ANNALY CAPITAL MANAGEMENT, INC. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Special Note Regarding Forward-Looking Statements Certain statements contained in this quarterly report, and certain statements contained in our future filings with theSecurities and Exchange Commission (the "SEC" or the "Commission"), in our press releases or in our other public or stockholder communications contain or incorporate by reference certain forward-looking statements which are based on various assumptions (some of which are beyond our control) and may be identified by reference to a future period or periods or by the use of forward-looking terminology, such as "may," "will," "believe," "expect," "anticipate," "continue," or similar terms or variations on those terms or the negative of those terms. Actual results could differ materially from those set forth in forward-looking statements due to a variety of factors, including, but not limited to, risks and uncertainties related to the COVID-19 pandemic, including as related to adverse economic conditions on real estate-related assets and financing conditions (and our outlook for our business in light of these conditions, which is uncertain); changes in interest rates; changes in the yield curve; changes in prepayment rates; the availability of mortgage-backed securities and other securities for purchase; the availability of financing and, if available, the terms of any financing; changes in the market value of our assets; changes in business conditions and the general economy; our ability to grow our commercial business; our ability to grow our residential credit business; our ability to grow our middle market lending business; credit risks related to our investments in credit risk transfer securities, residential mortgage-backed securities and related residential mortgage credit assets, commercial real estate assets and corporate debt; risks related to investments in MSRs; our ability to consummate any contemplated investment opportunities; changes in government regulations or policy affecting our business; our ability to maintain our qualification as a REIT forU.S. federal income tax purposes; our ability to maintain our exemption from registration under the Investment Company Act; and the risk that the expected benefits, including long-term cost savings, of the Internalization are not achieved. For a discussion of the risks and uncertainties which could cause actual results to differ from those contained in the forward-looking statements, see "Risk Factors" in our most recent annual report on Form 10-K and Item 1A "Risk Factors" in this quarterly report on Form 10-Q. We do not undertake, and specifically disclaim any obligation, to publicly release the result of any revisions which may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our most recent annual report on Form 10-K. All references to "Annaly," "we," "us," or "our" meanAnnaly Capital Management, Inc. and all entities owned by us, except where it is made clear that the term means only the parent company. Refer to the section titled "Glossary of Terms" located at the end of this Item 2 for definitions of commonly used terms in this quarterly report on Form 10-Q. 49 --------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis INDEX TO ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Page Overview 51 Business Environment and Coronavirus Disease 2019 ("COVID-19") 51 Economic Environment 53 Results of Operations 54 Net Income (Loss) Summary 54 Non-GAAP Financial Measures 54
Core earnings (excluding PAA), core earnings (excluding PAA) attributable to common stockholders, core earnings (excluding PAA) per average common share and annualized core return on average equity (excluding PAA)
54
Premium Amortization Expense
57
Interest Income (excluding PAA), economic interest expense and economic net interest income (excluding PAA)
57
Experienced and Projected Long-term CPR
58
Average Yield on Interest Earning Assets (excluding PAA), Net Interest Spread (excluding PAA) and Net Interest Margin (excluding PAA)
59
Economic Interest Expense and Average Economic Cost of Interest Bearing Liabilities
60
Realized and Unrealized Gains (Losses) 60
Other Income (Loss) 62
General and Administrative Expenses 62
Return on Average Equity 63
Unrealized Gains and Losses - Available-for-Sale Investments 63
Financial Condition 63
Residential Securities 64
Contractual Obligations 67
Off-Balance Sheet Arrangements 67
Capital Management 67
Stockholders' Equity 68
Capital Stock 68
Leverage and Capital 69
Risk Management 69
Risk Appetite 69
Governance 70
Description of Risks 70
Capital, Liquidity and Funding Risk Management 71
Funding 71
Excess Liquidity 72
Maturity Profile 74
Stress Testing 75
Liquidity Management Policies 75
Investment/Market Risk Management 76
Credit Risk Management 77
Counterparty Risk Management 77
Operational Risk Management 78
Compliance, Regulatory and Legal Risk Management 78
Critical Accounting Policies and Estimates 79
Valuation of Financial Instruments 79
Residential Securities 79
Residential Mortgage Loans 79
Commercial Real Estate Investments 79
Interest Rate Swaps 80
Revenue Recognition 80
Consolidation of Variable Interest Entities 80
Use of Estimates 80
Glossary of Terms 81
50
--------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis
Overview
We are a leading diversified capital manager that invests in and finances residential and commercial assets. Our principal business objective is to generate net income for distribution to our stockholders and optimize our returns through prudent management of our diversified investment strategies. We are an internally-managedMaryland corporation founded in 1997 that has elected to be taxed as a REIT. Prior to the closing of the Internalization (as defined below) onJune 30, 2020 , we were externally managed byAnnaly Management Company LLC (the "Manager"). Our common stock is listed on theNew York Stock Exchange under the symbol "NLY." We use our capital coupled with borrowed funds to invest primarily in real estate related investments, earning the spread between the yield on our assets and the cost of our borrowings and hedging activities. For a full discussion of our business, refer to the section titled "Business Overview" in our most recent Annual Report on Form 10-K. Recent Developments Closing of the Internalization and Termination of Management Agreement OnFebruary 12, 2020 , the Company entered an internalization agreement (the "Internalization Agreement") with the Manager and certain affiliates of the Manager. Pursuant to the Internalization Agreement, the Company agreed to acquire all of the outstanding equity interests of the Manager and the Manager's direct and indirect parent companies from their respective owners (the "Internalization") for nominal cash consideration ($1.00 ). In connection with the closing of the Internalization, onJune 30, 2020 , Annaly acquired all of the assets and liabilities of the Manager (the net effect of which was immaterial in amount), and Annaly transitioned from an externally-managed real estate investment trust ("REIT") to an internally-managed REIT. At the closing, all employees of the Manager became employees of Annaly. The parties terminated the Amended and Restated Management Agreement by and between Annaly and the Manager (the "Management Agreement") and therefore we no longer pay a management fee to, or reimburse expenses of, the Manager. Pursuant to the Internalization Agreement, the Manager waived any Acceleration Fee (as defined in the Management Agreement). In connection with the Internalization, we entered into employment and severance contracts with our executive officers (other thanMr. Votek ) that became effective at the closing of the Internalization. Strategic Relationships In line with our focus on establishing and growing strategic relationships with industry leading partners, during the second quarter of 2020, we entered into a relationship withGIC Private Limited , a leadingSovereign Wealth Fund , through the creation of a joint venture with the purpose of investing in residential credit assets, including newly-originated residential loans and securities issued by our subsidiaries. Retirement ofGlenn A. Votek from Senior Advisor RoleGlenn A. Votek , our former Interim Chief Executive Officer and President, was appointed to the role of Senior Advisor to Annaly onMarch 13, 2020 to assist with the leadership transition upon the promotion ofMr. Finkelstein as our Chief Executive Officer.Mr. Votek has notified Annaly of his intention to retire from his role as Senior Advisor effectiveAugust 31, 2020 .Mr. Votek will continue to serve as a member of our Board of Directors following his retirement as Senior Advisor. Appointment of Chief Operating Officer OnJune 30, 2020 ,Steven F. Campbell was appointed as our Chief Operating Officer.Mr. Campbell joined Annaly inApril 2015 and was most recently serving as the Head of Business Operations. Business Environment and Coronavirus Disease 2019 ("COVID-19") The second quarter of 2020 marked an improvement in financial conditions from the first quarter, despite protracted disruptions to theU.S. and world economies from the outbreak of COVID-19. The COVID-19 pandemic outbreak continues to affect nearly all ways of life and nearly every aspect of the economy. The far-reaching stimulus measures undertaken in March and April by theU.S. Congress and theFederal Reserve ("Fed") have helped consumers and businesses impacted to fight the pandemic and should help support an economic recovery going forward. Indeed, following the near total cessation of all non-essential economic activity in certainU.S. cities and states in late March and April, much of theU.S. began to reopen businesses in the second half 51 --------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of the quarter. As a result, economic activity saw a recovery from the activity lows in May and June, though the recent spike in COVID-19 cases risks delaying a continued recovery. The outlook for the economic recovery remains uncertain as COVID-19 cases in theU.S. have been rising sharply in recent weeks. While social distancing measures and the shutdown to the economy were much less significant than during the early spring months, it remains difficult to judge the recovery timeline and the degree to which changes across the economy will be structural versus just cyclical. In the current environment, we continue to believe the Agency sector presents the most attractive investment opportunity, aided in part by the sector's strong liquidity and lower volatility. Given the sector's fundamental and technical factors, we anticipate further room for spread tightening throughout the remainder of the year. While we expect our allocation to credit to remain at the lower end of recent years allocation, we continue to evaluate opportunities to deploy capital across our three credit businesses, an analysis informed by increasing clarity into the underlying fundamentals of each credit sector. Overall, we maintain a constructive view of the operating environment and our ability to deliver compelling returns as each of our businesses' respective markets begin to emerge from the volatility and disruption caused by the pandemic. Agency mortgage-backed security ("MBS") spreads stabilized meaningfully from the extreme volatility seen in March as the Fed intervened by buying more than$830 billion gross of portfolio paydowns between March and June, to improve market functioning. Agency MBS spreads have stabilized at levels somewhat above their average levels in 2019 as the market continues to face two major headwinds, high levels of supply and meaningfully elevated levels of prepayments, both a result of the record low in mortgage rates. In this environment, we further increased our position in MBS to-be-announced ("TBA") contracts as these offer attractive financing conditions given the Fed's involvement, while simultaneously rotating out of higher coupon pools into lower coupon pools to reduce premium dollar price MBS positions. Meanwhile, funding conditions have improved meaningfully from the stresses seen in March. Driven by the large-scale liquidity injections from the Fed's asset purchases and temporary repo operations, financial system liquidity rose meaningfully, in turn increasing repo counterparties' ability to provide funding. Moreover, with short-term interest rates at levels close to zero percent, funding costs have improved meaningfully as seen in the significant decline in the average economic cost of funds quarter over quarter. Over the quarter, our credit business portfolios remained largely unchanged. Market conditions improved meaningfully across all credit businesses in the second quarter, though recovery varied between individual sectors. Residential credit saw a stronger recovery on the back of continued supply/demand imbalances in the loan and securitized product markets combined with the fading impact of forbearance policies implemented earlier this year. Meanwhile, commercial credit investment activity remained lackluster, with investment volumes falling some estimated 80 percent year-over-year. The reduced transaction volumes were in large part driven by continued elevated uncertainties aroundCommercial Real Estate ("CRE") operating fundamentals, primarily in the hardest hit sectors such as hospitality and retail sector, while multifamily and office sector valuations have held up on continued strong rent collections. Similar to CRE, our middle market lending business has seen reduced activity, but valuations improved on better market technicals. We took prudent steps during the second quarter with an aim of positioning the Company to be prepared to capitalize on potential opportunities that could arise in later parts of the economic recovery. As part of our preparation, we have strived to be conservative with respect to our leverage as well as our dividend. Our goal in this market environment has been to maintain strong liquidity and to manage the portfolio within conservative risk parameters to produce high quality earnings without using excess leverage or risk.
Business Continuity
Our well-established Business Continuity Planning ("BCP") has been designed to
ensure continued, effective operations through a variety of scenarios including
natural disasters and disease pandemics. It identifies critical systems,
processes, roles and third parties, and can be adjusted on a real-time basis to
address situations as they arise.
The BCP is regularly updated and tested. Annual testing includes extensive,
remote Disaster Recovery testing and tabletop exercise scenarios with
management. Key tenets of the planning include active communication between our
Crisis Response Team , which is comprised of senior leaders across a number of
functions, and our internal and external stakeholders to afford efficient,
thoughtful, effective responses to evolving emergency situations.
Historical tabletop exercises have included use of CDC Influenza Pandemic
exercise materials. That exercise documented our response and possible impacts
to a variety of scenarios, including those in which "shelter in place orders"
were required and response/ impact assessments to those scenarios. Regular
meetings were commenced to implement and review active internal and external
communications planning. These exercises, along with regulatory and industry
guidance, informed our staged response to the conditions created by COVID-19. We
took proactive actions, which included canceling non-essential travel and
instituting 100% remote working, ahead of New York State -mandated
requirements. To protect the health and well-being of our employees,
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ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis
their families and communities remote work requirements began in phases in early
March, culminating with a company-wide exercise on March 13, 2020 to test
connectivity and functionality. All employees were able to successfully perform
their duties in this testing and we have operated remotely since that time.
As a result, all of our business activities continue to be performed remotely
until such time that federal, state and local authorities issue further guidance
and our Crisis Response Team deems it appropriate for employees to return to our
corporate office. Throughout this period there were no significant changes to
processes or controls resulting from remote work requirements.
Economic Environment
The pace of economic growth recorded its most meaningful contraction in several
decades in the second quarter, with U.S. gross domestic product ("GDP")
registering a 32.9% decline on a seasonally adjusted annualized rate as the
COVID-19 pandemic led to wide-spread closures of manufacturing and services
businesses, while disrupting global supply chains. Economic growth is expected
to reverse a portion of the contraction and expand in the second half of 2020 as
restrictions on social distancing were eased and economic activity appears to
have increased in certain parts of the country. However, the degree, timing and
velocity of any recovery remains highly uncertain and it is unlikely that the
economy will be able to fully replace the lost output before sometime in 2021 at
the earliest.
The Fed conducts monetary policy with a dual mandate: full employment and price
stability. The unemployment rate rose to 11.1% in June after reading just 3.5%
in February prior to the COVID-19 pandemic according to the Bureau of Labor
Statistics . The sharp rise in the unemployment rate was driven by employers
reporting a 13.3 million decline in non-farm payrolls during the quarter as many
industries laid off workers in light of closed businesses and reduced activity.
The labor market saw a modest improvement in the later parts of the second
quarter, with a portion of employees regaining work, though the disruption to
employment remains nearly unprecedented and will take significant time to fully
repair. Wage growth, as measured by the year-over-year change in private sector
Average Hourly Earnings, rose sharply during the quarter, reading 5.0% in the
month of June compared to 3.4% in March 2020 . The sharp rise in wage growth is
largely seen as a statistical anomaly. A majority of the layoffs appear to have
occurred in traditionally lower-paying sectors, such as the leisure industry,
which in turn inflated the wages of the remaining employed individuals.
Inflation has declined meaningfully below the Fed's 2% target in the second
quarter of 2020 as measured by the year-over-year changes in the Personal
Consumption Expenditure Chain Price Index ("PCE"). The headline PCE measure
increased by 0.75% year-over-year in June 2020 . The more stable core PCE
measure, which excludes volatile food and energy prices, registered a similar
0.95% year-over-year increase, below the 1.7% year-over-year growth measured in
March. In light of the sharp economic downturn and the fast deceleration in
inflation, the Fed appears worried that the core and headline PCE measures will
remain significantly below its target for an extended period of time.
