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Annaly Capital Management Announces Monthly Commentary for August

^{Published on 2010-08-10 11:25:40 - Market Wire}
 

NEW YORK--([ BUSINESS WIRE ])--Annaly Capital Management, Inc. (NYSE: NLY) released its monthly commentary for August which includes an update on developments in Washington as well as a review of the economy and the residential mortgage, commercial mortgage, corporate credit and Treasury markets. Through its monthly commentary and blog, [ Annaly Salvos ], Annaly expresses its thoughts and opinions on issues and events in the financial markets. Please visit our website, [ www.annaly.com ], to check out all of the new features and to view the complete [ commentary ] with charts and graphs.

"have a very modest impact on overall loss assumptions (and home price forecasts) due to the low expected eligibility."

Washington Update

Washington continues to dominate the attention of the financial markets. The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law on July 21. Rather than signaling the end of a long legislative process, the signing ceremony ushered in the beginning of a long regulatory rulemaking process. A lot of work remains to be done, with an estimated 243 rulemakings and 67 studies delegated to regulators. Much remains unresolved on many important items, such as the Volcker Rule requirements, swap business pushout rules, bank capital requirements, risk retention and which firms would be considered systemically important, so firms and participants are attempting to quantify the costs of compliance. Others are considering getting ahead of the regulators, i.e., reports on Goldman Sachs spinning out its principal trading teams and Morgan Stanley reducing its stake in FrontPoint Partners. This will continue to take time and effort by a wide range of constituencies, but it stands to reason that implementation will be limited until the rules are settled.

One item that is conspicuously absent from Dodd-Frank is GSE reform. We have no issue with its absence, as the tenuous state of the housing market precludes any serious change to the housing finance system at this time. Moreover, there is little activity in the American mortgage market outside of Ginnie Mae, Fannie Mae and Freddie Mac, with virtually no private label securitization taking place (due to uneconomic pricing and related rating agency policies). Nevertheless, the issue remains high on the agenda of policymakers and the discussion is in full swing. The Department of Treasury had requested public input on the housing finance system in the US, and received over 400 responses from a wide range of market participants. Annaly Capital Management [ submitted a response ], in which we made the following main points:

• The key to overhauling housing finance in America is to understand what was broken, then keep what worked and discard what didna™t.
• What did work? The current housing finance system (certainly the one that prevailed outside of the mortgage credit bubble) is the most efficient and scalable credit delivery system the world has ever seen.
  • Thanks to securitization, the government guarantee and the connection between primary mortgage borrower and secondary market investor that is facilitated by Fannie Mae and Freddie Mac. These are features worth keeping.
• What didna™t work? The Agenciesa™ retained portfolio activities and poor underwriting standards in the broader mortgage marketplace.
  • The private market can replace the portfolio activities as long as there is a dependable funding market, and policymakers should focus on incentivizing and enforcing robust underwriting practices for both rentals and homeownership.
• The market will adapt to whatever policy objective comes out of Washington, most likely by repricing the risk, uncertainty and friction of whatever replaces the current system. The consequences of change are that the size, scope, availability and efficiency of the current housing finance system will change as well. If the new system is significantly different than the housing finance system we have now, the consequences may be that our housing finance system will be smaller, perhaps more appropriately priced, but with lower housing values and less flexibility and mobility for borrowers.

Treasury has planned a conference on the topic to be held on August 17 (Annaly will be in attendance), and the House Financial Services Committee, which has already held a number of hearings, has called for its next one to be held in September. Treasury has pledged to have its proposal for housing finance reform complete by January 2011, so the process will undoubtedly pick up speed in advance of that deadline. Stay tuned.

The Economy

The data flow during the month of July painted a relatively weak picture of the economic recovery. Measures of consumer confidence declined, retail sales disappointed, durable goods orders softened, and the employment situation continues to frustrate us. Initial unemployment claims, though distorted recently by seasonal adjustment factors, remain stubbornly over the 450,000 line on average. Nonfarm payroll data for July was generally weak. A favorite leading indicator for the path of total jobs, temporary help, turned negative for the first time in nine months. The private sector added a total of 71,000 jobs, but the real story here is that state and local governments are shedding jobs at such a rate that they are offsetting much of these mild private sector employment gains. Besides the federal government shedding around 143,000 census jobs, state and local governments shrunk their payrolls by roughly 48,000. Since September 2008, state and local governments have cut 316,000 jobs, with more than half of those in the last seven months alone. Ongoing budget issues at the state and local government level suggest this will continue to be a headwind.

