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Annaly Capital Management Announces Monthly Commentary for September

^{Published on 2010-09-10 14:35:36 - Market Wire}
 

NEW YORK--([ BUSINESS WIRE ])--Annaly Capital Management, Inc. (NYSE: NLY) released its monthly commentary for September providing 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.

"and major originators are also adding staff in the area of underwriters and loan officers."

The Economy

August economic data were weak, including initial jobless claims ticking up, retail sales less than robust, and nonfarm payrolls positive but still anemic. As expected, second quarter GDP growth was revised lower, to 1.6% from 2.4%, and Wall Street economists and strategists are slowly beginning to take down their expectations for future quarters.

At the annual Jackson Hole conference, [ Chairman Bernanke gave a speech ] that offered a pretty clear-eyed assessment of the recovery. Despite his acknowledgement that a[c]entral bankers alone cannot solve the worlda™s economic problems,a the markets viewed his remarks as dovish largely due to his conclusion that athe FOMC will do all that it can to ensure continuation of the economic recovery.a As for what the Fed could do in the event growth deteriorates further, he repeated much of what hea™s already said on the subject:

• Additional purchases of longer-term securities, otherwise known as the aportfolio balance channel,a which he suggested works best when financial conditions are poor and liquidity is tight (which is not the current situation).
• Modifying the FOMCa™s communication to say it would be akeeping the target for the federal funds rate low for a longer period than is currently priced in the markets.a This would presumably restrain long-term inflation expectations.
• Lastly, the Federal Reserve (the Fed) could lower rates paid on excess reserves held by banks at the Fed. They are currently paying 0.25% on these reserves, and ostensibly this would cause the banks to push these reserves out into the money supply by issuing new loans. The Chairman stated that the effect of a move like this would likely be negligible for the economy, but it could be disruptive to the money markets.

He went on to mention that some economists were calling for the FOMC to increase its inflation goals aabove levels consistent with price stability.a Bernanke went on to dismiss the idea, saying that there was no support from the committee and it would be an inappropriate action given his belief that inflation expectations were already areasonably well-anchored.a

He didna™t give any hints that they were ready to do anything further. What are the hurdles to further action? Will sub-par growth be enough, or does GDP growth have to turn negative? The Wall Street Journala™s fly-on-the-wall at the Fed, Jon Hilsenrath, wrote about an internal debate at the Fed about what (if anything) should be done going forward. In brief, the debate is about whether to do more now, or to wait and see how things develop and be reactive to future weakness as it arrives.

We believe the Fed is also worried about a deflationary scenario similar to Japan. Central bankers typically think of deflation (or too-low inflation) as being caused by a slump in aggregate demand, and they believe that they have several channels by which they can address it. The diagram, available in our [ online version ], is taken from a 2002 New York Fed paper entitled [ aThe Monetary Transmission Mechanism ].a It illustrates the classical model that central bankers usea"beginning with open market operations creating reserves in the banking system, and ending with aggregate demand.

The aportfolio balance channel,a as Bernanke called it in his Jackson Hole speech, is not on the diagram in our [ online version ]. According to Bernanke, the portfolio balance channel aholds that once short-term interest rates have reached zero, the Federal Reserve's purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public.a We saw how the Feda™s purchases of MBS and Treasuries sent buyers into other asset classes like investment grade and high yield corporates. If the diagram in our [ online version ] were updated to 2010, the portfolio balance channel would likely be squeezed in on the right side near the Monetarist channel. In any event, the bottom line is still aggregate demand, and the assumption is that higher aggregate demand will take care of a deflationary or excessively disinflationary scenario.

With this in mind, we read a speech delivered by Minneapolis Fed president Narayana Kocherlakota on August 17 to an audience at Northern Michigan University entitled a[ Inside the FOMC ].a It starts out as a professorial recitation of what a regional Fed president does every day, but towards the end Kocherlakota challenges the central banking tenet of reliance on the interest rate channel to target aggregate demand (emphasis is ours).

It is conventional for central banks to attribute deflationary outcomes to temporary shortfalls in aggregate demand. Given that interpretation, central banks then respond to deflation by easing monetary policy in order to generate extra demand. Unfortunately, this conventional response leads to problems if followed for too long. The fed funds rate is roughly the sum of two components: the real, net-of-inflation, return on safe short-term investments and anticipated inflation. Monetary policy does affect the real return on safe investments over short periods of time. But over the long run, money is, as we economists like to say, neutral. This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2% over the long run.