Following its nearly unprecedented action in the first quarter of 2020, the
Federal Open Market Committee ("FOMC") maintained the Federal Funds Rate in the
0.00% - 0.25% range during the second quarter. Moreover, the FOMC began to
signal that it will maintain the rate at current levels for an extended period
of time in order to aid the economic recovery following the COVID-19 related
slowdown in the U.S. and global economy. In addition, the FOMC continued its
quantitative easing program while implementing a number of lending programs to
support the U.S. economy. The combined Fed actions have meaningfully improved
financial conditions and market functioning, which in turn has helped the
economic recovery in its infancy.
During the second quarter ending June 30, 2020 , the 10-year U.S. Treasury rate
remained nearly unchanged at 0.66% as Fed monetary policy actions maintained a
range-bound interest rate environment in U.S. Treasuries, while LIBOR-based
interest rates continued to decline in light of reduced concerns about liquidity
and credit risk. The mortgage basis, or the spread between the 30-year Agency
mortgage-backed security coupon and 10-year U.S. Treasury rate, normalized
following a volatile first quarter, but remained somewhat higher than seen
during most of 2019 amid investor concerns over mortgage refinancing activity.
The following table presents interest rates and spreads at each date presented:
June 30, 2020 December 31, 2019 June 30, 2019
30-Year mortgage current coupon 1.57% 2.71% 2.74%
Mortgage basis 91 bps 79 bps 73 bps
10-Year U.S. Treasury rate 0.66% 1.92% 2.01%
LIBOR
1-Month 0.16% 1.76% 2.40%
6-Month 0.37% 1.91% 2.20%
London Interbank Offered Rate ("LIBOR") Transition
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ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis
We have established a cross-functional LIBOR transition committee to determine
our transition plan and facilitate an orderly transition to alternative
reference rates. Our plan includes steps to evaluate exposure, review contracts,
assess impact to our business, process and technology and define a communication
strategy with shareholders, regulators and other stakeholders. The committee
also continues to engage with industry working groups and other market
participants regarding the transition.
Results of Operations
The results of our operations are affected by various factors, many of which are
beyond our control. Certain of such risks and uncertainties are described herein
(see "Special Note Regarding Forward-Looking Statements" above) and in Part I,
Item 1A. "Risk Factors" of our most recent Annual Report on Form 10-K and in
Part II, Item 1A. "Risk Factors" in this Quarterly Report on Form 10-Q and in
our Quarterly Report on Form 10-Q for the quarter ended March 31, 2020 .
This Management Discussion and Analysis section contains analysis and discussion
of financial results computed in accordance with U.S. generally accepted
accounting principles ("GAAP") and non-GAAP measurements. To supplement our
consolidated financial statements, which are prepared and presented in
accordance with GAAP, we provide non-GAAP financial measures to enhance investor
understanding of our period-over-period operating performance and business
trends, as well as for assessing our performance versus that of industry peers.
Refer to the "Non-GAAP Financial Measures" section for additional information.
Net Income (Loss) Summary
The following table presents financial information related to our results of
operations as of and for the three and six months ended June 30, 2020 and 2019.
As of and for the Three Months Ended June 30, As of and for the Six Months Ended June 30,
2020 2019 2020 2019
(dollars in thousands, except per share data)
Interest income $ 584,812 $ 927,598 $ 1,139,838 $ 1,793,784
Interest expense 186,032 750,217 689,505 1,397,912
Net interest income 398,780 177,381 450,333 395,872
Realized and unrealized gains (losses) 511,951 (1,909,482 ) (3,143,790 ) (2,921,408 )
Other income (loss) 15,224 28,181 30,150 58,683
Less: Total general and administrative
expenses 67,666 78,408 145,295 162,145
Income (loss) before income taxes 858,289 (1,782,328 ) (2,808,602 ) (2,628,998 )
Income taxes 2,055 (5,915 ) (24,647 ) (3,334 )
Net income (loss) 856,234 (1,776,413 ) (2,783,955 ) (2,625,664 )
Less: Net income (loss) attributable
to noncontrolling interests 32 (83 ) 98 (184 )
Net income (loss) attributable to
Annaly 856,202 (1,776,330 ) (2,784,053 ) (2,625,480 )
Less: Dividends on preferred stock 35,509 32,422 71,018 64,916
Net income (loss) available (related)
to common stockholders $ 820,693 $ (1,808,752 ) $ (2,855,071 ) $ (2,690,396 )
Net income (loss) per share available
(related) to common stockholders
Basic $ 0.58 $ (1.24 ) $ (2.00 ) $ (1.88 )
Diluted $ 0.58 $ (1.24 ) $ (2.00 ) $ (1.88 )
Weighted average number of common
shares outstanding
Basic 1,423,909,112 1,456,038,736 1,427,451,716 1,427,485,102
Diluted 1,423,909,112 1,456,038,736 1,427,451,716 1,427,485,102
Other information
Asset portfolio at period-end $ 90,442,332 $ 128,843,443 $ 90,442,332 $ 128,843,443
Average total assets $ 95,187,964 $ 125,486,663 $ 106,890,336 $ 118,920,284
Average equity $ 13,252,567 $ 15,744,426 $ 14,100,492 $ 15,202,217
Leverage at period-end (1) 5.5:1 7.2:1 5.5:1 7.2:1
Economic leverage at period-end (2) 6.4:1 7.6:1 6.4:1 7.6:1
Capital ratio (3) 13.0 % 11.4 % 13.0 % 11.4 %
Annualized return on average total
assets 3.60 % (5.66 )% (5.21 %) (4.42 )%
Annualized return on average equity 25.84 % (45.13 )% (39.49 %) (34.54 )%
Net interest margin (4) 1.89 % 0.58 % 0.90 % 0.68 %
Average yield on interest earning
assets (5) 2.77 % 3.03 % 2.27 % 3.09 %
Average GAAP cost of interest bearing
liabilities (6) 0.96 % 2.71 % 1.48 % 2.71 %
Net interest spread 1.81 % 0.32 % 0.79 % 0.38 %
Weighted average experienced CPR for
the period 19.5 % 11.2 % 16.6 % 9.3 %
Weighted average projected long-term
CPR at period-end 18.0 % 14.5 % 18.0 % 14.5 %
Common stock book value per share $ 8.39 $ 9.33 $ 8.39 $ 9.33
Non-GAAP metrics (7)
Interest income (excluding PAA) $ 636,554 $ 1,067,361 $ 1,482,302 $ 2,015,418
Economic interest expense (6) $ 250,593 $ 666,564 $ 768,046 $ 1,180,224
Economic net interest income
(excluding PAA) $ 385,961 $ 400,797 $ 714,256 $ 835,194
Premium amortization adjustment cost
(benefit) $ 51,742 $ 139,763 $ 342,464 $ 221,634
Core earnings (excluding PAA) (8) $ 424,580 $ 391,153 $ 754,798 $ 824,308
Core earnings (excluding PAA) per
common share $ 0.27 $ 0.25 $ 0.48 $ 0.53
Annualized core return on average
equity (excluding PAA) 12.82 % 9.94 % 10.71 % 10.85 %
Net interest margin (excluding PAA)
(4) 1.88 % 1.28 % 1.50 % 1.39 %
Average yield on interest earning
assets (excluding PAA) (5) 3.01 % 3.48 % 2.96 % 3.47 %
Average economic cost of interest
bearing liabilities (6) 1.29 % 2.41 % 1.65 % 2.29 %
Net interest spread (excluding PAA) 1.72 % 1.07 % 1.31 % 1.18 %
(1) Debt consists of repurchase agreements, other secured financing, debt issued by securitization vehicles and mortgages payable. Debt issued
by securitization vehicles, certain credit facilities (included within other secured financing), and mortgages payable are non-recourse to us.
(2) Computed as the sum of Recourse Debt, cost basis of TBA and CMBX derivatives outstanding and net forward purchases (sales) of investments
divided by total equity.
(3) Calculated as total stockholders' equity divided by total assets inclusive of outstanding market value of TBA positions and exclusive of
consolidated VIEs.
(4) Net interest margin represents our interest income less interest expense divided by the average interest earning assets. Net interest
margin (excluding PAA) represents the sum of our interest income (excluding PAA) plus TBA dollar roll income and CMBX coupon income less
interest expense and the net interest component of interest rate swaps divided by the sum of average interest earning assets plus average
outstanding TBA contract and CMBX balances.
(5) Average yield on interest earning assets represents annualized interest income divided by average interest earning assets. Average interest
earning assets reflects the average amortized cost of our investments during the period. Average yield on interest earning assets (excluding
PAA) is calculated using annualized interest income (excluding PAA).
(6) Average GAAP cost of interest bearing liabilities represents annualized interest expense divided by average interest bearing liabilities.
Average interest bearing liabilities reflects the average balances during the period. Average economic cost of interest bearing liabilities
represents annualized economic interest expense divided by average interest bearing liabilities. Economic interest expense is comprised of GAAP
interest expense and the net interest component of interest rate swaps.
(7) Represents a non-GAAP financial measure. Refer to the "Non-GAAP Financial Measures" section for additional information.
(8) Excludes dividends on preferred stock.
GAAP
Net income (loss) was $856.2 million , which includes $32.0 thousand attributable
to noncontrolling interests, or $0.58 per average basic common share, for the
three months ended June 30, 2020 compared to ($1.8) billion , which includes
($83.0) thousand attributable to noncontrolling interests, or ($1.24 ) per
average basic common share, for the same period in 2019. We attribute the
majority of the change in net income (loss) to favorable changes in unrealized
gains (losses) on interest rate swaps, net gains (losses) on other derivatives,
net gains (losses) on disposal of investments and other and net unrealized gains
(losses) on instruments measured at fair value through earnings, and higher net
interest income, partially offset by higher realized losses on termination or
maturity of interest rate swaps. Net unrealized gains (losses) on interest rate
swaps was $1.5 billion for the three months ended June 30, 2020 compared to
($1.3) billion for the same period in 2019. Net gains (losses) on other
derivatives was $170.9 million for the three months ended June 30, 2020 compared
to ($506.4) million for the same period in 2019. Net gains (losses) on disposal
of investments and other was $246.7 million for the three months ended June 30,
2020 compared to ($38.3) million for the same period in 2019. Unrealized gains
(losses) on instruments measured at fair value through earnings for the three
months ended June 30, 2020 was $254.8 million compared to ($4.9) million for the
same period in 2019. Net interest income for the three months ended June 30,
2020 was $398.8 million compared to $177.4 million for the same period in 2019.
Realized gains (losses) on termination or maturity of interest rate swaps was
($1.5) billion for the three months ended June 30, 2020 compared to ($167.5)
million for the same period in 2019. Refer to the section titled "Realized and
Unrealized Gains (Losses)" located within this Item 2 for additional information
related to these changes.
Net income (loss) was ($2.8) billion , which includes $0.1 million attributable
to noncontrolling interests, or ($2.00 ) per average basic common share, for the
six months ended June 30, 2020 compared to ($2.6) billion , which includes ($0.2)
million attributable to noncontrolling interests, or ($1.88 ) per average basic
common share, for the same period in 2019. We attribute the majority of the
change in net income (loss) to higher realized losses on termination or maturity
of interest rate swaps, lower interest income and an unfavorable change in net
unrealized gains (losses) on instruments measured at fair value through
earnings, partially offset by a favorable change in net gains (losses) on other
derivatives, lower interest expense and a favorable change in net gains (losses)
on disposal of investments and other. Realized gains (losses) on termination or
maturity of interest rate swaps was ($1.9) billion for the six months ended
June 30, 2020 compared to ($755.7) million for the same period in 2019. Interest
income for the six months ended June 30, 2020 was $1.1 billion compared to $1.8
billion for the same period in 2019. Unrealized gains (losses) on instruments
measured at fair value through earnings for the six months ended June 30, 2020
was ($475.4) million compared to $42.7 million for the same period in 2019. Net
gains (losses) on other derivatives was $377.3 million for the six months ended
June 30, 2020 compared to ($621.6) million for the same period in 2019. Interest
expense for the six months ended June 30, 2020 was $689.5 million compared to
$1.4 billion for the same period in 2019. Net gains (losses) on disposal of
investments and other was $453.3 million for the six months ended June 30, 2020
compared to ($132.2) million for the same period in 2019. Refer to the section
titled "Realized and Unrealized Gains (Losses)" located within this Item 2 for
additional information related to these changes.
Non-GAAP
Core earnings (excluding premium amortization adjustment ("PAA")) were $424.6
million , or $0.27 per average common share, for the three months ended June 30,
2020 , compared to $391.2 million , or $0.25 per average common share, for the
same period in 2019. The change in core earnings (excluding PAA) during the
three months ended June 30, 2020 compared to the same period in 2019 was
primarily due to lower interest expense from lower borrowing rates and higher
TBA dollar roll income, partially offset by lower coupon income resulting from a
decrease in the average yield on interest earnings assets and lower average
interest earning assets, and unfavorable changes in the net interest component
of interest rate swaps.
Core earnings (excluding premium amortization adjustment ("PAA")) were $754.8
million , or $0.48 per average common share, for the six months ended June 30,
2020 , compared to $824.3 million , or $0.53 per average common share, for the
same period in 2019. The change in core earnings (excluding PAA) during the
three months ended June 30, 2020 compared to the same period in 2019 was
primarily due to lower coupon income resulting from a decrease in the average
yield on interest earnings assets, increased amortization due to asset sales and
unfavorable changes in the net interest component of interest rate swaps,
partially offset by lower interest expense from lower borrowing rates and higher
TBA dollar roll income.
Non-GAAP Financial Measures
To supplement our consolidated financial statements, which are prepared and
presented in accordance with GAAP, we provide the following non-GAAP financial
measures:
• core earnings (excluding PAA);
• core earnings (excluding PAA) attributable to common stockholders;
• core earnings (excluding PAA) per average common share;
• annualized core return on average equity (excluding PAA);
• interest income (excluding PAA);
• economic interest expense;
• economic net interest income (excluding PAA);
• average yield on interest earning assets (excluding PAA);
• average economic cost of interest bearing liabilities;
• net interest margin (excluding PAA); and
• net interest spread (excluding PAA).
These measures should not be considered a substitute for, or superior to,
financial measures computed in accordance with GAAP. While intended to offer a
fuller understanding of our results and operations, non-GAAP financial measures
also have limitations. For example, we may calculate our non-GAAP metrics, such
as core earnings (excluding PAA), or the PAA, differently than our peers making
comparative analysis difficult. Additionally, in the case of non-GAAP measures
that exclude the PAA, the amount of amortization expense excluding the PAA is
not necessarily representative of the amount of future periodic amortization nor
is it indicative of the term over which we will amortize the remaining
unamortized premium. Changes to actual and estimated prepayments will impact the
timing and amount of premium amortization and, as such, both GAAP and non-GAAP
results.
