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Annaly Capital Management Releases Monthly Commentary for October, Providing a Review of the Economy and the Residential Mortga

^{Published on 2010-10-08 17:21:44 - Market Wire}
 

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

"Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability."

The Economy

September was a big month for the stock market, with the S&P 500 up nearly 9%. Treasury yields ended the month near where they started. Incoming economic data indicated moderating growth (from an already low level), and low inflation (0% month-over-month growth in core CPI, less than 1% year-over-year). Not surprisingly, the FOMC made no adjustment to the target rate on September 21, although this is no longer the main story in FOMC statements. The statement is now scrutinized for the Feda™s intentions regarding the more unconventional aspects of its policymaking. In this statement, the Fed tipped its hand on inflation. aMeasures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability.a With these words, investors are assuming another round of balance sheet expansion is near and the reasons for such a move have been well-telegraphed: the recovery is too weak to turn around the jobs picture, so a zero interest rate policy (ZIRP) and balance sheet expansion (QE) will lower borrowing costs for the economy and spur investment, growth and inflation. There are, of course, dissenters to the wisdom of such a move, and their arguments are also in the market: the unemployment rate problem is structural and therefore unresponsive to lower long-term rates, the language and signaling could actually drive inflationary expectations even lower, and QE2 will not be as effective as QE1 because rates are already so low and markets are functioning relatively well.

Here we will add a few things to consider.

Brian Sack, head of the New York Feda™s market group, says aBalance sheet policy can still lower longer-term borrowing costs for many households and businesses.a When QE forces down Treasury yields, aall long-term yields fall, and so firms should be more willing to undertake long-term capital expansions or hire permanent employees,a says Naryana Kocherlakota, president of the Minneapolis Fed. This idea is taken as a given, even though the economic impact hasna™t actually happened yet. Corporations remain hesitant to expand and hire, despite significantly lower borrowing costs. Milton Friedman developed a theory called the Permanent Income Hypothesis which stated that consumers will determine their consumption based on their long-term income expectations, not current income. This means that temporarily high current income will be disproportionately saved and not spent. We would suggest there should be a corollary for corporations called the Permanent Cost of Capital Hypothesis: corporations will base their long-term investment decisions on their long-term cost of capital expectations, not just their current cost of borrowing. This means that temporarily depressed borrowing costs will disproportionately be used for refinancing existing debt and not used to justify new investment. At some point this will change, at least that is the hope of the doves.

The ultimate goal of ZIRP and QE is to stimulate debt growth and thus aggregate demand, but as wea™ve discussed [ elsewhere ], debt is already too high and is likely to continue to come down. Monetary policy strategies whose aim is to increase borrowing are likely to be less successful than hoped. Just ask Japan; theya™ve been trying for years. Most of the focus on Japanese debt goes to Japanese Government Bonds (JGBs), where government debt to GDP is approaching 200%. However, household and nonfinancial corporate sector debt growth has corresponded much more tightly with GDP growth, and this measure of debt growth peaked out in 1989 along with Japana™s equity and property bubbles, and began to shrink in the mid 1990s, as can be seen in the chart in our [ online version. ]

Government debt growth picked up in an attempt to offset this falloff in private debt, to no avail. It appears that we are in a similar situation here in the U.S. It was reported yesterday that consumer credit fell $3.3 billion in August, and now stands $168 billion below its 2008 peak. The vast majority of this drop has been from revolving credit card debt, a serious change of consumer behavior. The chart, available in our [ online version, ] shows household and nonfinancial corporate debt in both the U.S. and Japan, lining them up with their respective peaks. The graph, available in our [ online version ], is more than a little suggestive, but we believe ita™s something worth thinking about.

A word on the graph (available in [ online version ]): The data above are not directly comparable: the U.S. data looks at all credit market debt, while the Japan data is only loans. The Japanese peak occurred in 1995 and the US peaked in 2008. The chart only shows through the end of 2009 for the U.S., and debt has come down a further $145 billion through the first two quarters of 2010.

The simple truth, however, is people and companies respond to incentives, and they are currently being heavily incentivized to borrow. The FOMC may yet be successful at spurring debt growth, but wea™ll have to wait and see.

The Residential Mortgage Market

September prepayment speeds (October release) for 30-year Fannie Mae mortgage-backed securities increased 6% from the previous month, from 23.5 to 24.9 Constant Prepayment Rate (CPR) while Freddie Mac 30-year prepayments inched 9% higher to 28.3 CPR. In Fannie Mae space, the lower coupon stack (4s and 4.5s) experienced higher CPRs again, increasing 15% to 8 CPR and 21 CPR, while 5s were up 10% to 29.8 CPR. Clearly, borrowers who were underwritten to the newer tighter guidelines are able to take advantage of these historically low rates, while, in contrast, older vintages like 6.5s actually slowed down 4% to 22.4 CPR. Freddie Mac also experienced the similar coupon stack story as Fannie Mae with 4s up 23% to 12.7 CPR, 4.5s up 18% to 24.6 CPR and 5s up 11% to 32.9 CPR while 6.5s were unchanged at 24.7 CPR.