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? Ita™s simple arithmetic. Leta™s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25%. The only way to get that is to add a negative numbera"in this case, a"0.75%.

To sum up, over the long run, a low fed funds rate must lead to consistenta"but lowa"levels of deflation.

Bernanke said in his Jackson Hole speech that his goal, if necessary, would be to make the markets think that the Fed would keep rates low for longer than expected. Kocherlakota says that this prophecy will become self-fulfilling, becoming precisely the thing that will causedeflation, not simply prevent inflation. If ultra-low rates become entrenched, deflation is actually necessary for investors to reach their required rate of return on risk-free assets. This sounds exactly like Japan, where a deflationary mindset has become entrenched. This is part of the reasoning for committing to low short rates, but also including an inflation target or specifying a timeline for zero rates. Both would have the effect of keeping inflation expectations positively anchored if they began to turn negative. With the economy weakening again, the risk of deflation may be more real than the Chairman let on in his Jackson Hole speech.

The Residential Mortgage Market

For the week ending August 27, mortgage contract interest rates remained at historically low levels (conforming 30-year fixed rate mortgages averaged 4.43% while the 15-year conforming rate dipped to 3.88%). Prepayment speeds in August (September release) for 30-year Fannie Mae MBS increased 27% from the previous month, from 18.5 Constant Prepayment Rate (CPR) to 23.5 CPR. The 2008-2009 4.5% and 5% coupons in particular paid faster than expected; despite tighter underwriting standards applied to these loans, borrowers have been able to capture the rate incentives. Freddie Mac prepayments increased 32% in August to 32 CPR from 19.7 CPR in July, with the lower coupons paying faster than expected. The talk of a refinancing wave occurring seems to be aimed at the lower end of the coupon stack with the higher end remaining stagnant due to credit impairment or negative equity. Going forward, capacity constraints to refinancing activity are easing as originators are hiring. aSmaller and more nimble lenders have led the way so far,a write analysts at JP Morgan, aand major originators are also adding staff in the area of underwriters and loan officers.a

Everything is related in the mortgage market, and two other headlines hit the market recently that provoked market discussion. First is the news that the FHA is ramping up its previously announced program of ashort-refis,a where a lender has the ability to write down underwater mortgages and put them into the FHA. Loans held by Fannie Mae and Freddie Mac are not eligible. The efficacy of the program is in doubt for several reasons: it is only open to borrowers who are current, which lessens the attractiveness to lenders; participation is voluntary on the part of lenders; second-lien holders would have to cooperate and there is an inherent conflict because the largest second-lien holders also service the primary mortgage; and borrowers who benefit will nonetheless get hit in their credit rating. Like other government-instigated modification programs, the effects of this program are likely to be marginal at best. Morgan Stanleya™s research team estimates that while 1.5 million non-conforming borrowers may be eligible, just 20% to 40% would actually participate.

The other headline of note popped up on the [ front page of the New York Times ] on the day before Labor Day: aHousing Woes Bring a New Cry: Let the Market Fall.a The article points out that even as policymakers have exhausted many options to help housinga"tax credits, mortgage modification programs, foreclosure avoidance programs, direct assistance, government-backed mortgages and, of course, record-low mortgage ratesa"the housing market continues to suffer. The [ shadow inventory of homes for sale ] puts supply at a mammoth 26 months at current sales pace, the expiration of the housing tax credit was quickly followed by a dramatic slump in sales, and the re-default rate on modified loans remains high. The question for policymakers is the standard one: if there is strong evidence that a policy isna™t working, do you change the policy or double down? This particular article, penned by David Streitfeld, suggests that more market observers are coming to the conclusion that the best option for now would be to allow the market to find its clearing price.

The Commercial Mortgage Market

During August, the American Council of Life Insurers (ACLI) issued its Second Quarter 2010 Commercial Mortgage Commitments report. As we noted in our [ June monthly commentary ], the life insurance companies have been the primary source of debt capital for commercial real estate. Consequently, their pricing information and commitment volumes are illuminating in terms of asset allocation, pricing and strategy. This month we analyze the latest data to glean further insights.

In the June 2010 commentary, we reviewed the first quarter ACLI report and estimated that commercial mortgage spreads for newly originated loans would continue to tighten in concert with high-grade spread products. In fact our estimates were within 25 basis points (bps) of the amounts reported for the period, as depicted in the yellow dashed line (chart available in our [ online version ]).