These non-GAAP measures provide additional detail to enhance investor
understanding of our period-over-period operating performance and business
trends, as well as for assessing our performance versus that of industry peers.
Additional information pertaining to our use of these non-GAAP financial
measures, including discussion of how each such measure may be useful to
investors, and reconciliations to their most directly comparable GAAP results
are provided below.
Core earnings (excluding PAA), core earnings (excluding PAA) attributable to
common stockholders, core earnings (excluding PAA) per average common share and
annualized core return on average equity (excluding PAA)
Our principal business objective is to generate net income for distribution to
our stockholders and optimize our returns through prudent management of our
diversified investment strategies. We generate net income by earning a net
interest spread on our investment portfolio, which is a function of interest
income from our investment portfolio less financing, hedging and operating
costs. Core earnings (excluding PAA), which is defined as the sum of (a)
economic net interest income, (b) TBA dollar roll income and CMBX coupon income,
(c) realized amortization of MSRs, (d) other income (loss) (excluding
depreciation and amortization expense on real estate and related intangibles,
non-core income allocated to equity method investments and other non-core
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ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis
components of other income (loss)), (e) general and administrative expenses
(excluding transaction expenses and non-recurring items), and (f) income taxes
(excluding the income tax effect of non-core income (loss) items), and excludes
(g) the premium amortization adjustment ("PAA") representing the cumulative
impact on prior periods, but not the current period, of quarter-over-quarter
changes in estimated long-term prepayment speeds related to our Agency
mortgage-backed securities, is used by management and, we believe, used by
analysts and investors to measure our progress in achieving our principal
business objective.
We seek to fulfill our principal business objective through a variety of factors
including portfolio construction, the degree of market risk exposure and related
hedge profile, and the use and forms of leverage, all while operating within the
parameters of our capital allocation policy and risk governance framework.
We believe these non-GAAP measures provide management and investors with
additional details regarding our underlying operating results and investment
portfolio trends by (i) making adjustments to account for the disparate
reporting of changes in fair value where certain instruments are reflected in
GAAP net income (loss) while others are reflected in other comprehensive income
(loss), and (ii) by excluding certain unrealized, non-cash or episodic
components of GAAP net income (loss) in order to provide additional transparency
into the operating performance of our portfolio. Annualized core return on
average equity (excluding PAA), which is calculated by dividing core earnings
(excluding PAA) over average stockholders' equity, provides investors with
additional detail on the core earnings generated by our invested equity capital.
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ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis
The following table presents a reconciliation of GAAP financial results to non-GAAP core earnings for the periods presented:
For the Three Months Ended June 30, For the Six Months Ended June 30,
2020 2019 2020 2019
(dollars in thousands, except per share data)
GAAP net income (loss) $ 856,234 $
(1,776,413 )
32 (83 ) 98 (184 )
Net income (loss) attributable to Annaly 856,202 (1,776,330 ) (2,784,053 ) (2,625,480 )
Adjustments to exclude reported realized and unrealized
(gains) losses
Realized (gains) losses on termination or
maturity of interest rate swaps 1,521,732 167,491 1,919,293 755,747
Unrealized (gains) losses on interest
rate swaps (1,494,628 ) 1,276,019 1,333,095 1,666,575
Net (gains) losses on disposal of
investments and other (246,679 ) 38,333 (453,262 ) 132,249
Net (gains) losses on other derivatives (170,916 ) 506,411
(377,342 ) 621,570
Net unrealized (gains) losses on
instruments measured at fair value
through earnings (254,772 ) 4,881 475,388 (42,748 )
Loan loss provision (1) 72,544 - 172,537 5,703
Other adjustments
Depreciation expense related to
commercial real estate and amortization
of intangibles (2) 8,714 10,147 16,648 20,261
Non-core (income) loss allocated to
equity method investments (3) 4,218 11,327 23,616 20,823
Transaction expenses and non-recurring
items (4) 1,075 3,046 8,320 13,028
Income tax effect of non-core income
(loss) items 3,353 (3,507 ) (20,509 ) (2,781 )
TBA dollar roll income and CMBX coupon
income (5) 97,524 33,229 142,428 71,363
MSR amortization (6) (25,529 ) (19,657 ) (43,825 ) (33,636 )
Plus:
Premium amortization adjustment cost (benefit) 51,742 139,763 342,464 221,634 Core earnings (excluding PAA) (7) 424,580 391,153 754,798 824,308 Dividends on preferred stock 35,509 32,422 71,018 64,916 Core earnings (excluding PAA) attributable to common stockholders (7)$ 389,071 $ 358,731 $ 683,780 $ 759,392 GAAP net income (loss) per average common share $ 0.58$ (1.24 ) $ (2.00 )$ (1.88 ) Core earnings (excluding PAA) per average common share (7) $ 0.27$ 0.25 $ 0.48$ 0.53 GAAP return (loss) on average equity 25.84 % (45.13 %) (39.49 %) (34.54 %) Core return on average equity (excluding PAA) (7) 12.82 % 9.94 % 10.71 % 10.85 %
(1) Includes
unfunded loan commitments for the three and six months ended
respectively, which is reported in Other income (loss) in the Consolidated
Statements of Comprehensive Income (Loss).
(2) Includes depreciation and amortization expense related to equity method
investments.
(3) Represents unrealized (gains) losses allocated to equity interests in a
portfolio of MSR which is a component of Other income (loss).
(4) The three and six months ended
connection with the Internalization and costs incurred in connection with
the CEO transition. The six months ended
incurred in connection with securitizations of residential whole loans and
Agency mortgage-backed securities. The three and six months ended June 30,
2019 includes costs incurred in connection with a securitization of
residential whole loans. The six months ended
costs incurred in connection with a securitization of commercial loans.
(5) TBA dollar roll income and CMBX coupon income each represent a component of
Net gains (losses) on other derivatives. CMBX coupon income totaled
million and
CMBX coupon income totaled $0.8 million and $1.9 million for the three and
six months ended June 30, 2019 , respectively.
(6) MSR amortization represents the portion of changes in fair value that isattributable to the realization of estimated cash flows on the Company's MSR
portfolio and is reported as a component of Net unrealized gains (losses) on
instruments measured at fair value.
(7) Represents a non-GAAP financial measure.
From time to time, we enter into TBA forward contracts as an alternate means of
investing in and financing Agency mortgage-backed securities. A TBA contract is
an agreement to purchase or sell, for future delivery, an Agency mortgage-backed
security with a specified issuer, term and coupon. A TBA dollar roll represents
a transaction where TBA contracts with the same terms but different settlement
dates are simultaneously bought and sold. The TBA contract settling in the later
month typically prices at a discount to the earlier month contract with the
difference in price commonly referred to as the "drop". The drop is a reflection
of the expected net interest income from an investment in similar Agency
mortgage-backed securities, net of an implied financing cost, that would be
foregone as a result of settling the contract in the later month rather than in
the earlier month. The drop between the current settlement month price and the
forward settlement month price occurs because in the TBA dollar roll market, the
party providing the financing is the party that would retain all principal and
interest payments accrued during the financing period.
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ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis
Accordingly, TBA dollar roll income generally represents the economic equivalent
of the net interest income earned on the underlying Agency mortgage-backed
security less an implied financing cost.
TBA dollar roll transactions are accounted for under GAAP as a series of
derivatives transactions. The fair value of TBA derivatives is based on methods
similar to those used to value Agency mortgage-backed securities. We record TBA
derivatives at fair value on our Consolidated Statements of Financial Condition
and recognize periodic changes in fair value in Net gains (losses) on other
derivatives in our Consolidated Statements of Comprehensive Income (Loss), which
includes both unrealized and realized gains and losses on derivatives (excluding
interest rate swaps).
TBA dollar roll income is calculated as the difference in price between two TBA
contracts with the same terms but different settlement dates multiplied by the
notional amount of the TBA contract. Although accounted for as derivatives, TBA
dollar rolls capture the economic equivalent of net interest income, or carry,
on the underlying Agency mortgage-backed security (interest income less an
implied cost of financing). TBA dollar roll income is reported as a component of
Net gains (losses) on other derivatives in the Consolidated Statements of
Comprehensive Income (Loss).
The CMBX index is a synthetic tradable index referencing a basket of 25
commercial mortgage-backed securities of a particular rating and vintage. The
CMBX index allows investors to take a long position (referred to as selling
protection) or short position (referred to as purchasing protection) on the
respective basket of commercial mortgage-backed securities and is structured as
a "pay-as-you-go" contract whereby the protection seller receives and the
protection buyer pays a standardized running coupon on the contracted notional
amount. Additionally, the protection seller is obligated to pay to the
protection buyer the amount of principal losses and/or coupon shortfalls on the
underlying commercial mortgage-backed securities as they occur. We report income
(expense) on CMBX positions in Net gains (losses) on other derivatives in the
Consolidated Statements of Comprehensive Income (Loss). The coupon payments
received or paid on CMBX positions is equivalent to interest income (expense)
and therefore included in core earnings (excluding PAA).
Premium Amortization Expense
In accordance with GAAP, we amortize or accrete premiums or discounts into
interest income for our Agency mortgage-backed securities, excluding
interest-only securities, multifamily and reverse mortgages, taking into account
estimates of future principal prepayments in the calculation of the effective
yield. We recalculate the effective yield as differences between anticipated and
actual prepayments occur. Using third-party model and market information to
project future cash flows and expected remaining lives of securities, the
effective interest rate determined for each security is applied as if it had
been in place from the date of the security's acquisition. The amortized cost of
the security is then adjusted to the amount that would have existed had the new
effective yield been applied since the acquisition date. The adjustment to
amortized cost is offset with a charge or credit to interest income. Changes in
interest rates and other market factors will impact prepayment speed projections
and the amount of premium amortization recognized in any given period.
Our GAAP metrics include the unadjusted impact of amortization and accretion
associated with this method. Certain of our non-GAAP metrics exclude the effect
of the PAA, which quantifies the component of premium amortization representing
the cumulative impact on prior periods, but not the current period, of
quarter-over-quarter changes in estimated long-term Constant Prepayment Rate
("CPR").
The following table illustrates the impact of the PAA on premium amortization
expense for our Residential Securities portfolio and residential securities
transferred or pledged to securitization vehicles, for the periods presented:
For the Three Months Ended For the Six Months Ended
June 30, June 30,
2020 2019 2020 2019
(dollars in thousands)
Premium amortization expense $ 270,688 $ 318,587 $ 887,625 $ 566,033
Less: PAA cost (benefit) 51,742 139,763 342,464 221,634
Premium amortization expense
(excluding PAA) $ 218,946 $ 178,824 $ 545,161 $ 344,399
Interest income (excluding PAA), economic interest expense and economic net
interest income (excluding PAA)
Interest income (excluding PAA) represents interest income excluding the effect
of the premium amortization adjustment, and serves as the basis for deriving
average yield on interest earning assets (excluding PAA), net interest spread
(excluding PAA) and net interest margin (excluding PAA), which are discussed
below. We believe this measure provides management and investors with additional
detail to enhance their understanding of our operating results and trends by
excluding the component of premium amortization expense representing the
cumulative effect of quarter-over-quarter changes in estimated long-term
prepayment speeds
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ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis
related to our Agency mortgage-backed securities (other than interest-only
securities, multifamily and reverse mortgages), which can obscure underlying
trends in the performance of the portfolio.
Economic interest expense is comprised of GAAP interest expense and the net
interest component of interest rate swaps. We use interest rate swaps to manage
our exposure to changing interest rates on repurchase agreements by economically
hedging cash flows associated with these borrowings. Accordingly, adding the net
interest component of interest rate swaps to interest expense, as computed in
accordance with GAAP, reflects the total contractual interest expense and thus,
provides investors with additional information about the cost of our financing
strategy. We may use market agreed coupon ("MAC") interest rate swaps in which
we may receive or make a payment at the time of entering into such interest rate
swap to compensate for the off-market nature of such interest rate swap. In
accordance with GAAP, upfront payments associated with MAC interest rate swaps
are not reflected in the net interest component of interest rate swaps in the
Consolidated Statements of Comprehensive Income (Loss). We did not enter into
any MAC interest rate swaps during the three and six months ended June 30, 2020 .
Similarly, economic net interest income (excluding PAA), as computed below,
provides investors with additional information to enhance their understanding of
the net economics of our primary business operations.
The following tables provide GAAP measures of interest expense and net interest
income and details with respect to reconciling the aforementioned line items on
a non-GAAP basis for each respective period:
Interest Income (excluding PAA)
GAAP Interest Income PAA Cost Interest Income
(Benefit) (excluding PAA) (1)
For the three months ended (dollars in thousands)
June 30, 2020 $ 584,812 $ 51,742 $ 636,554
June 30, 2019 $ 927,598 $ 139,763 $ 1,067,361
For the six months ended
June 30, 2020 $ 1,139,838 $ 342,464 $ 1,482,302
June 30, 2019 $ 1,793,784 $ 221,634 $ 2,015,418
(1) Represents a non-GAAP financial measure.
Economic Interest Expense and Economic Net Interest Income (excluding PAA)
Less: Net
Interest Economic Net
GAAP Add: Net Interest Economic GAAP Net Component Economic Add: PAA Interest Income
Interest Component of Interest Interest of Interest Rate Net Interest Cost (excluding PAA)
Expense Interest Rate Swaps Expense (1) Income Swaps Income (1) (Benefit) (1)
For the three months ended (dollars in thousands)
June 30, 2020 $ 186,032 $ 64,561 $ 250,593 $ 398,780 $ 64,561 $ 334,219 $ 51,742 $ 385,961
June 30, 2019 $ 750,217 $ (83,653 ) $ 666,564 $ 177,381 $ (83,653 ) $ 261,034 $ 139,763 $ 400,797
For the six months ended
June 30, 2020 $ 689,505 $ 78,541 $ 768,046 $ 450,333 $ 78,541 $ 371,792 $ 342,464 $ 714,256
June 30, 2019 $ 1,397,912 $ (217,688 ) $ 1,180,224 $ 395,872 $ (217,688 ) $ 613,560 $ 221,634 $ 835,194
(1) Represents a non-GAAP financial measure.
Experienced and Projected Long-Term CPR
Prepayment speeds, as reflected by the CPR and interest rates vary according to
the type of investment, conditions in financial markets, competition and other
factors, none of which can be predicted with any certainty. In general, as
prepayment speeds and expectations of prepayment speeds on our Agency
mortgage-backed securities portfolio increase, related purchase premium
amortization increases, thereby reducing the yield on such assets. The following
table presents the weighted average experienced CPR and weighted average
projected long-term CPR on our Agency mortgage-backed securities portfolio as of
and for the periods presented.