The release of this prepayment report eased a lot of the marketa™s fear surroundingthe call risks associated with mortgages, even as we continue to enter historically low interest rate environments, since speeds remain mild given the move in rates. The latest MBA mortgage index release for October 1 confirms the limited activity in the mortgage market. Mortgage applications were down for a 5^th straight week even with the lowest mortgage rates on record (4.25% for 30-year mortgages and 3.73% for 15-year mortgages) and the MBA purchase index has been steadily trending lower. The reasons for the low turnover remain the same: tighter credit standards, negative equity, and capacity constraints. Further adding to the malaise is the news during the month that further stalling of the foreclosure process is coming due to a wave of litigation related to the mishandling of foreclosure documents by major banks. Most of these issues stem from missing and mismanaged mortgage documents by banks not validating the accuracy of the foreclosure affidavits being sent to the homeowners. Attorneys General from several states are filing their own suits. This will slow the already snail-like pace of homes moving through the foreclosure process, which will have the near-term effect of keeping REO inventories lower than they would otherwise have been, and possibly keeping home prices higher. However, the long-run effect will be to delay the release of the growing shadow inventory, possibly increasing loss severities, and delaying the eventual recovery in the housing market. In the end, this story will likely garner plenty of headlines in the coming weeks and while we expect no immediate effect on Agency MBS, we remain aware of the changing landscape.

Finally, proving that some ideas never die, this month Rep. Dennis Cardoza (D-CA) reintroduced the HOME ACT. This program is essentially the same as all of the other insta-refi plans that wea™ve previously discussed over the past few months, with the same low probability of getting implemented. One of the structural problems in the U.S. economy today is low housing turnover, and therefore low worker mobility. One unintended consequence (among many) of insta-refi plans is that housing turnover and worker mobility would surely freeze even more if everybody is handed a mortgage at what could be a lifetime low of 4%.

The Commercial Mortgage Market

CMBS market participants are finally nearing an answer to the question that had been foremost in many minds: who would control Stuyvesant Town/Peter Cooper Village, given the default on the first mortgage? Or, in the specific case brought to the New York State Supreme Court Appellate division, could a subordinate debt holder foreclose on an asset that is in default without paying off the senior debt instruments? The subordinate note holder does not have any rights to the collateral until the senior debt is made current. In the event that the commercial mortgage collateral underperforms, the subordinate investor has the option of keeping the investment current by injecting capital or walking away. In the case of Stuy Town, since the senior loan, or first mortgage, had been accelerated the subordinate note holder would have to bring the transaction current. This would entail writing a check for some $3.6 billion. With this hard truth, we wonder why the scramble for control and ownership of Stuy Town still garners headlines.

The answer is that aside from the fact that it is the poster child of the frothiness that enveloped the commercial real estate market, Stuy Town remains a viable property. Even with an attached bill of $3.6 billion, the average indebtedness equates to approximately $353 per square foot or $320,000 per unit. Those who know the New York City residential real estate market recognize that if the units were priced at that level, they could sell themselves. On October 1 Bloomberg News reported that aManhattan apartment sales jumped 19% in the third quarter from a year earliera and athe median price of co-ops and condos that changed hands increased 7.5% to $914,000a.a However an acquisition strategy of Stuy Town that is predicated on removing 11,000 units of rent controlled apartments to facilitate a co-op conversion would probably be met with strong opposition by city officials.

So while some life returned to New York residential sales, no doubt driven by very low residential mortgage rates, the Moodya™s/REAL composite commercial property index trended down in July by 3.1% and is 43.2% off the highs recorded in October 2007 (see graph in [ online version ]).

The index, which charts periodic same-property round-trip investment price changes, is occasionally maligned for lacking a sufficient amount of transactions to generate meaningful data. In fact the total number and dollar amount of sales transactions both declined in July. Moodya™s reported that there were 119 repeat sales totaling $1.35 billion-compared to 153 transactions totaling $2.1 billion in June 2010. We can speculate and make excuses about the lighter activity but maybe it is still a case of the bid-ask being too wide.

So with the index bouncing along what appears to be near or at the bottom, what has been happening in the CMBS market? As of September 30, the overall delinquency rate was 8.93%, up only 10 basis points from August. The slowing of the increase in the delinquency rate may be attributable to special servicers pursuing more aggressive liquidation strategies particularly in the form of bulk sale liquidations. The hotel and multifamily sectors remain the most challenged, exhibiting delinquency rates of 16.71% and 14.81%, respectively. In terms of vintage, the 2006 and 2007 originations remain the worst performing with delinquencies of 10.34% and 10.58%, respectively.

The Corporate Credit Market

The great yield reach is driving flows into corporate assets across the capital structure spectruma"investment grade, high yield and leveraged loans. Even with the robust new issue calendar of late, demand has been sufficiently strong to drive valuations tighter, particularly in high yield. Here, the benchmark index yield pierced the 8% in threshold last month and now stands at 7.63%. This compares to 2004a™s low yield of 6.90%.