If, as it appears, the effect of fiscal and monetary stimulus is fading, it is no surprise that the baton is being passed to the Federal Reserve. Throughout its history, the Federal Reserve could respond to economic weakness by lowering short-term rates. But with the Federal Reserve Funds rate effectively at zero, Chairman Bernanke & Co. have moved down the checklist of alternative policy moves outlined in his seminal [ deflation speech ] back in 2002, most of which are related to the Federal Reserve balance sheet. As the graph, available in our [ online version ], demonstrates, the structure of the balance sheet accommodation has changed over time, as the needs of the system and the Federal Reservea™s goals have changed.

Early in the financial crisis, Federal Reserve efforts were devoted to stopping the bleeding, providing liquidity to those who needed it, and helping markets function. The aOthera line above represents line items like the commercial paper funding facility, liquidity swaps, and the holdings of the Maiden Lanes, Aurora LLC, and ALICO Holdings. Later the focus shifted to asset purchases, primarily of Agency MBS. As this $1.25 trillion flowed through the markets, and in conjunction with various financing facilities (TALF, etc), spreads tightened in every sector. Given how wide credit spreads were at the time, this strategy was justifiable. Spreads that wide crimp borrowing and serve as a drag on the economy. This is a new kind of Federal Reserve policy: If borrowing rates dona™t follow the Federal Reserve Funds rate down, the Federal Reserve can use its balance sheet in a variety of ways to make it happen. This requires a new type of analysis by the Federal Reserve (and Fed-watchers) to expand beyond rates and spreads to take into account the actual borrowing levels both from banks and the capital markets. This means we should be watching money supply.

Whether or not the Federal Reserve is actually paying attention to money supply, it is behaving as if it were watching the money supply. This is what we read between the lines in articles like the recent [ Wall Street Journal article ] touting a possible asymbolic shifta in Federal Reserve balance sheet management to reinvesting cash flow from the existing portfolio of Treasuries and mortgage-backed securities. Thanks to this runoff, the balance sheet at the Federal Reserve has recently begun to shrink, as can be seen in the graph in our [ online version ]. There is much debate over how this run-off will be handled, and we believe the market is prepared to adapt to whatever the Federal Reserve decides to do. The fact of the matter is that a shrinking asset portfolio at the Federal Reserve is a de facto tightening. With a sub-3% 10-year Treasury, mortgage rates at historic lows, Target Corp (TGT) able to borrow for 10 years near 4%, and IBM selling one-year paper at 1%, Federal Reserve policy is more likely focusing on money supply than rates. When the Federal Reserve buys assets, it creates reserves at banks. In normal times, the banks would then take those reserves and lend them out, putting that new money out into the economy. This is the relationship that the money multiplier shows. But the problem for the Federal Reserve is that it controls the monetary base (including reserves) but it doesna™t control broad money supply. The normal mechanism isna™t working, excess reserves are sitting at the Federal Reserve, and loan portfolios at the banks continue to shrink. The Federal Reserve needs a new playbook.

The Residential Mortgage Market

The month of July ended with contract mortgage rates remaining at historically low levels, as 30-year fixed-rate conforming mortgages averaged 4.60% and 15-year conforming rates dipped to 4.03%. Despite such low levels, prepayment speeds excluding the GSE delinquency buyouts have yet to gain any traction. Prepayment speeds (measured as Constant Prepayment Rate, or CPR, which is the percentage of principal that is returned on an annualized basis in a given month), in June (July release) for 30-year Fannie Mae MBS dropped 38% from the previous month, from 28.1 CPR to 17.5 CPR, as their buyout program came to an end. Freddie Mac, whose buyouts were completed back in March, reported speeds 19.4% faster, up from CPR of 14.4 to 17.2. Speeds in July (August release) for 30-year Fannie Mae MBS increased 6% to 18.5, while Freddie Mac speeds for the month increased 14.5% to 19.7.