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ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis
Experienced CPR (1) Projected Long-term CPR (2)
For the three months ended
June 30, 2020 19.5 % 18.0 %
June 30, 2019 11.2 % 14.5 %
For the six months ended
June 30, 2020 16.6 % 18.0 %
June 30, 2019 9.3 % 14.5 %
(1) For the three and six months ended
(2) AtJune 30, 2020 and 2019, respectively. Average Yield on Interest Earning Assets (excluding PAA), Net Interest Spread (excluding PAA), Net Interest Margin (excluding PAA) and Average Economic Cost of Interest Bearing Liabilities Net interest spread (excluding PAA), which is the difference between the average yield on interest earning assets (excluding PAA) and the average economic cost of interest bearing liabilities, which represents annualized economic interest expense divided by average interest bearing liabilities, and net interest margin (excluding PAA), which is calculated as the sum of interest income (excluding PAA) plus TBA dollar roll income and CMBX coupon income less interest expense and the net interest component of interest rate swaps divided by the sum of average interest earning assets plus average TBA contract and CMBX balances, provide management with additional measures of our profitability that management relies upon in monitoring the performance of the business. Disclosure of these measures, which are presented below, provides investors with additional detail regarding how management evaluates our performance. Net Interest Spread (excluding PAA) Average Yield on Average Interest Economic Cost Economic Net Net Earning of Interest Interest Interest Average Interest Interest Income Assets Average Interest Economic Bearing Income Spread Earning (excluding PAA) (excluding Bearing Interest Expense Liabilities (excluding (excluding Assets (1) (2) PAA) (2) Liabilities (2)(3) (2)(3) PAA) (2) PAA) (2) For the three months ended (dollars in thousands) June 30, 2020$ 84,471,839 $ 636,554 3.01 %$ 76,712,894 $ 250,593 1.29 % 385,961 1.72 % June 30, 2019$ 122,601,881 $ 1,067,361 3.48 %$ 109,628,007 $ 666,564 2.41 % 400,797 1.07 % For the six months ended June 30, 2020$ 100,267,867 $ 1,482,302 2.96 %$ 91,871,180 $ 768,046 1.65 % 714,256 1.31 %
2.29 % 835,194 1.18 %
(1) Based on amortized cost.
(2) Represents a non-GAAP financial measure.
(3) Average economic cost of interest bearing liabilities represents annualized economic interest expense divided by average interest bearing
liabilities. Average interest bearing liabilities reflects the average balances during the period. Economic interest expense is comprised of GAAP
interest expense and the net interest component of interest rate swaps.
Net Interest Margin (excluding PAA)
TBA Dollar Net
Roll and Net Interest Average TBA Interest
Interest Income CMBX Component of Contract and Margin
(excluding PAA) Coupon Interest Rate Average Interest CMBX (excluding
(1) Income (2) Interest Expense Swaps Subtotal Earnings Assets Balances Subtotal PAA) (1)
For the three months ended (dollars in thousands)
June 30, 2020 $ 636,554 97,524 (186,032 ) (64,561
)
1.88 % June 30, 2019$ 1,067,361 33,229 (750,217 ) 83,653
1.28 % For the six months ended June 30, 2020$ 1,482,302 142,428 (689,505 ) (78,541
)
1.50 % June 30, 2019$ 2,015,418 71,363 (1,397,912 ) 217,688
1.39 %
(1) Represents a non-GAAP financial measure.
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--------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis
(2) TBA dollar roll income and CMBX coupon income each represent a component of
Net gains (losses) on other derivatives. CMBX coupon income totaled
million and
respectively. CMBX coupon income totaled $0.8 million and $1.9 million for
the three and six months ended June 30, 2019 , respectively.
Economic Interest Expense and Average Economic Cost of Interest Bearing
Liabilities
Typically, our largest expense is the cost of interest bearing liabilities and
the net interest component of interest rate swaps. The table below shows our
average interest bearing liabilities and average economic cost of interest
bearing liabilities as compared to average one-month and average six-month LIBOR
for the periods presented.
Economic Cost of Funds on Average Interest Bearing Liabilities
Average Economic
Average Economic Cost Cost
of Interest of Interest
Average Economic Average Bearing Bearing
Cost of Average Average One-Month LIBOR Liabilities Liabilities
Average Interest Bearing Economic Interest One- Six- Relative to Relative to Relative to
Interest Bearing Liabilities at Interest Bearing Month Month Average Six- Average One- Average
Liabilities Period End Expense (1) Liabilities (2) LIBOR LIBOR Month LIBOR Month LIBOR Six-Month LIBOR
For the three months endedJune 30, 2020$ 76,712,894 $ 75,160,724 $ 250,593 1.29 % 0.35 % 0.70 % (0.35 %) 0.94 % 0.59 % June 30, 2019$ 109,628,007 $ 112,779,398 $ 666,564 2.41 % 2.44 % 2.50 % (0.06 %) (0.03 %) (0.09 %) For the six months ended June 30, 2020$ 91,871,180 $ 75,160,724 $ 768,046 1.65 % 0.89 % 1.10 % (0.21 %) 0.76 % 0.55 % June 30, 2019$ 102,578,913 $ 112,779,398 $ 1,180,224 2.29 % 2.47 % 2.63 % (0.16 %)
(0.18 %) (0.34 %) (1) Economic interest expense is comprised of GAAP interest expense and the net interest component of interest rate swaps. (2) Represents a non-GAAP financial measure.
Economic interest expense decreased by$416.0 million for the three months endedJune 30, 2020 compared to the same period in 2019. Economic interest expense decreased by$412.2 million for the six months endedJune 30, 2020 compared to the same period in 2019. The change in each period was due to lower borrowing rates and decreases in average interest bearing liabilities, partially offset by the change in the net interest component of interest rate swaps, which was($64.6) million for the three months endedJune 30, 2020 compared to$83.7 million for the same period in 2019 and($78.5) million for the six months endedJune 30, 2020 compared to$217.7 million for the same period in 2019. We do not manage our portfolio to have a pre-designated amount of borrowings at quarter or year end. Our borrowings at period end are a snapshot of our borrowings as of a date, and this number may differ from average borrowings over the period for a number of reasons. The mortgage-backed securities we own pay principal and interest towards the end of each month and the mortgage-backed securities we purchase are typically settled during the beginning of the month. As a result, depending on the amount of mortgage-backed securities we have committed to purchase, we may retain the principal and interest we receive in the prior month, or we may use it to pay down our borrowings. Moreover, we generally use interest rate swaps, swaptions and other derivative instruments to hedge our portfolio, and as we pledge or receive collateral under these agreements, our borrowings on any given day may be increased or decreased. Our average borrowings during a quarter may differ from period end borrowings as we implement our portfolio management strategies and risk management strategies over changing market conditions by increasing or decreasing leverage. Additionally, these numbers may differ during periods when we conduct equity capital raises, as in certain instances we may purchase additional assets and increase leverage in anticipation of an equity capital raise. Since our average borrowings and period end borrowings can be expected to differ, we believe our average borrowings during a period provide a more accurate representation of our exposure to the risks associated with leverage than our period end borrowings. AtJune 30, 2020 andDecember 31, 2019 , the majority of our debt represented repurchase agreements and other secured financing arrangements collateralized by a pledge of ourResidential Securities , residential mortgage loans, commercial real estate investments and corporate loans. All of ourResidential Securities are currently accepted as collateral for these borrowings. However, we limit our borrowings, and thus our potential asset growth, in order to maintain unused borrowing capacity and maintain the liquidity and strength of our balance sheet. 60
--------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis Realized and Unrealized Gains (Losses) Realized and unrealized gains (losses) is comprised of net gains (losses) on interest rate swaps, net gains (losses) on disposal of investments and other, net gains (losses) on other derivatives and net unrealized gains (losses) on instruments measured at fair value through earnings. These components of realized and unrealized gains (losses) for the three and six months endedJune 30, 2020 and 2019 were as follows: For the Three Months Ended June 30, For the Six Months Ended June 30, 2020 2019 2020 2019 (dollars in thousands) Net gains (losses) on interest rate swaps (1)$ (91,665 ) $ (1,359,857 ) $ (3,330,929 ) $ (2,204,634 ) Net gains (losses) on disposal of investments and other 246,679 (38,333 ) 453,262 (132,249 ) Net gains (losses) on other derivatives 170,916 (506,411 ) 377,342 (621,570 ) Net unrealized gains (losses) on instruments measured at fair value through earnings 254,772 (4,881 ) (475,388 ) 42,748 Loan loss provision (68,751 ) - (168,077 ) (5,703 ) Total$ 511,951 $
(1,909,482 )
(1) Includes the net interest component of interest rate swaps, realized gains (losses) on termination or maturity of interest rate swaps and unrealized gains (losses) on interest rate swaps.
For the Three Months Ended
Net gains (losses) on interest rate swaps for the three months endedJune 30, 2020 was($91.7) million compared to($1.4) billion for the same period in 2019. The change was primarily attributable to favorable changes in unrealized gains (losses) on interest rate swaps, partially offset by unfavorable changes in realized gains (losses) on termination or maturity of interest rate swaps. Unrealized gains (losses) on interest rate swaps was$1.5 billion for the three months endedJune 30, 2020 , reflecting the reversal of unrealized losses upon termination of swaps during the period compared to($1.3) billion for the same period in 2019, reflecting a decline in forward interest rates during the period. Realized gains (losses) on termination or maturity of interest rate swaps was($1.5) billion resulting from fixed-rate payer and receiver interest rate swaps with notional amounts of$38.2 billion and$38.1 billion , respectively, for the three months endedJune 30, 2020 compared to($167.5) million resulting from the termination or maturity of fixed-rate payer interest rate swaps with a notional amount of$18.6 billion for the same period in 2019. Net gains (losses) on disposal of investments and other was$246.7 million for the three months endedJune 30, 2020 compared to($38.3) million for the same period in 2019. For the three months endedJune 30, 2020 , we disposed ofResidential Securities with a carrying value of$5.5 billion for an aggregate net gain of$259.9 million . For the same period in 2019, we disposed ofResidential Securities with a carrying value of$9.1 billion for an aggregate net loss of($34.3) million . Net gains (losses) on other derivatives was$170.9 million for the three months endedJune 30, 2020 compared to($506.4) million for the same period in 2019. The change in net gains (losses) on other derivatives was primarily comprised of lower net losses on futures derivatives, which was($17.3) million for the three months endedJune 30, 2020 compared to($597.2) million for the same period in 2019 and higher net gains on TBA derivatives, which was$204.2 million for the three months endedJune 30, 2020 compared to$105.9 million for the same period in 2019. Net unrealized gains (losses) on instruments measured at fair value through earnings was$254.8 million for the three months endedJune 30, 2020 compared to($4.9) million for the same period in 2019, primarily due to favorable changes in unrealized gains (losses) on commercial securitized loans of consolidated VIEs, credit risk transfer securities, residential loans and non-Agency mortgage-backed securities, partially offset by unfavorable changes in unrealized gains (losses) on commercial securitized debt of consolidated VIEs for the three months endedJune 30, 2020 compared to the same period in 2019. For the three months endedJune 30, 2020 , a loan loss provision of($68.8) million was recorded on commercial mortgage and corporate loans. No loan loss provision was recorded on loans for the three months endedJune 30, 2019 . Refer to the "Loans" Note located within Item 1 for additional information related to these loan loss provisions.
For the Six Months Ended
Net gains (losses) on interest rate swaps for the six months endedJune 30, 2020 was($3.3) billion compared to($2.2) billion for the same period in 2019, primarily attributable to unfavorable changes in realized gains (losses) on termination or maturity of interest rate swaps. Realized gains (losses) on termination or maturity of interest rate swaps was($1.9) billion resulting from fixed-rate payer and receiver interest rate swaps with notional amounts of$65.0 billion and$38.1 billion , respectively, for the six months endedJune 30, 2020 compared to($755.7) million resulting from fixed-rate payer and receiver interest rate swaps with notional amounts of$45.4 billion and$11.3 billion , respectively, for the same period in 2019. 61 --------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis Net gains (losses) on disposal of investments and other was$453.3 million for the six months endedJune 30, 2020 compared to($132.2) million for the same period in 2019. For the six months endedJune 30, 2020 , we disposed ofResidential Securities with a carrying value of$47.4 billion for an aggregate net gain of$527.1 million . For the same period in 2019, we disposed ofResidential Securities with a carrying value of$19.5 billion for an aggregate net loss of($126.8) million . Net gains (losses) on other derivatives was$377.3 million for the six months endedJune 30, 2020 compared to($621.6) million for the same period in 2019. The change in net gains (losses) on other derivatives was primarily comprised of lower net losses on futures derivatives, which was($289.9) million for the six months endedJune 30, 2020 compared to($886.6) million for the same period in 2019 and higher net gains on TBA derivatives, which was$635.9 million for the six months endedJune 30, 2020 compared to$279.7 million for the same period in 2019. Net unrealized gains (losses) on instruments measured at fair value through earnings was($475.4) million for the six months endedJune 30, 2020 compared to$42.7 million for the same period in 2019, primarily due to unfavorable changes in unrealized gains (losses) on commercial securitized loans of consolidated VIEs, securitized debt of consolidated VIEs backed by Agency mortgage-backed securities, Agency interest-only securities, credit risk transfer securities and residential loans, partially offset by favorable changes in unrealized gains (losses) on commercial securitized debt of consolidated VIEs for the six months endedJune 30, 2020 compared to the same period in 2019. For the six months endedJune 30, 2020 , a loan loss provision of($168.1) million was recorded on commercial mortgage and corporate loans. For the six months endedJune 30, 2019 , a loan loss provision of($5.7) million was recorded on a commercial mortgage loan. Refer to the "Loans" Note located within Item 1 for additional information related to these loan loss provisions. Other Income (Loss) Other income (loss) includes certain revenues and costs associated with our investments in commercial real estate, including rental income and recoveries, net servicing income on MSRs, operating costs as well as depreciation and amortization expense. We report in Other income (loss) items whose amounts, either individually or in the aggregate, would not, in the opinion of management, be meaningful to readers of the financial statements. Given the nature of certain components of this line item, balances may fluctuate from period to period. General and Administrative Expenses General and administrative ("G&A") expenses consist of compensation and management fee and other expenses. The following table shows our total G&A expenses as compared to average total assets and average equity for the periods presented. G&A Expenses and Operating Expense Ratios Total G&A Total G&A Expenses/Average Total G&A Expenses/Average Expenses (1) Assets (1) Equity (1) For the three months ended (dollars in thousands) June 30, 2020 $ 67,666 0.28 % 2.04 % June 30, 2019 $ 78,408 0.25 % 1.99 % For the six months ended June 30, 2020$ 145,295 0.27 % 2.06 % June 30, 2019$ 162,145 0.27 % 2.13 % (1) Includes$1.1 million of costs incurred in connection with the Internalization and costs incurred in connection with the CEO transition for the three months ended June 30, 2020. Includes$8.3 million of transaction costs incurred in connection with securitizations of residential whole loans and Agency mortgage-backed securities as well as costs incurred in connection with the Internalization and costs incurred in connection with the CEO transition for the six months ended June 30, 2020. Includes$3.0 million and$13.0 million of transaction costs incurred in connection with securitizations of residential whole loans and commercial loans for the three and six months ended June 30, 2019, respectively. Excluding these transaction costs, G&A expenses as a percentage of average total assets were 0.28% and 0.26% and as a percentage of average equity were 2.01% and 1.94% for the three and six months ended June 30, 2020, respectively. Excluding these transaction costs, G&A expenses as a percentage of average total assets were 0.24% and 0.25% and as a percentage of average equity were 1.91% and 1.96% for the three and six months ended June 30, 2019, respectively.
