higher acquisition prices, faster prepayments or higher funding costs. It expected swap pay rates to decline as higher-rate swaps mature or are replaced.
- Interest-rate, yield-curve and mortgage-prepayment movements are central risks. Management’s sensitivity model estimated that a parallel 75-basis-point rate increase would reduce economic net interest income by 3.91% and portfolio value by 0.57%; a 75-basis-point decrease would increase them by 4.54% and 0.22%, respectively. Management cautioned actual outcomes could differ significantly.
- Repurchase financing and collateral requirements create liquidity and refinancing risk. At June 30, pledged collateral was $102.2 billion, the weighted-average repo haircut was approximately 5%, and the excess collateral cushion was approximately $5.4 billion. The company reported no unsatisfied repo margin calls through quarter-end.
- Interest-rate swaps had a $2.82 billion net fair-value liability. Certain swap agreements permit termination following specified events; the filing estimates approximately $2.9 billion, including accrued interest, could be payable upon termination for relevant contracts, and says this amount was fully collateralized.
- Exposure to 12 European-domiciled counterparties or their U.S. subsidiaries was reported at $1.77 billion, or 1.38% of total assets. The company did not use credit default swaps to hedge this exposure and warned European financial stress could adversely affect financing and operations.
- Annaly reported compliance with REIT requirements and the Investment Company Act exemption it relies on. It noted the SEC was reviewing interpretive issues concerning the exemption; potential outcomes and timing were unclear. Loss of REIT status or the exemption could materially affect the business.
- Management said ordinary-course legal matters were not expected to have a material effect and no accrual was required. There were no material changes to the risk factors in the prior Form 10-K. Disclosure controls were judged effective; no material change in internal control over financial reporting was reported.
Important facts for investors to verify
- Whether asset yields and net interest spread continue to decline, and how that affects earnings and the common dividend.
- Current prepayment speeds, premium amortization, and the sensitivity of earnings to mortgage rates and refinancing activity.
- Repo renewal terms, collateral haircuts, available borrowing capacity, margin-call exposure and counterparty concentration.
- Swap portfolio economics, collateral and termination provisions, and the difference between cash swap payments and reported fair-value losses.
- Potential dilution and financing costs from convertible notes, preferred stock and the authorized common-share distribution program.
- Changes in REIT qualification, the Investment Company Act exemption review, and any subsequent legal or regulatory developments.