Has the commercial mortgage spread compression abated or will there be further tightening? We anticipate that by the time we receive the third quarter ACLI report it will show further tightening, as depicted by the red dashed line (chart available in our [ online version ]). We come to this belief because one of the best proxies for relative value when pricing commercial mortgages is high-grade corporate bonds, both public and private. Structurally, the instruments share common ground. Many corporate bonds are issued with 5- and 10-year maturities similar to the favored durations for commercial mortgages. Both instruments are also call-protected, which enables a good match between assets and liabilities.

Another reason we expect to see further spread tightening is the rally in commercial mortgage rates that we noted. In the graph available in our [ online version ], we have plotted the reported commercial mortgage coupons to the amount of commitments made by insurance companies as reported by ACLI for the period ending June 30, 2010.

While the transaction volume has been relatively consistent, ranging from $1.5 billion to $2.1 billion per month, mortgage coupons have rallied 140 basis points over the same period. One could argue that competition from other sources caused the precipitous drop. Yes, excess money flows from fixed income investors attracted to the excess spread versus high grade corporate and commercial mortgages came into the market, but there was still little traction from CMBS conduit commitments. So why did the coupons drop? We believe the lack of new investable product steered the insurance companies into a position where they bid against themselves to gain business. A 6.5% mortgage may look really good one day, but 6.25% might look even better the next day.

The lower coupons, engineered by a price war among the various insurance companies, coupled with the rally in the super-senior tranches of CMBS, has led to signs of life in the CMBS conduit lending programs. Thus the insurance companies appear to be sowing the seeds of competition that will put further pressure on their mortgage coupons.

The Corporate Credit Market

One would think this golden age of fixed income would be more enjoyable. But many have been surprised by just how low yields have fallen this year. One attributing factor is the flood of new investor money into the sector, an almost daily press headline. This unprecedented technical overshadows an equally important fundamental force in the fixed income markets, the slower growth or outright contraction in investible product due to private sector deleveraging.

Bond indices show the most up-to-date snapshot of the big picture. As seen in the charts available in our [ online version ], the annual change in the dollar volume of outstanding bonds in different sectors of the Bank of America Merrill Lynch bond indexes is either decelerating or shrinking. The chart on the left (see [ online version ]) represents the big sectorsa" Treasuries, Mortgages, Investment Grade Corporates, and Agenciesa" which account for 90% of the domestic aggregate benchmark. The chart of the right (see [ online version ]) is the aalphaa or acore plusa sectorsa"ABS, CMBS, High Yield and Emerging Marketsa" which are commonly a source of outperformance to the benchmark. While the growth of net Treasury supply has exploded since late 2008, the growth in other sectors is either stagnant or shrinking. The exception is investment grade (IG), high yield (HY) and emerging markets.

With all the talk of corporate balance sheet deleveraging, the trend in the corporate credit sectors may come as a surprise. The net supply of IG and HY index-eligible assets has grown a respective 11% and 16% in the past year. There are several drivers to consider. First, firms are managing their liquidity very differently than in the past. This is partly in memory of the crisis-era problems with short-term funding and bank lines. Commercial paper (CP) outstanding for nonfinancial firms stands at a mere $128 billion, a far cry from peak balances of $350 billion in 2000. One has to wonder what ever happened to the old practice of using CP to manage short term variance in working capital. For domestic and foreign financial CP, balances now stand at $520 billion; this compares to an $854 billion peak in early 2008. Recent changes to money market fund guidelines which tighten the credit quality and maturity of fund holdings could bring these balances down further in the months ahead. Moreover, the rating agencies view of a financial firmsa™ liquidity changed in the crisis era. They like to see sufficient cash to pay off over 1.0x the bond maturities of the next 12 months. So dona™t count on those cash balances to fall. More broadly, it appears the in the aftermath of the crisis industrial and financial firms are both holding more cash and issuing more long-term debt, a strange barbell indeed.

IG and HY are growing for different reasons. The IG market is comprised of numerous multinational companies that spew massive amounts of cash. Many of these firms issue debt and buy shares to target optimal leverage. Alternatively, firms can use cash to fund acquisitions. The drivers of share repurchases and mergers stem from the fact that over the long run, excess liquidity can depress return on equity. As a result, there is a nominal component to the level of balance: as retained earnings grows so does debt outstanding (particularly at todaya™s relative prices). Simply put, it should grow with time.