G&A expenses were
62
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ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis
and first half of 2020 reflecting lower adjusted stockholders' equity balances
compared to the same periods in 2019 and lower transaction costs in the second
quarter and first half of 2020 compared to the same periods in 2019.
Return on Average Equity
The following table shows the components of our annualized return on average
equity for the periods presented.
Components of Annualized Return on Average Equity
Economic Net Realized and
Interest Unrealized Gains G&A
Income/ and Other Income Expenses/ Income
Average Losses/Average (Loss)/Average Average Taxes/ Average Return on
Equity (1) Equity (2) Equity Equity Equity Average Equity
For the three
months ended
June 30, 2020 10.09 % 17.40 % 0.46 % (2.04 %) (0.07 %) 25.84 %
June 30, 2019 6.63 % (50.64 %) 0.72 % (1.99 %) 0.15 % (45.13 %)
For the six
months ended
June 30, 2020 5.27 % (43.48 %) 0.43 % (2.06 %) 0.35 % (39.49 %)
June 30, 2019 8.07 % (41.25 %) 0.73 % (2.13 %) 0.04 % (34.54 %)
(1) Economic net interest income includes the net interest component of interest rate swaps. (2) Realized and unrealized gains and losses excludes the net interest component of interest rate swaps.
Unrealized Gains and Losses - Available-for-Sale Investments
With our available-for-sale accounting treatment on our Agency mortgage-backed
securities, which represent the largest portion of assets on balance sheet, as
well as certain commercial mortgage-backed securities, unrealized fluctuations
in market values of assets do not impact our GAAP net income (loss) but rather
are reflected on our balance sheet by changing the carrying value of the asset
and stockholders' equity under accumulated other comprehensive income (loss). As
a result of this fair value accounting treatment, our book value and book value
per share are likely to fluctuate far more than if we used amortized cost
accounting. As a result, comparisons with companies that use amortized cost
accounting for some or all of their balance sheet may not be meaningful.
The table below shows cumulative unrealized gains and losses on our
available-for-sale investments reflected in the Consolidated Statements of
Financial Condition.
June 30, 2020 December 31, 2019
(dollars in thousands)
Unrealized gain $ 3,846,064 $ 2,267,577
Unrealized loss (3,990 )
(129,386 )
Accumulated other comprehensive income (loss)
Unrealized changes in the estimated fair value of available-for-sale investments may have a direct effect on our potential earnings and dividends: positive changes will increase our equity base and allow us to increase our borrowing capacity while negative changes tend to reduce borrowing capacity. A very large negative change in the net fair value of our available-for-saleResidential Securities might impair our liquidity position, requiring us to sell assets with the potential result of realized losses upon sale. The fair value of these securities being less than amortized cost atJune 30, 2020 is solely due to market conditions and not the quality of the assets. Substantially all of the Agency mortgage-backed securities are "AAA" rated or carry an implied "AAA" rating. The investments are not considered to be other-than-temporarily impaired because we currently have the ability and intent to hold the investments to maturity or for a period of time sufficient for a forecasted market price recovery up to or beyond the cost of the investments, and it is not more likely than not that we will be required to sell the investments before recovery of the amortized cost bases, which may be maturity. Also, we are guaranteed payment of the principal and interest amounts of the securities by the respective issuing Agency. Financial Condition Total assets were$93.5 billion and$130.3 billion atJune 30, 2020 andDecember 31, 2019 , respectively. The change, consistent with our portfolio repositioning to strengthen our balance sheet in the first quarter of 2020, was primarily due to a decrease in Agency mortgage-backed securities of$36.1 billion , excluding assets transferred or pledged to securitization vehicles, non-Agency mortgage-backed securities of$0.5 billion and residential mortgage loans of$0.5 billion , partially offset by an increase in assets 63 --------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis transferred or pledged to securitization vehicles of$0.7 billion . Our portfolio composition, net equity allocation and debt-to-net equity ratio by asset class were as follows atJune 30, 2020 : Residential Commercial CRE Debt &
Non-Agency MBS and Preferred
Agency MBS and Residential Mortgage Equity
MSRs TBAs (1) CRTs Loans (2) Investments Investments in CRE Corporate Debt
Total (3)
Assets (dollars in thousands)
Fair value/carrying
value $ 78,821,908 $ 19,148,701 $ 362,901 $ 4,620,863 $ 3,705,329 $ 746,067 $ 2,185,264 $ 90,442,332
Debt
Repurchase
agreements 65,730,018 19,030,505 51,654 708,792 673,134 - - 67,163,598
Other secured
financing 2,014 - - 641,189 - - 895,793 1,538,996
Debt issued by
securitization
vehicles 1,661,180 - - 2,356,828 2,440,122 - - 6,458,130
Net forward
purchases 1,363,933 - - 11,720 - - - 1,375,653
Mortgages payable - - - - - 508,565 - 508,565
Net equity allocated
902,334
$ 13,397,390 (4) Net equity allocated (%) 75 % 1 % 2 % 7 % 4 % 2 % 10 % 100 % Debt/net equity ratio 6.8:1 NM 0.2:1 4.1:1 5.3:1 2.1:1 0.7:1 5.5:1 (5) (1) Fair value/carrying value represents implied market value and repurchase agreements represent the notional value. (2) Includes loans held for sale, net. (3) Excludes the TBA asset, debt and equity balances. (4) Net Equity Allocated, as disclosed in the above table, excludes non-portfolio related activity and may differ from stockholders' equity per the Consolidated Statements of Financial Condition. (5) Represents the debt/net equity ratio as determined using amounts on the Consolidated Statements of Financial Condition. NM Not meaningful.Residential Securities Substantially all of our Agency mortgage-backed securities atJune 30, 2020 andDecember 31, 2019 were backed by single-family residential mortgage loans and were secured with a first lien position on the underlying single-family properties. Our mortgage-backed securities were largely Freddie Mac, Fannie Mae orGinnie Mae pass through certificates or CMOs, which carry an actual or implied "AAA" rating. We carry all of our Agency mortgage-backed securities at fair value on the Consolidated Statements of Financial Condition. We accrete discount balances as an increase to interest income over the expected life of the related interest earning assets and we amortize premium balances as a decrease to interest income over the expected life of the related interest earning assets. AtJune 30, 2020 andDecember 31, 2019 we had on our Consolidated Statements of Financial Condition a total of$92.8 million and$156.9 million , respectively, of unamortized discount (which is the difference between the remaining principal value and current amortized cost of ourResidential Securities , excluding securities transferred or pledged to securitization vehicles, acquired at a price below principal value) and a total of$3.8 billion and$5.3 billion , respectively, of unamortized premium (which is the difference between the remaining principal value and the current amortized cost of ourResidential Securities , excluding securities transferred or pledged to securitization vehicles, acquired at a price above principal value). The weighted average experienced prepayment speed on our Agency mortgage-backed securities portfolio for the three months endedJune 30, 2020 and 2019 was 19.5% and 11.2%, respectively. The weighted average projected long-term prepayment speed on our Agency mortgage-backed securities portfolio as ofJune 30, 2020 and 2019 was 18.0% and 14.5%, respectively. Given our current portfolio composition, if mortgage principal prepayment rates were to increase over the life of our mortgage-backed securities, all other factors being equal, our net interest income would decrease during the life of these mortgage-backed securities as we would be required to amortize our net premium balance into income over a shorter time period. Similarly, if mortgage principal prepayment rates were to decrease over the life of our mortgage-backed securities, all other factors being equal, our net interest income would increase during the life of these mortgage-backed securities as we would amortize our net premium balance over a longer time period. 64 --------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis The following tables present ourResidential Securities , excluding securities transferred or pledged to securitization vehicles, that were carried at fair value atJune 30, 2020 andDecember 31, 2019 . June 30, 2020 December 31, 2019 Estimated Fair Value Agency (dollars in thousands) Fixed-rate pass-through$ 74,214,631 $ 108,723,414 Adjustable-rate pass-through 589,140 1,524,331 CMO 162,674 160,016 Interest-only 522,934 708,562 Multifamily 1,213,206 1,717,197 Reverse mortgages 59,215 59,847 Total agency securities$ 76,761,800 $ 112,893,367 Residential credit CRT$ 362,901 $ 531,322 Alt-A 90,652 151,383 Prime 177,045 276,257 Prime interest-only 1,932 3,167 Subprime 120,687 348,979 NPL/RPL 190,515 164,268 Prime jumbo (>= 2010 vintage) 35,587
184,664
Prime jumbo (>= 2010 vintage) interest-only 3,422
7,150
Total residential credit securities
$ 77,744,541 $ 114,560,557
The following table summarizes certain characteristics of our
65
--------------------------------------------------------------------------------
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis
June 30, 2020 December 31, 2019
Residential Securities (1) (dollars in thousands)
Principal amount $ 70,653,951 $ 107,412,143
Net premium 3,027,942 4,309,668
Amortized cost 73,681,894 111,721,811
Amortized cost / principal amount 104.29 % 104.01 %
Carrying value 77,216,164 113,841,402
Carrying value / principal amount 109.29 % 105.99 % Weighted average coupon rate 3.72 % 3.91 % Weighted average yield 3.14 % 3.07 %Adjustable-rate Residential Securities (1) Principal amount$ 1,277,151 $
2,513,310
Weighted average coupon rate 3.50 % 4.13 % Weighted average yield 4.29 % 3.52 % Weighted average term to next adjustment 17 Months 13 Months Weighted average lifetime cap (2) 0.56 % 8.24 % Principal amount at period end as % of total residential securities 1.81 % 2.34 %Fixed-rate Residential Securities (1) Principal amount$ 69,376,800 $ 104,898,833 Weighted average coupon rate 3.72 % 3.90 % Weighted average yield 3.12 % 3.06 % Principal amount at period end as % of total residential securities 98.19 % 97.66 %Interest-only Residential Securities Notional amount$ 4,105,487 $ 5,447,193 Net premium 651,697 876,129 Amortized cost 651,697 876,129 Amortized cost / notional amount 15.87 % 16.08 % Carrying value 528,377
719,155
Carrying value / notional amount 12.87 % 13.20 % Weighted average coupon rate 4.13 % 3.29 % Weighted average yield NM 1.73 % (1) Excludes interest-only mortgage-backed securities. (2) Excludes non-Agency mortgage-backed securities and CRT securities as this attribute is not applicable to these asset classes. NM Not meaningful.
The following tables summarize certain characteristics of our Residential Credit
portfolio at
Payment Structure Investment Characteristics
60+
Product Total Senior Subordinate Coupon Credit Enhancement Delinquencies 3M VPR (1)
(dollars in thousands)
Agency credit risk
transfer $ 347,845 $ - $ 347,845 4.61 % 0.62 % 1.98 % 30.31 %
Private label credit
risk transfer 15,056 - 15,056 5.64 % 17.66 % 0.21 % 21.28 %
Alt-A 90,652 25,742 64,910 3.69 % 8.08 % 19.03 % 15.36 %
Prime 177,045 29,042 148,003 4.22 % 8.44 % 10.98 % 19.10 %
Prime interest-only 1,932 1,932 - 0.46 % - 4.12 % 42.15 %
Subprime 120,687 69,078 51,609 1.05 % 8.55 % 19.54 % 5.61 %
Re-performing loan
securitizations 190,515 59,238 131,277 3.96 % 26.56 % 28.43 % 6.18 %
Prime jumbo (>=2010
vintage) 35,587 - 35,587 3.83 % 1.87 % 3.35 % 45.14 %
Prime jumbo (>=2010
vintage) interest-only 3,422 3,422 - 0.37 % - 2.44 % 36.04 %
Total/weighted average
(2) $ 982,741 $ 188,454 $ 794,287 3.88 % 8.61 % 12.11 % 19.96 %
(1) Represents the 3 month voluntary prepayment rate ("VPR"). (2) Total investment characteristics exclude the impact of IOs.
66
--------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis Bond Coupon Estimated Product ARM Fixed Floater
Interest-Only Fair Value
(dollars in thousands)
Agency credit risk transfer $ - $ -
- $ 347,845
Private label credit risk
transfer - - 15,056 - 15,056
Alt-A 28,567 46,338 15,747 - 90,652
Prime 30,113 120,479 26,453 - 177,045
Prime interest-only - - - 1,932 1,932
Subprime - 4,088 116,501 98 120,687
Re-performing loan
securitizations - 190,515 - - 190,515
Prime jumbo (>=2010 vintage) - 35,587 - - 35,587
Prime jumbo (>=2010 vintage)
interest-only - - - 3,422 3,422
Total $ 58,680 $ 397,007 $ 521,602 $ 5,452 $ 982,741
Contractual Obligations
The following table summarizes the effect on our liquidity and cash flows from
contractual obligations at June 30, 2020 . The table does not include the effect
of net interest rate payments on our interest rate swap agreements. The net swap
payments will fluctuate based on monthly changes in the floating rate. At
June 30, 2020 , the interest rate swaps had a net fair value of ($1.2) billion .
Within One One to Three Three to Five More than
Year Years Years Five Years Total
(dollars in thousands)
Repurchase agreements $ 67,163,598 $ - $ - $ - $ 67,163,598
Interest expense on repurchase
agreements (1) 88,581 - - - 88,581
Other secured financing 632,407 10,796 895,793 - 1,538,996
Interest expense on other
secured financing (1) 25,947 41,524 26,223 - 93,694
Debt issued by securitization
vehicles (principal) - - 205,445 6,235,881 6,441,326
Interest expense on debt issued
by securitization vehicles 150,690 229,338 226,808 2,577,044 3,183,880
Mortgages payable (principal) 22,726 39,961 172,843 278,475 514,005
Interest expense on mortgages
payable 20,419 40,000 37,578 130,784 228,781
Long-term operating lease
obligations 3,927 7,727 7,723 965 20,342
Total $ 68,108,295 $ 369,346 $ 1,572,413 $ 9,223,149 $ 79,273,203
(1) Interest expense on repurchase agreements and other secured financing
calculated based on rates at June 30, 2020 .