If refinancing behavior were based on rates alone, then prepayment speeds would normally be much faster. Consider the graph, available in our [ online version ], courtesy of Barclays research. During most of the past decade, the CPR of borrowers who are 100 basis points ain the moneya for a lower rate was about 50 to 60. In other words, from 2000 to 2008 50% to 60% of borrowers who had the opportunity to lower their mortgage rate by 100 basis points would have refinanced. In 2009, however, only 20% to 25% of borrowers who are 100 basis points ain the moneya took advantage of the lower rate, behavior that is more common when there is no particular rate incentive at all. In past commentaries we have reviewed the reasons why refinancing behavior currently is atypically slow, so suffice it to say that we expect refinancing speeds will stay this slow until banks regain their footing, negative equity issues are resolved or credit trends generally improve.

Which brings us to the latest chatter in the residential mortgage space: There has been speculation that the government is planning to break this refinancing logjam by eliminating all underwriting standards such as income verification, FICO requirements and LTV restrictions and quickly refinance all GSE-owned mortgages down to current mortgage rates. The speculation picked up speed after it was suggested as a possibility by some Street research and picked up by reputable news sources. In general the market barely blinked at the story, but the Treasury took the unusual step of refuting it. aThe administration is not considering a change in policy in this area,a said Treasury spokesman Andrew Williams. We can see the attraction of the simple outline of the rumor: Instant stimulus without needing Congressional approval, a win-win for a party facing a tough mid-term election. In any event, there are already plans like this in place under HAMP and HARP.

Leaving aside the moral hazard involved (the lender has no responsibility under a mortgage agreement to protect the downside risk of home prices falling just as the homeowner has no obligation to share any upside with the lender), the rumored plan doesna™t hold water. First, the potential savings amountsa"about $46 billion per year, according to the economics team at Morgan Stanleya"is not insignificant, but it is not without cost. The actual process of refinancing itself would constitute a large capital call on banks needing to refinance the mortgages. Furthermore, to the extent that Fannie Mae and Freddie Mac are taking steps to protect taxpayersa"through putting back mortgages that were improperly underwritten or suing issuers of fraudulent private label securitiesa"a refinancing program like this would completely undermine that effort. If there are no underwriting standards as part of a refi/stimulus plan under the GSE umbrella, the government would essentially be guaranteeing unknown collateral. This idea is nothing more than an interesting hypothetical thought exercise.

On August 6 the FHA released more details on a previously announced program to facilitate short refis into an FHA loan. The program, said FHA Commissioner David Stevens, is a alifeline out to those families who are current on their mortgage and are experiencing financial hardships because property values in their community have declined.a Starting Sept 7, 2010 the FHA will offer certain non-FHA borrowers the opportunity to qualify for a new FHA-insured mortgage as long as they are FHA eligible and their lenders agree to write off at least 10% percent of the unpaid principal balance of the first mortgage. Importantly, participation is voluntary by the lender. Barclays concluded the program will affect private-label securities but estimates that the program will ahave a very modest impact on overall loss assumptions (and home price forecasts) due to the low expected eligibility.a

The Commercial Mortgage Market

Slowly, multi-borrower, mixed collateral CMBS transactions have been getting some traction since the late spring. To date, three transactions totaling $1.8 billion have been sold. The two most recent of these, one sponsored by JP Morgan Chase (JPMCC 2010-C1) and the other by Goldman Sachs (GSMS 2010-C1), included below-investment grade bonds at the bottom of the capital stack. Aside from the usual questions on pricing levels and collateral quality, investors have also focused on new control rights and actions for certain certificate holders. This month, wea™ll examine highlights of some new control features in these transactions.

As previously reported in our February 2010 commentary, an investor in the lowest-rated certificatea"provided the certificate had a least 25% of its initial face amount outstandinga"was the Directing Certificate Holder who was responsible for approving special servicer recommendations. Unrealized losses had no impact on the certificates. Once a certificatea™s balance was wiped out through realized losses, however, the Directing Certificate Holder rights were passed on to the next class outstanding. An unintended consequence of these structures was the potential to anoint investors in very, very thin bond tranches as the Directing Certificate Holder. This potential outcome led investors to the calculus of which tranche would be the afulcrum bonda™ of the deal in different scenarios, thereby enabling that tranche to become the Directing Certificate Holder.

