ANNALY CAPITAL MANAGEMENT INC quarterly report, Q2 FY2009

Business context and reporting period

Annaly Capital Management, Inc. is a REIT that invests primarily in agency mortgage-backed securities (MBS), financed largely through repurchase agreements. Its subsidiaries also earn investment-advisory, service and broker-dealer fees. This Form 10-Q covers the quarter and six months ended June 30, 2009; comparisons below are to the corresponding 2008 periods unless noted.

Financial performance and position

Metric	Q2 2009	Q2 2008	Six months 2009	Six months 2008
Interest income	$710.4 million	$773.4 million	$1,426.4 million	$1,564.5 million
Net interest income	$387.8 million	$331.1 million	$725.2 million	$584.6 million
Net income	$597.1 million	$308.0 million	$946.9 million	$551.1 million
Net income per common share, basic	$1.09	$0.60	$1.72	$1.14
Net interest rate spread	2.47%	1.99%	2.29%	1.72%

Q2 average asset yield was 5.04% and average cost of funds was 2.57%. Interest income declined as asset yields and prepayment-adjusted returns fell, but lower funding costs more than offset the decline.
Reported Q2 net income included a $230.2 million unrealized gain on interest-rate swaps. The six-month figure included $265.8 million of such gains. These gains materially contributed to the year-over-year increase and followed the discontinuation of hedge accounting in late 2008.
At June 30, total assets were $68.3 billion, including $65.2 billion of MBS; total liabilities were $59.5 billion, including $51.3 billion of repurchase agreements. Stockholders’ equity was $8.7 billion. Cash and cash equivalents were $1.35 billion.
Repurchase agreements were $51.3 billion, up from $46.7 billion at December 31, 2008. Debt-to-equity was 5.9:1, compared with 6.4:1 at year-end; management’s stated usual target range is 8:1 to 12:1. Borrowings had a 2.54% weighted-average cost after swaps and 196-day weighted-average remaining maturity.
For the six months, operating cash flow was $4.07 billion, investing cash flow was negative $4.30 billion, financing cash flow was positive $670.3 million, and cash increased by $443.4 million. Operating cash flow includes substantial matched-book repo activity.
The common dividend declared for Q2 was $0.60 per share, or $326.6 million, paid July 29, 2009. The six-month common dividend was $1.10 per share.

Material changes versus prior comparable periods

Q2 net income rose $289.1 million year over year, while net interest income increased $56.7 million. The swap mark-to-market gain was the largest identified contributor to the earnings increase.
Q2 interest income fell $63.0 million year over year, as average MBS yield declined to 5.04% from 5.50%; interest expense fell $119.7 million as the average cost of funds declined to 2.57% from 3.51%.
For the first half, net interest income rose $140.6 million, while interest income declined $138.1 million and interest expense declined $278.6 million. Six-month basic EPS fell to $1.72 from $1.14? No: it increased to $1.72 from $1.14 as reported; common-share count also increased.
MBS fair value rose to $65.2 billion from $55.0 billion at year-end. Fixed-rate MBS principal was 68.9% of investment securities; adjustable-rate MBS principal was 31.1%. The portfolio’s weighted-average yield was 4.75%, down from 5.15% at year-end.
Average MBS prepayment speed was 19% in Q2, versus 16% a year earlier. Management cited increased foreclosure and refinancing activity; faster prepayments can accelerate amortization of the portfolio’s net premium.
Accumulated other comprehensive income increased to $1.36 billion from $252.2 million at year-end, chiefly reflecting unrealized gains on available-for-sale securities and swaps. These fair-value movements affect equity and book value.

Outlook, risks, contingencies and unusual items

No specific earnings, spread, dividend or portfolio-growth guidance is provided. Management says it continues to assess complementary strategies but gives no assurance any will be implemented. It says it limits asset growth to preserve unused borrowing capacity and liquidity.
Management identifies interest rates, yield-curve shifts, prepayment speeds, financing availability and terms, asset values, market liquidity, regulation and REIT qualification as key uncertainties. In its modeled parallel-rate scenarios, a 75-basis-point increase was associated with a 5.02% decline in projected net interest income; a 75-basis-point decrease was associated with a 1.35% increase. These are estimates, not forecasts.
The company had $19.8 billion of interest-rate swap notional at June 30. The swaps had a net unrealized loss of approximately $715 million in the contractual-obligations discussion; swap fair values and accounting treatment can cause earnings and equity volatility. Counterparty performance and collateral access are additional risks.
Management warns that lender disruption, falling collateral values or margin calls could raise funding costs, reduce liquidity or force asset sales. It reported no repo margin calls it could not meet through June 30 and said it had 30 uncommitted lenders, but these facilities are not committed funding.
Nearly all MBS were agency securities with actual or implied AAA ratings. The filing nevertheless highlights uncertainty around Fannie Mae and Freddie Mac, government support, mortgage-modification and refinancing programs, and the possible effects on guarantees, asset values, prepayments and spreads.
A $16.9 million receivable from Lehman Brothers International (Europe) was carried using the last account statement dated September 15, 2008. Recovery is uncertain; management had not determined a loss probable as of June 30.
The company early adopted new fair-value and impairment guidance; it reported no MBS losses deemed other-than-temporary. Routine legal matters were not expected to have a material effect. Merganser’s former owners may receive an unquantified earn-out in 2012 depending on performance.
Subsequent to quarter-end, the company reported $372.6 million lent to Chimera under reverse repos and $4.3 billion of repo agreements outstanding with RCap as of August 4. It also extended and expanded its New York office lease through December 2014.

Important facts for investors to verify

Separate recurring net interest earnings from the $230.2 million Q2 unrealized swap gain; review the impact of discontinued hedge accounting and future swap fair-value changes.
Assess financing concentration, repo renewal terms, collateral requirements, unused borrowing capacity and the ability to meet margin calls in stressed markets.
Track portfolio mix, asset yields, funding costs, net interest spread and prepayment speeds, particularly given the substantial net premium on MBS.
Verify the carrying value and eventual recoverability of the $16.9 million LBIE receivable, and monitor related-party exposures involving Chimera and RCap.
Evaluate dividend sustainability against taxable income, REIT distribution requirements, leverage and liquidity; the filing states that no minimum dividend is established.
Consider the sensitivity of book value and earnings to rate movements, agency guarantee changes, market liquidity and REIT or Investment Company Act compliance.