In the coming periods, we expect to continue to finance our Residential
Securities in a manner that is largely consistent with our current operations
via repurchase agreements. We may use securitization structures, credit
facilities, mortgages payable or other term financing structures to finance
certain of our assets. During the six months ended June 30, 2020 , we received
$9.3 billion from principal repayments and $46.8 billion in cash from disposal
of Residential Securities . During the six months ended June 30, 2019 , we
received $6.1 billion from principal repayments and $13.2 billion in cash from
disposal of Residential Securities .
Off-Balance Sheet Arrangements
We do not have any relationships with unconsolidated entities or financial
partnerships which would have been established for the sole purpose of
facilitating off-balance sheet arrangements or other contractually narrow or
limited purposes.
We have limited future funding commitments related to certain of our
unconsolidated joint ventures. In addition, we have provided customary
non-recourse carve-out and environmental guarantees (or underlying indemnities
with respect thereto) with respect to mortgage loans held by subsidiaries of
these unconsolidated joint ventures. We believe that the likelihood of making
any payments under these guarantees is remote, and have not accrued a related
liability at June 30, 2020 .
Capital Management
67
--------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis Maintaining a strong balance sheet that can support the business even in times of economic stress and market volatility is of critical importance to our business strategy. A strong and robust capital position is essential to executing our investment strategy. Our capital strategy is predicated on a strong capital position, which enables us to execute our investment strategy regardless of the market environment. Our capital policy defines the parameters and principles supporting a comprehensive capital management practice. The major risks impacting capital are capital, liquidity and funding risk, investment/market risk, credit risk, counterparty risk, operational risk and compliance, regulatory and legal risk. For further discussion of the risks we are subject to, please see Part I, Item 1A. "Risk Factors" in our most recent Annual Report on Form 10-K and in Part II, Item 1A. "Risk Factors" in this Quarterly Report on Form 10-Q and in our Quarterly Report on Form 10-Q for the quarter endedMarch 31, 2020 . Capital requirements are based on maintaining levels above approved thresholds, ensuring the quality of our capital appropriately reflects our asset mix, market and funding structure. In the event we fall short of our internal thresholds, we will consider appropriate actions which may include asset sales, changes in asset mix, reductions in asset purchases or originations, issuance of capital or other capital enhancing or risk reduction strategies. Stockholders' Equity The following table provides a summary of total stockholders' equity atJune 30, 2020 andDecember 31, 2019 :June 30, 2020 December 31, 2019 Stockholders' equity (dollars in
thousands)
7.50% Series D cumulative redeemable preferred stock$ 445,457 $
445,457
6.95% Series F fixed-to-floating rate cumulative redeemable preferred stock 696,910
696,910
6.50% Series G fixed-to-floating rate cumulative redeemable preferred stock 411,335
411,335
6.75% Series I fixed-to-floating rate cumulative redeemable preferred stock 428,324 428,324 Common stock 14,077 14,301 Additional paid-in capital 19,827,216 19,966,923 Accumulated other comprehensive income (loss) 3,842,074 2,138,191 Accumulated deficit (11,871,927 ) (8,309,424 ) Total stockholders' equity$ 13,793,466 $ 15,792,017 Capital Stock
The following table provides activity related to our Direct Purchase and Dividend Reinvestment Program for the periods presented:
For the Three Months Ended
June 30, 2020 June 30, 2019
(dollars in thousands)
Shares issued through direct purchase and
dividend reinvestment program 63,000 180,000
Amount raised from direct purchase and dividend reinvestment program $ 405 $
1,795
During the six months endedJune 30, 2019 , we closed the public offering of an original issuance of 75.0 million shares of common stock for proceeds of$730.5 million before deducting offering expenses. In connection with the offering, we granted the underwriters a thirty-day option to purchase up to an additional 11.3 million shares of common stock, which the underwriters exercised in full resulting in an additional$109.6 million in proceeds before deducting offering expenses. No shares were issued under the at-the-market sales program during the six months endedJune 30, 2020 . During the three and six months endedJune 30, 2019 , we issued 8.0 million and 56.0 million shares, respectively, for proceeds of$80.1 million and$569.1 million , respectively, net of commissions and fees, under the at-the-market sales program. InJune 2019 , we announced that our Board had authorized the repurchase of up to$1.5 billion of our outstanding shares of common stock throughDecember 31, 2020 . During the three and six months endedJune 30, 2020 , we repurchased an aggregate of 22.9 million shares of our common stock for an aggregate amount of$143.3 million , excluding commission costs. All common shares purchased were part of a publicly announced plan in open-market transactions. 68 --------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis During the three and six months endedJune 30, 2019 , we redeemed all 2.2 million of our issued and outstanding shares of 8.125% Series H Cumulative Redeemable Preferred Stock ("Series H Preferred Stock") for$55.0 million . The cash redemption amount for each share of Series H Preferred Stock was$25.00 plus accrued and unpaid dividends to, but not including, the redemption date ofMay 31, 2019 . During the three and six months endedJune 30, 2019 , we issued 16.0 million shares of our 6.750% Series I Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock for gross proceeds of$400.0 million before deducting the underwriting discount and other estimated offering costs. Leverage and Capital We believe that it is prudent to maintain conservative debt-to-equity and economic leverage ratios as there may be continued volatility in the mortgage and credit markets. Our capital policy governs our capital and leverage position including setting limits. Based on the guidelines, we generally expect to maintain an economic leverage ratio of less than 10:1. Our actual economic leverage ratio varies from time to time based upon various factors, including our opinion of the level of risk of our assets and liabilities, our liquidity position, our level of unused borrowing capacity, the availability of credit, over-collateralization levels required by lenders when we pledge assets to secure borrowings and our assessment of domestic and international market conditions. Our debt-to-equity ratio atJune 30, 2020 andDecember 31, 2019 was 5.5:1 and 7.1:1, respectively. Our economic leverage ratio, which is computed as the sum of Recourse Debt, cost basis of TBA derivative and CMBX notional outstanding and net forward purchases (sales) of investments divided by total equity was 6.4:1 and 7.2:1 atJune 30, 2020 andDecember 31, 2019 , respectively. Our capital ratio, which represents our ratio of stockholders' equity to total assets (inclusive of total market value of TBA derivatives and shown net of debt issued by securitization vehicles), was 13.0% and 12.0% atJune 30, 2020 andDecember 31, 2019 , respectively. Risk Management For more information on COVID-19, including actions we have taken in response, please refer to the section titled "Business Environment and Coronavirus Disease 2019 ("COVID-19")" within this Item 2. We are subject to a variety of risks in the ordinary conduct of our business. The effective management of these risks is of critical importance to the overall success of Annaly. The objective of our risk management framework is to identify, measure and monitor these risks. Our risk management framework is intended to facilitate a holistic, enterprise wide view of risk. We have built a strong and collaborative risk management culture throughout Annaly focused on awareness which supports appropriate understanding and management of our key risks. Each employee is accountable for identifying, monitoring and managing risk within their area of responsibility. Risk Appetite We maintain a firm-wide risk appetite statement which defines the types and levels of risk we are willing to take in order to achieve our business objectives, and reflects our risk management philosophy. We engage in risk activities based on our core expertise that aim to enhance value for our stockholders. Our activities focus on income generation and capital preservation through proactive portfolio management, supported by a conservative liquidity and leverage posture. The risk appetite statement asserts the following key risk parameters to guide our investment management activities: Risk Parameter Description Portfolio We will maintain a portfolio comprised of target assets approved Composition by our Board and in accordance with our capital allocation policy. Leverage We generally expect to maintain an economic leverage ratio no greater than 10:1. We will seek to maintain an unencumbered asset portfolio Liquidity Risk sufficient to meet our liquidity needs under adverse market conditions. Interest Rate We will seek to manage interest rate risk to protect the Risk portfolio from adverse rate movements utilizing derivative instruments targeting both income and capital preservation. We will seek to manage credit risk by making investments which Credit Risk conform within our specific investment policy parameters and optimize risk-adjusted returns. Capital We will seek to protect our capital base through disciplined Preservation risk management practices. We will seek to comply with regulatory requirements needed to Compliance maintain our REIT status and our exemption from registration under the Investment Company Act. 69
--------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis
Governance
Risk management begins with our Board, through the review and oversight of the
risk management framework, and executive management, through the ongoing
formulation of risk management practices and related execution in managing risk.
The Board exercises its oversight of risk management primarily through the Board
Risk Committee ("BRC") and Board Audit Committee ("BAC"). The BRC is responsible
for oversight of our risk governance structure, risk management and risk
assessment guidelines and policies and our risk appetite. The BAC is responsible
for oversight of the quality and integrity of our accounting, internal controls
and financial reporting practices, including independent auditor selection,
evaluation and review, and oversight of the internal audit function.
Risk assessment and risk management are the responsibility of our management. A
series of management committees has oversight or decision-making
responsibilities for risk management activities. Membership of these committees
is reviewed regularly to ensure the appropriate personnel are engaged in the
risk management process. Four primary management committees have been
established to provide a comprehensive framework for risk management. The
management committees responsible for our risk management include the Enterprise
Risk Committee ("ERC"), Asset and Liability Committee ("ALCO"), Investment
Committee and the Financial Reporting and Disclosure Committee ("FRDC"). Each of
these committees reports to our management Operating Committee which is
responsible for oversight and management of our operations, including oversight
and approval authority over all aspects of our enterprise risk management.
Audit Services is an independent function with reporting lines to the BAC. Audit
Services is responsible for performing our internal audit activities, which
includes independently assessing and validating key controls within the risk
management framework.
Our compliance group is responsible for oversight of our regulatory compliance.
Our Chief Compliance Officer has reporting lines to the BAC.
Description of Risks
We are subject to a variety of risks due to the business we operate. Risk
categories are an important component of a robust enterprise wide risk
management framework.
We have identified the following primary categories that we utilize to identify,
assess, measure and monitor risk.
Risk Description
Risk to earnings, capital or business resulting from
Capital, Liquidity and our inability to meet our obligations when they come
Funding Risk due without incurring unacceptable losses because of
inability to liquidate assets or obtain adequate
funding.
Risk to earnings, capital or business resulting in
the decline in value of our assets or an increase in
Investment/Market Risk the costs of financing caused by changes in market
variables, such as interest rates, which affect the
values of investment securities and other investment
instruments.
Risk to earnings, capital or business resulting from
an obligor's failure to meet the terms of any
Credit Risk contract or otherwise failure to perform as agreed.
This risk is present in lending and investing
activities.
Risk to earnings, capital or business resulting from
a counterparty's failure to meet the terms of any
Counterparty Risk contract or otherwise failure to perform as agreed.
This risk is present in funding, hedging and
investing activities.
Risk to earnings, capital, reputation or business
Operational Risk arising from inadequate or failed internal processes
or systems (including proprietary and third party
models), human factors or external events.
Risk to earnings, capital, reputation or conduct of
business arising from violations of, or
Compliance, Regulatory nonconformance with internal and external applicable
and Legal Risk rules and regulations, losses resulting from
lawsuits or adverse judgments, or from changes in
the regulatory environment that may impact our
business model.
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--------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis Capital, Liquidity and Funding Risk Management Our capital, liquidity and funding risk management strategy is designed to ensure the availability of sufficient resources to support our business and meet our financial obligations under both normal and adverse market and business environments. Our capital, liquidity and funding risk management practices consist of the following primary elements: Element Description Funding Availability of diverse and stable sources of funds. Excess Liquidity Excess liquidity primarily in the form of unencumbered assets and cash. Maturity Profile Diversity and tenor of liabilities and modest use of leverage. Stress Testing Scenario modeling to measure the resiliency of our liquidity position. Liquidity Management Comprehensive policies including monitoring, risk Policies limits and an escalation protocol. Funding Our primary financing sources are repurchase agreements provided through counterparty arrangements and through Arcola, other secured financing, debt issued by securitization vehicles, mortgages, credit facilities, note sales and various forms of equity. We maintain excess liquidity by holding unencumbered liquid assets that could be either used to collateralize additional borrowings or sold. We seek to conservatively manage our repurchase agreement funding position through a variety of methods including diversity, breadth and depth of counterparties and maintaining a staggered maturity profile. Our wholly-owned subsidiary, Arcola, provides direct access to third party funding as aFINRA member broker-dealer. Arcola borrows funds through the General Collateral Finance Repo service offered by the FICC, with FICC acting as the central counterparty. In addition, Arcola has historically borrowed funds through direct repurchase agreements. To reduce our liquidity risk we maintain a laddered approach to our repurchase agreements. AtJune 30, 2020 andDecember 31, 2019 , the weighted average days to maturity was 74 days and 65 days, respectively. Our repurchase agreements generally provide that in the event of a margin call we must provide additional securities or cash on the same business day that a margin call is made. Should prepayment speeds on the mortgages underlying our Agency and Residential mortgage-backed securities and/or market interest rates or other factors move suddenly and cause declines in the market value of assets posted as collateral, resulting margin calls may cause an adverse change in our liquidity position. We maintain access toFederal Home Loan Bank ("FHLB") funding through our captive insurance subsidiaryTruman Insurance Company LLC ("Truman"). A 2016 rule from theFederal Housing Finance Agency ("FHFA") requires captive insurance companies to terminate their FHLB membership, however, given the length of its membership at the time the rule was enacted, Truman was granted a five year sunset provision whereby its membership will expire inFebruary 2021 . We believe our business objectives align well with the mission of the FHLB System. While there can be no assurances that such steps will be taken, we believe it would be appropriate for there to be legislative or other action to permit Truman and similar captive insurance subsidiaries to retain their membership status beyond the current sunset period. However, in anticipation of the expiration of our membership, we have commenced actions to refinance our FHLB advances with alternative funding sources, including credit facilities and securitization funding. AtJune 30, 2020 , we had total financial assets and cash pledged against existing liabilities of$75.5 billion . The weighted average haircut was approximately 4% on repurchase agreements. The quality and character of theResidential Securities and commercial real estate investments that we pledge as collateral under the repurchase agreements and interest rate swaps did not materially change atJune 30, 2020 compared to the same period in 2019, and our counterparties did not materially alter any requirements, including required haircuts, related to the collateral we pledge under repurchase agreements and interest rate swaps during the three months endedJune 30, 2020 . The following table presents our quarterly average and quarter-end repurchase agreement and reverse repurchase agreement balances outstanding for the periods presented: 71
--------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis Repurchase Agreements
Reverse Repurchase Agreements
Average Daily Average Daily
Amount Ending Amount Amount Ending Amount
Outstanding Outstanding Outstanding Outstanding
For the three months ended (dollars in thousands)
June 30, 2020 $ 68,468,813 $ 67,163,598 $ 183,423 $ -
March 31, 2020 96,756,341 72,580,183 461,123 -
December 31, 2019 102,760,107 101,740,728 1,006,487 -
September 30, 2019 108,389,796 102,682,104 1,459,070 -
June 30, 2019 101,983,828 105,181,241 3,478,510 -
March 31, 2019 87,781,404 88,554,170 3,937,769 523,449
December 31, 2018 83,984,254 81,115,874 2,741,022 650,040
September 30, 2018 79,214,382 79,073,026 2,330,519 1,234,704
June 30, 2018 80,582,681 75,760,655 2,929,470 259,762
The following table provides information on our repurchase agreements and other
secured financing by maturity date at June 30, 2020 . The weighted average
remaining maturity on our repurchase agreements and other secured financing was
95 days at June 30, 2020 :
June 30, 2020
Principal Weighted
Balance Average Rate % of Total
(dollars in thousands)
1 day $ 15,091,891 0.15 % 22.0 %2 to 29 days 18,084,981 0.48 % 26.3 % 30 to 59 days 4,992,032 0.67 %
7.3 %
60 to 89 days 5,436,637 0.47 % 7.9 %
90 to 119 days 8,671,500 0.58 % 12.6 %
Over 120 days (1) 16,425,553 0.86 % 23.9 %
Total $ 68,702,594 0.52 % 100.0 %
(1) Approximately 3% of the total repurchase agreements and other
secured financing had a remaining maturity over 1 year.