New control features were introduced in June with the JPMCC 2010-C1 transaction that had elements of the existing CMBS structures. First, approval rights would initially be granted to the B piece buyers. Thus, change of control abilities would be established at the outset and limited to subordinate investors. Second, a change of control occurred not only with realized losses but with unrealized losses through appraisal reductions as well. The latter mechanism enabled the removal of zombie entities that had no further economic upside by holding the position. Finally, a aControl Eventa™ concept was introduced which meant that if losses, realized and unrealized, wiped out the initial B piece buyers and junior participants then a new Directing Certificate Holder would then be selected by senior certificate holders. This mechanism clearly aligned the remaining economics of the deal with the senior certificate holders, the majority of which would be AAA.

In late July, the GSMS 2010-C1 transaction introduced another significant change-in-control feature. Simply, the most junior investor no longer had the ability to appoint or direct the actions of a special servicer in the event a loan went bad. From the outset, this right was conveyed to the most senior certificate holders who are the largest investors in a deal. Also a deal website that provides the status and updates on specially serviced loans was provided. Given changes that senior certificate holders have been recommending to revamp CMBS structures, this was certainly a win for them. However, as we have noted before, working relationships are not always as smooth as envisioned.

To us, these changes reflect the balance of power in CMBS securitizations. First, structurers are clearly listening and reacting to investorsa™ concerns about control features and special servicing, as worst-case outcomes have pushed the envelope of the traditional structures and found them wanting. Of course, time will tell whether these new control features represent a better solution for dealing with problem loans and the resultant conflicts. Second, there is significant demand for the higher yielding opportunities of the mezzanine and junior tranches. Perhaps the new features are no more than a solution to the difficulty in placing AAA bonds yielding below 4%.

The Corporate Credit Market

Risk appetite has returned to the corporate credit market. Several catalysts underpin the change. First, the European bank stress tests proved to be a relative nonevent as only a handful of institutions tested were deemed undercapitalized in the stress scenarios. Second, US financial regulatory reform was finally signed into law by President Obama. Third, the BP oil spill appears to now be under control and firms affected have a better handle on the cost of the disaster and are prepared to take action. And fourth, the Q2 2010 earnings season is shaping up without a hitch. Hence, with certain fears allayed or at least defined, aliquiditya has once again become the driving force behind valuations.

Moving in sympathy with the Treasury market, investment grade corporate yields have dipped to a historic low of 3.94%, based on Bank of America Merrill Lyncha™s index (see graph in our [ online version ]). Declining yields have propelled 2010 total returns to an impressive 8.3% year-to-date. But todaya™s low yield underscores the increasing risk asymmetry of the asset class going forward. Average dollar prices have climbed to a lofty $110.20 and the effective duration of the market has is now a record long of 6.42 years. Increasingly, a aJapan Scenarioa is embedded in pricing.

Investment grade spreads are now at their annual tights, having fully retraced the Spring sell-off. Q2 earnings revealed that banksa™ top-line revenue was sluggish, but overall earnings were buoyed by reserve release, providing more evidence of managementsa™ belief that the cyclical peak in credit losses has passed. Moreover, several banks stated intentions to spin off certain lines of business, proactively addressing the Volcker Rule. Improving balance sheet credit quality and lower risk-taking are good things for bank credit and spreads narrowed accordingly. Issuers satisfied improved investor demand by selling new paper, propelling 2010 supply in the financials category to over $100 billion, an 80% year-over-year increase in volume.

Further down the credit spectrum, the high yield sector has performed in-sync with its investment-grade counterpart. This yeara™s returns are pacing at 8.4%, compared to equitiesa™ 1%. Declining default losses are supporting the sector. The default rate continues to march lower, dropping to 5.5% vs. the cycle peak of 13.5% last November. Moodya™s recently lowered its year-forward default expectation to a mere 1.8%. To put this rate of loss number in a return context, at current market pricing it translates into an implied one-year excess return of 7.5% assuming a 40% recovery rate. Contributing to lower default expectations is capital markets liquidity. Namely, the new issue market has once again reopened, allowing issuers to roll short-term debt and exchange bank debt for longer-term bond debt. Furthermore, high yield companies are deleveraging; debt leverage has declined a quarter of a turn (0.25x) to 4x for companies in Morgan Stanleya™s high yield universe over the past two quarters. The technicals of the high yield market are also stable; fund flows have marked their fourth straight inflow week after the springa™s net outflow period.

