ANNALY CAPITAL MANAGEMENT INC quarterly report, Q2 FY2010

Business Context and Reporting Period

Annaly Capital Management, Inc. is a REIT focused primarily on leveraged investment in agency mortgage-backed securities (MBS) and agency debentures. Its principal earnings source is the spread between investment income and financing costs; subsidiaries also provide investment-advisory and broker-dealer services. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2010. Balance-sheet comparisons are with December 31, 2009.

Financial Results and Key Metrics

Amounts below are U.S. dollars. The filing generally reports financial-statement amounts in thousands; figures are converted to millions or billions where indicated.

Metric	Q2 2010	Q2 2009	Six months 2010	Six months 2009
Interest income	$643.7 million	$710.4 million	$1,298.1 million	$1,426.4 million
Interest expense	$280.2 million	$322.6 million	$556.8 million	$701.2 million
Net interest income	$363.4 million	$387.8 million	$741.3 million	$725.2 million
Net income (loss)	$(218.2) million	$597.1 million	$62.8 million	$946.9 million
Net income (loss) available to common shareholders	$(222.9) million	$592.4 million	$53.6 million	$937.7 million
Basic earnings (loss) per common share	$(0.40)	$1.09	$0.10	$1.72

Q2 average asset yield was 4.16% and average cost of funds was 2.00%, producing a 2.16% net interest spread, compared with 5.04%, 2.57%, and 2.47%, respectively, in Q2 2009. Six-month net interest income increased despite lower yields, reflecting higher average asset and liability balances.
Q2 included a $593.0 million unrealized loss on interest-rate swaps, versus a $230.2 million unrealized gain a year earlier. For the first half, the swap mark-to-market loss was $709.8 million, versus a $265.8 million gain in 2009. The filing attributes most of the year-over-year net-income decline to this swing. Swap fair-value changes flow through earnings because hedge accounting was discontinued in 2008.
Q2 comprehensive income was $434.1 million, including $652.3 million of other comprehensive income, principally unrealized gains on available-for-sale securities. Such securities’ unrealized gains and losses generally affect equity, not earnings.
Six-month operating cash flow was $6.19 billion, investing cash flow was $(4.01) billion, and financing cash flow was $(3.35) billion; cash declined by $1.18 billion to $328.0 million. Operating cash flow includes substantial matched-book repo activity, so it should not be read as operating earnings.

Financial Position, Liquidity, and Capital

At June 30, 2010, total assets were $73.51 billion, including $69.42 billion of MBS and $2.39 billion of agency debentures. Total stockholders’ equity was $9.63 billion, compared with $9.55 billion at year-end.
Repurchase-agreement borrowings were $56.39 billion, up from $54.60 billion at year-end; reported leverage was 5.9:1 versus 5.7:1. Weighted-average repo borrowing cost, after swaps, was 2.09%; weighted-average remaining maturity was 163 days. Securities pledged as collateral had an estimated fair value of $60.7 billion.
Cash and cash equivalents were $328.0 million. Management reported 30 uncommitted repo lenders, said available borrowing capacity exceeded current needs, and stated that no repo margin calls had gone unsatisfied through quarter-end. The company nevertheless has no committed facility requiring lenders to renew repo financing.
In the first half, Annaly issued $600 million principal amount of 4% convertible senior notes due 2015, receiving approximately $582 million after underwriting expenses. The notes are convertible into common shares, subject to adjustment.
Annaly declared common dividends of $0.68 per share for Q2 and $1.33 per share for the first half. A $380.6 million Q2 dividend was payable July 29, 2010. Preferred dividends were also declared; the filing states required preferred dividends had been paid through June 30.

Material Changes and Management Commentary

MBS fair value rose to $69.42 billion from $64.81 billion at year-end; agency debentures rose to $2.39 billion from $915.8 million. The portfolio shifted further toward fixed-rate securities: fixed-rate principal was 81.32% of investment securities at June 30, versus 74.09% at year-end.
Average mortgage prepayment speed (CPR) was 32% in Q2 2010, versus 19% in Q2 2009. Management linked faster prepayments partly to Fannie Mae and Freddie Mac purchases of seriously delinquent loans from guaranteed pools. Faster prepayments accelerate amortization of the company’s substantial net MBS premium—$1.85 billion at June 30—and can reduce asset yields and net interest income.
The MBS portfolio had $2.59 billion of gross unrealized gains and $57.4 million of gross unrealized losses at June 30. Management said losses reflected market conditions rather than asset credit quality and reported no other-than-temporary impairment for the periods presented.
Annaly reported an average yield on investment securities of 4.16% in Q2 versus 5.04% a year earlier; management cited lower asset yields and faster prepayments. Funding costs fell, but not enough to prevent the Q2 net interest spread from narrowing year over year.
After quarter-end, Annaly issued 60 million common shares at $17.46 per share, with approximately $1.05 billion of proceeds reported before expenses; underwriters had an option for up to 9 million additional shares. This is a material post-period capital raise and potential dilution.
Management provided no specific earnings or dividend guidance. It described financial markets as showing signs of recovery but cautioned that outcomes depend on interest rates, yield-curve movements, prepayments, asset values, financing availability, regulation, and maintaining REIT status. It said it would continue considering strategic initiatives but gave no assurance any would be implemented.

Risks, Contingencies, and Unusual Items

Interest-rate and prepayment risk are central: management’s modeled parallel-rate shocks showed net interest income changing by +5.57% at a 75-basis-point decline and by −5.37% at a 75-basis-point increase. Modeled portfolio value, including swaps, changed +0.34% and −0.81%, respectively. The filing cautions actual outcomes may differ significantly.
Repo financing creates liquidity and collateral risk. Falling collateral values or faster prepayments may prompt margin calls or force asset sales; structured term repos include lender call options. Management’s confidence in access to financing is not a committed funding guarantee.
Interest-rate swaps had a negative fair value of $1.17 billion at June 30, with $25.46 billion notional. Counterparty default could also affect collateral recovery. Repo and swap values and the timing of swap-related earnings remain important sensitivities.
A receivable related to assets held by Lehman Brothers International (Europe) and affiliates remains subject to uncertain recovery. The company disclosed valuing certain assets believed held at affiliates at an 80% discount and gave no assurance of recovery.
The company disclosed ordinary-course legal claims that management did not expect to have a material effect. A possible Merganser earn-out in 2012 depends on performance targets; the amount was not determinable. Aggregate future lease commitments, net of sublease income, were $8.8 million.
Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter. It reported no material change to previously disclosed risk factors.

Important Facts for Investors to Verify

Reconcile Q2 and first-half earnings with the large noncash swap mark-to-market losses, and distinguish GAAP earnings from net interest income and OCI.
Track MBS yields, CPR, premium amortization, and the effects of agency delinquent-loan purchases on portfolio income.
Monitor repo leverage, maturity concentration, collateral coverage, lender access, and any margin calls; assess the risks of uncommitted financing and callable repo agreements.
Assess the effect of the post-quarter 60-million-share offering and potential overallotment shares on share count, equity, and per-share distributions.
Verify the terms, dilution potential, and cost of the 4% convertible notes, along with the sustainability of common dividends relative to taxable income and cash needs.
Follow swap exposure and fair value, Lehman-related recovery, and any updates to regulation, REIT qualification, or other disclosed contingencies.