The table below presents our outstanding debt balances and associated weighted
average rates and days to maturity at
Weighted Average Rate
Principal Weighted Average
Balance As of Period End For the Quarter Days to Maturity (1)
(dollars inthousands)
Repurchase agreements$ 67,163,598 0.49 % 0.79 % 74 Other secured financing (2) 1,538,996 1.99 % 2.50 % 990 Securitized debt of consolidated VIEs (3) 6,441,326 2.30 % 2.32 % 7,315 Mortgages payable (3) 514,005 3.99 % 4.08 % 4,274
Total indebtedness
(1) Determined based on estimated weighted-average lives of the underlying debt instruments. (2) Includes advances from theFederal Home Loan Bank of Des Moines of$0.6 billion and financing under credit facilities. (3) Non-recourse to Annaly. Excess Liquidity Our primary source of liquidity is the availability of unencumbered assets which may be provided as collateral to support additional funding needs. We target minimum thresholds of available, unencumbered assets to maintain excess liquidity. The following table illustrates our asset portfolio available to support potential collateral obligations and funding needs. 72 --------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis Assets are considered encumbered if pledged as collateral against an existing liability, and therefore are no longer available to support additional funding. An asset is considered unencumbered if it has not been pledged or securitized. The following table also provides the carrying amount of our encumbered and unencumbered financial assets atJune 30, 2020 : Unencumbered Encumbered Assets Assets Total Financial assets (dollars in thousands) Cash and cash equivalents $ 1,168,816$ 225,094 $ 1,393,910 Investments, at carrying value (1) Agency mortgage-backed securities (2) 71,576,324 5,671,495 77,247,819 Credit risk transfer securities 63,873 299,028 362,901 Non-agency mortgage-backed securities 524,463 95,377 619,840 Residential mortgage loans (2) 3,664,422 336,601 4,001,023 MSRs 2,517 224,883 227,400 Commercial real estate debt investments (2) 2,026,378 185,447 2,211,825 Commercial real estate debt and preferred equity, held for investment (2) 1,353,830 139,674 1,493,504 Corporate debt, held for investment 1,533,004 652,260 2,185,264 Other assets (3) - 103,038 103,038 Total financial assets$ 81,913,627 $ 7,932,897 $ 89,846,524 (1) The amounts reflected in the table above are on a settlement date basis and may differ from the total positions reported on the Consolidated Statements of Financial Condition. (2) Includes assets transferred or pledged to securitization vehicles. (3) Includes interests in certain joint ventures and equity instruments. We maintain liquid assets in order to satisfy our current and future obligations in normal and stressed operating environments. These are held as the primary means of liquidity risk mitigation. The composition of our liquid assets is also considered and is subject to certain parameters. The composition is monitored for concentration risk and asset type. We believe the assets we consider liquid can be readily converted into cash, through liquidation or by being used as collateral in financing arrangements (including as additional collateral to support existing financial arrangements). Our balance sheet also generates liquidity on an on-going basis through mortgage principal and interest repayments and net earnings held prior to payment of dividends. The following table presents our liquid assets as a percentage of total assets atJune 30, 2020 : Carrying Value (1) (dollars in Liquid assets thousands) Cash and cash equivalents$ 1,393,910 Residential Securities (2) (3)
76,397,754
Residential mortgage loans (4)
1,168,521
Commercial real estate debt investments (5)
61,202
Commercial real estate debt and preferred equity, held for investment (6)
552,374
Corporate debt, held for investment (7)
1,636,099
Total liquid assets $
81,209,860
Percentage of liquid assets to carrying amount of encumbered and unencumbered financial assets (8)
98.85 %
(1) Carrying value approximates the market value of assets. The assets
listed in this table include
pledged as collateral against existing liabilities at
Please refer to the Encumbered and Unencumbered Assets table for related
information.
(2) The amounts reflected in the table above are on a settlement date basisand may differ from the total positions reported on the Consolidated
Statements of Financial Condition.
(3) Excludes securitized Agency mortgage-backed securities of consolidated
VIEs carried at fair value of $1.8 billion .
(4) Excludes securitized residential mortgage loans transferred or pledged
to consolidated VIEs carried at fair value of $2.8 billion .
(5) Excludes securitized commercial mortgage loans of consolidated VIEs
carried at fair value of $2.2 billion .
(6) Excludes senior securitized commercial mortgage loans of consolidated
VIEs carried at fair value of $0.9 billion .
(7) Excludes certain second lien loans.
(8) Denominator is computed based on the carrying amount of encumbered andencumbered financial assets, excluding assets transferred or pledged to
securitization vehicles of $7.7 billion .
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--------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis Maturity Profile We consider the profile of our assets, liabilities and derivatives when managing both liquidity risk as well as investment/market risk employing a measurement of both the maturity gap and interest rate sensitivity gap. We determine the amount of liquid assets that are required to be held by monitoring several liquidity metrics. We utilize several modeling techniques to analyze our current and potential obligations including the expected cash flows from our assets, liabilities and derivatives. The following table illustrates the expected final maturities and cash flows of our assets, liabilities and derivatives. The table is based on a static portfolio and assumes no reinvestment of asset cash flows and no future liabilities are entered into. In assessing the maturity of our assets, liabilities and off balance sheet obligations, we use the stated maturities, or our prepayment expectations for assets and liabilities that exhibit prepayment characteristics. Cash and cash equivalents are included in the 'Less than 3 Months' maturity bucket, as they are typically held for a short period of time. With respect to each maturity bucket, our maturity gap is considered negative when the amount of maturing liabilities exceeds the amount of maturing assets. A negative gap increases our liquidity risk as we must enter into future liabilities. Our interest rate sensitivity gap is the difference between interest earning assets and interest bearing liabilities maturing or re-pricing within a given time period. Unlike the calculation of maturity gap, interest rate sensitivity gap includes the effect of our interest rate swaps. A gap is considered positive when the amount of interest-rate sensitive assets exceeds the amount of interest-rate sensitive liabilities. A gap is considered negative when the amount of interest-rate sensitive liabilities exceeds interest-rate sensitive assets. During a period of rising interest rates, a negative gap would tend to adversely affect net interest income, while a positive gap would tend to result in an increase in net interest income. During a period of falling interest rates, a negative gap would tend to result in an increase in net interest income, while a positive gap would tend to affect net interest income adversely. Because different types of assets and liabilities with the same or similar maturities may react differently to changes in overall market rates or conditions, changes in interest rates may affect net interest income positively or negatively even if assets and liabilities were perfectly matched in each maturity category. The amount of assets and liabilities utilized to compute our interest rate sensitivity gap was determined in accordance with the contractual terms of the assets and liabilities, except that adjustable-rate loans and securities are included in the period in which their interest rates are first scheduled to adjust and not in the period in which they mature. The effects of interest rate swaps, whereby we generally pay a fixed rate and receive a floating rate and effectively lock in our financing costs for a longer term, are also reflected in our interest rate sensitivity gap. 74
--------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis The interest rate sensitivity of our assets and liabilities in the following table atJune 30, 2020 could vary substantially based on actual prepayment experience. Less than 3 More than 1 Year to Months 3-12 Months 3 Years 3 Years and Over Total Financial assets (dollars in thousands) Cash and cash equivalents$ 1,393,910 $ - $ - $ -$ 1,393,910 Agency mortgage-backed securities (principal) 1,125,000 6,668 1,881,750 66,577,609 69,591,027 Credit risk transfer securities (principal) - - 36,906 373,226 410,132 Non-agency mortgage-backed securities (principal) - 10,104 229,870 412,818 652,792 Commercial mortgage-backed securities (principal) - - - 74,458 74,458 Total securities 1,125,000 16,772 2,148,526 67,438,111 70,728,409 Residential mortgage loans (principal) - - - 1,175,854 1,175,854 Commercial real estate debt and preferred equity (principal) 147,395 60,898 446,757 55,303 710,353 Corporate debt (principal) 2,506 40,649 328,143 1,895,613 2,266,911 Total loans 149,901 101,547 774,900 3,126,770 4,153,118 Assets transferred or pledged to securitization vehicles (principal) - - - 7,642,430 7,642,430 Total financial assets - maturity 2,668,811 118,319 2,923,426 78,207,311 83,917,867 Effect of utilizing reset dates (1) 6,185,251 1,250,330 (649,418 ) (6,786,163 ) - Total financial assets - interest rate sensitive$ 8,854,062 $ 1,368,649 $ 2,274,008 $ 71,421,148 $ 83,917,867 Financial liabilities Repurchase agreements$ 43,754,592 $ 23,409,006 $ - $ -$ 67,163,598 Other secured financing 23,100 609,307 10,796 895,793 1,538,996 Debt issued by securitization vehicles (principal) - - - 6,441,326 6,441,326 Total financial liabilities - maturity 43,777,692 24,018,313 10,796 7,337,119 75,143,920 Effect of utilizing reset dates (1)(2) (18,911,967 ) (4,425,614 ) 17,323,850 6,013,731 Total financial liabilities - interest rate sensitive$ 24,865,725 $ 19,592,699
Maturity gap$ (41,108,881 ) $ (23,899,994
)
Cumulative maturity gap
Interest rate sensitivity gap
Cumulative rate sensitivity gap
(1) Maturity gap utilizes stated maturities, or prepayment expectations for assets that exhibit prepayment characteristics, while interest rate sensitivity gap utilizes reset dates, if applicable. (2) Includes effect of interest rate swaps.
The methodologies we employ for evaluating interest rate risk include an analysis of our interest rate "gap," measurement of the duration and convexity of our portfolio and sensitivities to interest rates and spreads.
Stress Testing
We utilize liquidity stress testing to ensure we have sufficient liquidity under
a variety of scenarios and stresses. These stress tests assist with the
management of our pool of liquid assets and influence our current and future
funding plans. Our stress tests are modeled over both short term and longer time
horizons. The stresses applied include market-wide and firm-specific stresses.
Liquidity Management Policies
We utilize a comprehensive liquidity policy structure to inform our liquidity
risk management practices including monitoring and measurement, along with
well-defined key risk indicators. Both quantitative and qualitative targets are
utilized to measure the ongoing stability and condition of the liquidity
position, and include the level and composition of unencumbered assets, as well
as both short-term and long-term sustainability of the funding composition under
stress conditions.
We also monitor early warning metrics designed to measure the quality and depth
of liquidity sources based upon both company-specific and market conditions. The
metrics assist in assessing our liquidity conditions and are integrated into our
escalation protocol.
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--------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis Investment/Market Risk Management One of the primary risks we are subject to is investment/market risk. Changes in the level of interest rates can affect our net interest income, which is the difference between the income we earn on our interest earning assets and the interest expense incurred from interest bearing liabilities and derivatives. Changes in the level of interest rates and spreads can also affect the value of our securities and potential realization of gains or losses from the sale of these assets. We may utilize a variety of financial instruments, including interest rate swaps, swaptions, options, futures and other hedges, in order to limit the adverse effects of interest rates on our results. In the case of interest rate swaps, we utilize contracts linked to LIBOR but may also enter into interest rate swaps where the floating leg is linked to the overnight index swap rate or another index, particularly in light of a potential transition away from LIBOR. In addition, we may use MAC interest rate swaps in which we may receive or make a payment at the time of entering such interest rate swap to compensate for the off-market nature of such interest rate swap. MAC interest rate swaps offer price transparency, flexibility and more efficient portfolio administration through compression which is the process of reducing the number of unique interest rate swap contracts and replacing them with fewer contracts containing market defined terms. Our portfolio and the value of our portfolio, including derivatives, may be adversely affected as a result of changing interest rates and spreads. We simulate a wide variety of interest rate scenarios in evaluating our risk. Scenarios are run to capture our sensitivity to changes in interest rates, spreads and the shape of the yield curve. We also consider the assumptions affecting our analysis such as those related to prepayments. In addition to predefined interest rate scenarios, we utilize Value-at-Risk measures to estimate potential losses in the portfolio over various time horizons utilizing various confidence levels. The following tables estimate the potential changes in economic net interest income over a twelve month period and the immediate effect on our portfolio market value (inclusive of derivative instruments), should interest rates instantaneously increase or decrease by 25, 50 or 75 basis points, and the effect of portfolio market value if mortgage option-adjusted spreads instantaneously increase or decrease by 5, 15 or 25 basis points (assuming shocks are parallel and instantaneous). All changes to income and portfolio market value are measured as percentage changes from the projected net interest income and portfolio value at the base interest rate scenario. The net interest income simulations incorporate the interest expense effect of rate resets on liabilities and derivatives as well as the amortization expense and reinvestment of principal based on the prepayments on our securities, which varies based on the level of rates. The results assume no management actions in response to the rate or spread changes. The following table presents estimates atJune 30, 2020 . Actual results could differ materially from these estimates. Projected Percentage Change in Economic Estimated Percentage Estimated Change as Change in Interest Net Interest Change in Portfolio a Rate (1) Income (2) Value (3) % on NAV (3)(4) -75 Basis points (22.2%) -% (0.2%) -50 Basis points (16.2%) 0.1% 0.9% -25 Basis points (7.5%) 0.3% 1.7% +25 Basis points 4.3% (0.1%) (0.9%) +50 Basis points 14.8% (0.3%) (2.3%) +75 Basis points 20.9% (0.6%) (4.2%)
Estimated Change in Estimated Change as
MBS Spread Shock Portfolio Market a
(1) Value % on NAV (3)(4)
-25 Basis points 1.3% 8.8%
-15 Basis points 0.8% 5.3%
-5 Basis points 0.3% 1.8%
+5 Basis points (0.3%) (1.7%)
+15 Basis points (0.8%) (5.2%)
+25 Basis points (1.3%) (8.7%)
(1) Interest rate and MBS spread sensitivity are based on results from third party
models in conjunction with inputs from our internal investment professionals. Actual
results could differ materially from these estimates.