In contrast, flows into leveraged loans mutual funds have lost their robust start-of-year momentum. Over the past two months, the annualized pace of inflows has dropped by over 50%. One of the biggest drivers of this change is likely changing perceptions of the path of LIBOR, the rate on which most leverage loans are indexed. Increasingly, the tepid nature of the expansion and the likelihood that the stickiness in the high unemployment rate is due to structural factors has fostered a growing perception that the Federal Reserve funds rate will remain at 25 basis points for the next couple of years, keeping a low tether to LIBOR. The effect on income for loan product has been depressing: at 4.25% YTD total returns are running half of those of high yield bonds.

The Treasury/Rates Market

The Treasury market seemed unstoppable in July as prices marched higher and yields fell. Even a rally in stocks off their lows of the year and a move higher in other ariska assets couldna™t push Treasury prices lower as increased talk of a Japan-like deflation scenario started to seep into the market. The two-year Treasury reached an all time low yield for a second month in a row with a rate of .55% on July 30. It has since briefly breached the half-percent mark.

The Treasury sold $173 billion in notes and bonds in July, down $5 billion from June. Demand at auction time was varied across maturities. The three-year, seven-year, and 10-year note auctions saw tepid end user demand as indirect and direct bids were on the weaker side. Demand was stronger in the two-year note and 30-year bond auctions as bids were more consistent with previous auctions. The five-year note auction was the best of the month as end-user demand was particularly strong with combined indirect and direct bids totaling 58.7%, the strongest since April.

The strongest demand in the market in July was focused in the five- to seven-year sector of the Treasury curve. One of the main reasons behind the buying continues to be Federal Reserve maintaining the aextended perioda language in FOMC statements; market players thus are emboldened to take advantage of the yield roll down that part of the curve. Secondly, as mentioned earlier, economists (most notably St. Louis Federal Reserve president James Bullard) have started to compare the current rate environment in the US to Japan in the late 1990s when the Bank of Japana™s policy moves did little to prevent a deflation scenario.

In Chart 1, available in our [ online version ], we see the yield on the 5-year JGB since 1995 along with Japan CPI figures. You will see how yields dipped below 1.5% in 1997 and have yet to move above that level (Yields are currently under .40%). Chart 2, available in our [ online version ], shows the same data for the 5 year UST Bond where yields are approaching the same 1.5% level which is one reason for the Japanese deflation talk that has become so prevalent lately.

We will know more in five years whether the US is following in the footsteps of Japan. Yields have been steadily moving lower since April and all eyes will be on the Federal Reserve for clues on what tools they choose to use to manage the situation.

August 10, 2010

Jeremy Diamond*
Managing Director

Robert Calhoun
Vice President

Frederick Diehl
Vice President

Mary Rooney
Executive Vice President

*Please direct media inquiries to Jeremy Diamond at (212)696-010

This commentary is neither an offer to sell, nor a solicitation of an offer to buy, any securities of Annaly Capital Management, Inc. (aAnnalya), FIDAC or any other company. Such an offer can only be made by a properly authorized offering document, which enumerates the fees, expenses, and risks associated with investing in this strategy, including the loss of some or all principal. All information contained herein is obtained from sources believed to be accurate and reliable. However, such information is presented aas isa without warranty of any kind, and we make no representation or warranty, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use. While we have attempted to make the information current at the time of its release, it may well be or become outdated, stale or otherwise subject to a variety of legal qualifications by the time you actually read it. No representation is made that we will or are likely to achieve results comparable to those shown if results are shown. Results for the fund, if shown, include dividends (when appropriate) and are net of fees. ©2010 by Annaly Capital Management, Inc./FIDAC. All rights reserved. No part of this commentary may be reproduced in any form and/or any medium, without our express written permission.