The HY market is still undergoing acuresa that have supported gross issuance. Thanks to a very active August, year-to-date supply tallies to $128 billion. However, bond and loan refinancing reflect 61% of the use of proceeds. Thus, companies continue to pay down bank debt with less restrictive bond debt and extend maturities. The abonds for loansa explains part of the rise in debt bond supply. According to LCD, Standard & Poora™s leveraged finance research unit, the par amount of leveraged loans outstanding is 14% below the 2008 peak. But thata™s not the complete story. A couple of other factors are contributing to rising net HY supply: 1) M&A 2) special dividends; and 3) reemergence from bankruptcy. The first two forces relate partly to financial sponsors. Financing periods are closing which will force exits. Furthermore, as the Bush tax cuts sunset at the end of 2010 both dividend and capital gain taxes are likely to rise. Thus, sponsors are incented to engage in equity monetizations, such as recaps and special dividends, market conditions permitting. Already, $5.2 billion in equity monetization deals have been priced this year, the largest since 2006. We also expect more bankruptcy-exit-related financing as firms emerge from Chapter 11 or paydown previously issued exit-loan debt. In contrast to consumer debt where default represents a decline of net supply and the borrower will likely be shut out of the market for years, large cap companies re-emerge from bankruptcy and have capital markets access much sooner.

The corporate supply outlook is evolving. Some of new supply is recycled and some is fresh but it does not necessarily mean credit fundamentals are eroding. If the spread product market is starved for product, then this is a good thing.

The Treasury/Rates Market

The Treasury market had another unusually strong month in August. The difference was that longer maturities outpaced the rest of the curve and recouped some of their underperformance from previous months. Ten-year and 30-year rates rallied about 45 basis points while 2-years and 5-years were just 9 and 28 bps richer respectively. The sell-off in equities of about 5% on the month contributed to the price action, but a combination of a dovish Fed and softer economic data were supportive as well. The notion of the economy muddling forward with subpar growth became more firmly entrenched as did the belief that the Fed will not be raising rates any time soon. The Fed did nothing to dissuade investors from that belief when they announced at the conclusion of the August 10^th FOMC meeting that they would be reinvesting principal paydowns from their Agency MBS portfolio into U.S. Treasuries. The market was split on the reinvestment possibility, but the takeaway is that the bar for the next level of quantitative easing, commonly known as QE2, has been lowered.

While the Feda™s decision to reinvest portfolio paydowns aided the long end of the curve, the completion of the mid-August supply (3-years, 10-years, and 30-years) also improved the dynamic. On the month, the Treasury auctioned $176 billion of nominal notes and bonds. In summary, the auctions went well with few surprises: the auctions were all priced at levels that were close to market pricing at the time of the auction.

Going forward, the main question investors will ask themselves is what will push the Fed over the threshold of embracing further monetary stimulus. The market seems to be unanimous in the belief that the stimulus baton will need to be carried by fiscal activity. But there are still a handful of measures the Fed can implement to stoke the economy, perhaps in conjunction with fiscal stimulus, as discussed above. Of the three, it is the notion of QE2 that seems to have the most momentum, on the heels of the reinvestment decision. All eyes are on the economic releases to gauge whether we could see an announcement as soon as this fall.

In this context it makes sense to revisit the impact of the Feda™s announcement on Treasury rates at both stages of the first round of quantitative easing, or QE1. On November 25, 2008, the Fed announced its intent to purchase $100 billion in Agency debt and $500 billion in Agency MBS (we call it QE1a in the graph available in our[ online version ]). The impact on rates and the shape of the curve was immediate and sizable as can be seen in the chart in our [ online version ]a"the blue line is the 10-year yield and the red line is the spread between the 2-year and the 10-year, a proxy for the yield curve. When financial and economic conditions failed to improve, the Fed came back with a vengeance increasing the totals for Agency debt and MBS to $200 billion and $1.25 trillion, respectively, and adding $300 billion in Treasuries to the mix (QE1b). The initial impact was significant from the second round but concerns began to surface that the Fed was monetizing the debt of the government. In fairly short order the impact was reversed as investors took interest rates higher and the yield curve steeper.

This time around, the bar for more QE is undoubtedly high. Further, talk of debt monetization is low and the economic foundation for low yields and a flat curve seems rock solid. But it is worth demonstrating that the impact of further Fed purchases from here may not bring the desired effect.

September 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)696-0100

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.