On September 22, Thomson Reuters held their 16^th annual Loan Conference in New York. A wide range of loan market participants attended, and this month we summarize some of the conferencea™s themes. Please note that these ideas are those of the conference attendees and are constantly evolving.

The Demise of CLOs: One of the most consistent messages of conference was that the CLO primary market had not yet returned. Three factors drive this view: First, the economics dona™t currently work. Second, the uncertainty surrounding regulation and taxes. The Dodd-Frank requirement of 5% risk retention on securitization currently applies to CLOs. At present, there is a tremendous lack of clarity on the rule. At worst, originators would have to retain a pro-rata 5% share of credit risk, which is currently vaguely defined. The following time line bears watching: The Fed will release a study on how the rule affects every asset class in mid-October; the rules will be established by April 2011; and by April 2013 the rules will be implemented. On the tax side, FATCA, a 2010 tax rule that requires foreign financial institutions to provide the IRS with tax information on U.S. persons so they cannot hide income, applies to CLOs as they are typically off-shore vehicles. CLO managers will need to contact investors or interest payments will be subject to withholding taxes.

Third, permanent loss of investor base. A large chunk of top-of-capital-structure buyer base is forever gone (monolines, SIVs, conduits) and there is too much fear of headline risk around structured product investments to attract new investors. With CLO investors accounting for approximately 40% of total leveraged loan demand and reinvestment periods ending within the next couple of years, this is obliviously a concern.

New investor class driving higher cross-asset correlation: There was much of discussion about how to attract new investors to the asset class in the absence of CLO buyers and most agreed the buyer base is evolving away from the LIBOR-based CLO and bank investor toward a total return oriented investor (mainly loan and HY funds). Hence, absolute yield is likely to become a more important driver of market clearing levels than discount margin. A less buy-and-hold investor base subjects the loan market to the same macro driven volatility of other asset classes.

Robust supply pipeline: While the market has shrunk due to bond-for-loan takeouts, the pace is abating ($74 billion in 2009, and $63 billion this year). Dividend recaps, acquisition financing and LBOs will take a larger share of supply going forward. There were a few views on the so-called amaturity walla of debt refinancings on the horizon. First, there is always a maturity wall. Second, amend and extend has worked as bond-for-loan takeouts had moved the wall materially forward in time. Third, the wall is a material issue for firms that do not have access to capital markets (middle market firms and firms with untenable capital structures). Some deals may need fresh equity as part of a fix or a change of control.

Fear of macro tail risk underpinning discipline in pricing: There was consensus that the loan asset class would perform under the slow recovery scenario. However, many had real concerns about macro issues and the risk of the double dip. The historic link between GDP and defaults is strong. In the recession, many firms survived due to aggressive cost cuts; the fear is that there arena™t additional costs that can be cut in the double dip scenario. Many felt the astructural risk in the systema would come to bear in 2012-13 a" just as sovereigns, real estate and corporates had lots of liabilities coming due.

The Treasury/Rates Market

It was a mixed picture in the Treasury market during September as equities made an impressive comeback off the August lows. We saw lower prices and higher yields across the Treasury curve in the first half of the month as risk assets saw strong demand. As the month progressed, Treasuries stabilized and the 5-year rallied to a new low in yield as talk of further quantitative easing intensified, while the 30-year yield lagged and ultimately finished the month 17 basis points higher.

Auction sizes have continued to decrease, with $167 billion in nominal notes and bonds sold during September. Auction demand was strong across the curve with the exception of the 30-year as market participants have shied away from that sector. The 10-year auction saw very strong interest from indirect bidders which is usually a good gauge of foreign central bank demand. The amount of indirect bids accepted totaled 54.7% for the 10-year, which was the highest since September 2009. The 2-year through 7-year auctions were also well received as these maturities have been a particular favorite among both foreign and domestic buyers.

The reinvestment into Treasuries of principal payments on Agency debt and MBS in the Federal Reservea™s System Open Market Account (SOMA) has also helped boost prices in the mid-part or belly of the Treasury curve. The Federal Reserve has said they will concentrate their purchases in the 2- to 10-year sector of the nominal Treasury curve and that is exactly what has happened in September as seen in the chart available in our [ online version. ]

The richening that has occurred in the belly of the curve as a result of these purchases and in anticipation of further purchases has caused certain spreads to reach extreme levels. The yield spread on the 2-year-5-year-10-year butterfly [(10 year yield-5 year yield) - (5 year yield-2 year yield)] reached 40 basis points which is the highest it has been in more than 10 years. See chart in our [ online version ].

The increased talk over the last month about further quantitative easing has also contributed to the move we have seen in the belly. While the SOMA purchases so far have been concentrated in maturities under 8 years, many market participants are wondering if the Fed will have to spread out their purchases on the curve to the 8-10 year area, if and when QE2 is announced. There is sure to be plenty of speculation from economists and strategists over the coming month as to what exactly the Feda™s next move will be but we will ultimately have to wait and see if the richening trend in the belly continues or we normalize to somewhat lower levels.

*Please direct media inquiries to Jeremy Diamond at (212)696-0100

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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.