(2) Scenarios include Residential Securities , commercial real estate investments,
corporate debt, repurchase agreements, other secured financing and interest rate
swaps. Economic net interest income includes the net interest component of interest
rate swaps.
(3) Scenarios include Residential Securities , residential mortgage loans, MSRs and
derivative instruments.
(4) NAV represents book value of equity.
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--------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis Credit Risk Management Key risk parameters have been established to specify our credit risk appetite. We seek to manage credit risk by making investments which conform within the firm's specific investment policy parameters and optimize risk-return attributes. While we do not expect to encounter credit risk in our Agency mortgage-backed securities, we face credit risk on the non-Agency mortgage-backed securities and CRT securities in our portfolio. In addition, we are also exposed to credit risk on residential mortgage loans, commercial real estate investments and corporate debt. MSR values may also be impacted if overall costs to service the underlying mortgage loans increase due to borrower performance. We are subject to risk of loss if an issuer or borrower fails to perform its contractual obligations. We have established policies and procedures for mitigating credit risk, including establishing and reviewing limits for credit exposure. We will originate or purchase commercial investments that meet our comprehensive underwriting process and credit standards and are approved by the appropriate committee. Once a commercial investment is made, our ongoing surveillance process includes regular reviews, analysis and oversight of investments by our investment personnel and appropriate committee. We review credit and other risks of loss associated with each investment. Our management monitors the overall portfolio risk and determines estimates of provision for loss. Additionally, ALCO has oversight of our credit risk exposure. Our portfolio composition, based on balance sheet values, atJune 30, 2020 andDecember 31, 2019 was as follows:June 30, 2020 December 31 ,
2019
Category
Agency mortgage-backed securities (1) 86.9 % 89.5 % Credit risk transfer securities 0.4 % 0.4 % Non-agency mortgage-backed securities 0.7 % 0.9 % Residential mortgage loans (1) 4.4 % 3.3 % Mortgage servicing rights 0.3 % 0.3 % Commercial real estate (1) (2) 4.9 % 3.9 % Corporate debt 2.4 % 1.7 % (1) Includes assets transferred or pledged to securitization vehicles. (2) Net of unamortized origination fees. Counterparty Risk Management Our use of repurchase and derivative agreements and trading activities create exposure to counterparty risk relating to potential losses that could be recognized if the counterparties to these agreements fail to perform their obligations under the contracts. In the event of default by a counterparty, we could have difficulty obtaining our assets pledged as collateral. A significant portion of our investments are financed with repurchase agreements by pledging ourResidential Securities and certain commercial real estate investments as collateral to the applicable lender. The collateral we pledge generally exceeds the amount of the borrowings under each agreement. If the counterparty to the repurchase agreement defaults on its obligations and we are not able to recover our pledged asset, we are at risk of losing the over-collateralization or haircut. The amount of this exposure is the difference between the amount loaned to us plus interest due to the counterparty and the fair value of the collateral pledged by us to the lender including accrued interest receivable on such collateral. We also use interest rate swaps and other derivatives to manage interest rate risk. Under these agreements, we pledge securities and cash as collateral or settle variation margin payments as part of a margin arrangement. If a counterparty were to default on its obligations, we would be exposed to a loss to a derivative counterparty to the extent that the amount of our securities or cash pledged exceeded the unrealized loss on the associated derivative and we were not able to recover the excess collateral. Additionally, we would be exposed to a loss to a derivative counterparty to the extent that our unrealized gains on derivative instruments exceeded the amount of the counterparty's securities or cash pledged to us. We monitor our exposure to counterparties across several dimensions including by type of arrangement, collateral type, counterparty type, ratings and geography. Additionally, ALCO has oversight of our counterparty exposure. 77 --------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis The following table summarizes our exposure to counterparties by geography atJune 30, 2020 : Repurchase Number of Agreement Interest Rate Swaps Counterparties Financing at Fair Value Exposure (1) Geography (dollars in thousands) North America 23$ 52,333,146 $ (426,019 ) $ 3,313,398 Europe 10 10,506,709 (772,951 ) 975,579 Japan 2 4,323,743 - 227,072 Total 35$ 67,163,598 $ (1,198,970 ) $ 4,516,049 (1) Represents the amount of cash and/or securities pledged as collateral to each counterparty less the aggregate of repurchase agreement financing and unrealized loss on swaps for each counterparty. Operational Risk Management We are subject to operational risk in each of our business and support functions. Operational risk may arise from internal or external sources including human error, fraud, systems issues, process change, vendors, business interruptions and other external events. Model risk considers potential errors with a model's results due to uncertainty in model parameters and inappropriate methodologies used. The result of these risks may include financial loss and reputational damage. We manage operational risk through a variety of tools including policies and procedures that cover topics such as business continuity, personal conduct, cybersecurity and vendor management. Other tools include testing, including disaster recovery testing; systems controls, including access controls; training, including cybersecurity awareness training; and monitoring, which includes the use of key risk indicators. Employee-level lines of defense against operational risk include proper segregation of incompatible duties, activity-level internal controls over financial reporting, the empowerment of business units to identify and mitigate operational risk sources, testing by our internal audit staff, and our overall governance framework. We have established a Cybersecurity Committee to help mitigate cybersecurity risks. The role of the committee is to oversee cyber risk assessments, monitor applicable key risk indicators, review cybersecurity training procedures, oversee our Cybersecurity Incident Response Plan and engage third parties to conduct periodic penetration testing. Our cybersecurity risk assessment includes an evaluation of cyber risk related to sensitive data held by third parties on their systems. The Cybersecurity Committee periodically reports to the ERC, and the Board via the BRC and the BAC. There is no assurance that these efforts will effectively mitigate cybersecurity risk and mitigation efforts are not an assurance that no cybersecurity incidents will occur. We have purchased cybersecurity insurance, however, there is no assurance that the insurance policy will cover all cybersecurity breaches or that the policy will cover all losses. Compliance, Regulatory and Legal Risk Management Our business is organized as a REIT, and we seek to continue to meet the requirements for taxation as a REIT. The determination that we are a REIT requires an analysis of various factual matters and circumstances. Accordingly, we closely monitor our REIT status within our risk management program. We also regularly assess our risk management in respect of our regulated and licensed subsidiaries, which include our registered broker-dealer subsidiary Arcola and our subsidiary that is registered with theSEC as an investment adviser under the Investment Advisers Act. The financial services industry is highly regulated and receives significant attention from regulators, which may impact both our company as well as our business strategy. We proactively monitor the potential impact regulation may have both directly and indirectly on us. We maintain a process to actively monitor both actual and potential legal action that may affect us. Our risk management framework is designed to identify, measure and monitor these risks under the oversight of the ERC. We currently rely on the exemption from registration provided by Section 3(c)(5)(C) of the Investment Company Act, and we seek to continue to meet the requirements for this exemption from registration. The determination that we qualify for this exemption from registration depends on various factual matters and circumstances. Accordingly, in conjunction with our legal department, we closely monitor our compliance with Section 3(c)(5)(C) within our risk management program. The monitoring of this risk is also under the oversight of the ERC. 78
--------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis As a result of the Dodd-Frank Act, theU.S. Commodity Futures Trading Commission ("CFTC") gained jurisdiction over the regulation of interest rate swaps. The CFTC has asserted that this causes the operators of mortgage real estate investment trusts that use swaps as part of their business model to fall within the statutory definition of Commodity Pool Operator ("CPO"), and, absent relief from theDivision of Swap Dealer and Intermediary Oversight or the CFTC, to register as CPOs. OnDecember 7, 2012 , as a result of numerous requests for no-action relief from the CPO registration requirement for operators of mortgage real estate investment trusts, theDivision of Swap Dealer and Intermediary Oversight of the CFTC issued no-action relief entitled "No-Action Relief from the Commodity Pool Operator Registration Requirement forCommodity Pool Operators of Certain Pooled Investment Vehicles Organized as Mortgage Real Estate Investment Trusts" that permits a CPO to receive relief by filing a claim to perfect the use of the relief. A claim submitted by a CPO will be effective upon filing, so long as the claim is materially complete. The conditions that must be met relate to initial margin and premiums requirements, net income derived annually from commodity interest positions that are not qualifying hedging transactions, marketing of interests in the mortgage real estate investment trust to the public, and identification of the entity as a mortgage real estate investment trust in its federal tax filings with the Internal Revenue Service. While we disagree with the CFTC's position that mortgage REITs that use swaps as part of their business model fall within the statutory definition of a CPO, we have submitted a claim for the relief set forth in the no-action relief entitled "No-Action Relief from the Commodity Pool Operator Registration Requirement for Commodity Pool Operators of Certain Pooled Investment Vehicles Organized as Mortgage Real Estate Investment Trusts" and believe we meet the criteria for such relief set forth therein. Critical Accounting Policies and Estimates Our critical accounting policies that require us to make significant judgments or estimates are described below. For more information on these critical accounting policies and other significant accounting policies, see "Significant Accounting Policies" in the Notes to the Consolidated Financial Statements. Valuation of Financial InstrumentsResidential Securities There is an active market for our Agency mortgage-backed securities, CRT securities and non-Agency mortgage-backed securities. Since we primarily invest in securities that can be valued using actively quoted prices for actively traded assets, there is a high degree of observable inputs and less subjectivity in measuring fair value. Internal fair values are determined using quoted prices from the TBA securities market, theTreasury curve and the underlying characteristics of the individual securities, which may include coupon, periodic and life caps, reset dates and the expected life of the security. While prepayment rates may be difficult to predict and require estimation and judgment in the valuation of Agency mortgage-backed securities, we use several third party models to validate prepayment speeds used in fair value measurements of residential securities. All internal fair values are compared to external pricing sources and/or dealer quotes to determine reasonableness. Additionally, securities used as collateral for repurchase agreements are priced daily by counterparties to ensure sufficient collateralization, providing additional verification of our internal pricing. Residential Mortgage Loans There is an active market for the residential whole loans in which we invest. Since we primarily invest in residential loans that can be valued using actively quoted prices for similar assets, there are observable inputs in measuring fair value. Internal fair values are determined using quoted prices for similar market transactions, the swap curve and the underlying characteristics of the individual loans, which may include loan term, coupon, and reset dates. While prepayment rates may be difficult to predict and are a significant estimate requiring judgment in the valuation of residential whole loans, we validate prepayment speeds against those provided by independent pricing analytic providers specializing in residential mortgage loans. Internal fair values are generally compared to external pricing sources to determine reasonableness. MSRs Fair value estimates for our investment in MSRs are obtained from models, which use significant unobservable inputs in their valuations. These valuations primarily utilize discounted cash flow models that incorporate unobservable market data inputs including prepayment rates, delinquency levels, costs to service and discount rates. Model valuations are then compared to valuations obtained from third-party pricing providers. Management reviews the valuations received from third-party pricing providers and uses them as a point of comparison to modeled values. The valuation of MSRs requires significant judgment by management and the third-party pricing providers. Commercial Real Estate Investments The fair value of commercial mortgage-backed securities classified as available-for-sale is determined based upon quoted prices 79 --------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of similar assets in recent market transactions and requires the application of judgment due to differences in the underlying collateral. These securities must also be evaluated for impairment if the fair value of the security is lower than its amortized cost. Determining whether there is an other-than-temporary impairment may require us to exercise significant judgment and make estimates to determine expected cash flows incorporating assumptions such as changes in interest rates and loss expectations. For commercial real estate loans and preferred equity investments classified as held for investment, we apply significant judgment in evaluating the need for a loss reserve. Estimated net recoverable value of the commercial real estate loans and preferred equity investments and other factors such as the fair value of any collateral, the amount and status of senior debt, the prospects of the borrower and the competitive landscape where the borrower conducts business must be considered in determining the allowance for loan losses. For commercial real estate loans held for sale, significant judgment may need to be applied in determining the fair value of the loans and whether a valuation allowance is necessary. Factors that may need to be considered to determine the fair value of a loan held for sale include the borrower's credit quality, liquidity and other market factors and the fair value of the underlying collateral. Interest Rate Swaps We use the overnight indexed swap ("OIS") curve as an input to value substantially all of our uncleared interest rate swaps. We believe using the OIS curve, which reflects the interest rate typically paid on cash collateral, enables us to most accurately determine the fair value of uncleared interest rate swaps. Consistent with market practice, we exchange collateral (also called margin) based on the fair values of our interest rate swaps. Through this margining process, we may be able to compare our recorded fair value with the fair value calculated by the counterparty or derivatives clearing organization, providing additional verification of our recorded fair value of the uncleared interest rate swaps. We value our cleared interest rate swaps using the prices provided by the derivatives clearing organization. Revenue Recognition Interest income from coupon payments is accrued based on the outstanding principal amounts of theResidential Securities and their contractual terms. Premiums and discounts associated with the purchase of theResidential Securities are amortized or accreted into interest income over the projected lives of the securities using the interest method. To aid in determining projected lives of the securities, we use third-party model and market information to project prepayment speeds. Our prepayment speed projections incorporate underlying loan characteristics (i.e., coupon, term, original loan size, original loan-to-value ratio, etc.) and market data, including interest rate and home price index forecasts and expert judgment. Prepayment speeds vary according to the type of investment, conditions in the financial markets and other factors and cannot be predicted with any certainty. Changes to model assumptions, including interest rates and other market data, as well as periodic revisions to the model will cause changes in the results. Adjustments are made for actual prepayment activity as it relates to calculating the effective yield. Gains or losses on sales ofResidential Securities are recorded on trade date based on the specific identification method. Consolidation of Variable Interest Entities Determining whether an entity has a controlling financial interest in a VIE requires significant judgment related to assessing the purpose and design of the VIE and determination of the activities that most significantly impact its economic performance. We must also identify explicit and implicit variable interests in the entity and consider our involvement in both the design of the VIE and its ongoing activities. To determine whether consolidation of the VIE is required, we must apply judgment to assess whether we have the power to direct the most significant activities of the VIE and whether we have either the rights to receive benefits or the obligation to absorb losses that could be potentially significant to the VIE. Use of Estimates The use of GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates. 80 --------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis Glossary of Terms A Adjustable-Rate Loan / Security A loan / security on which interest rates are adjusted at regular intervals according to predetermined criteria. The adjustable interest rate is tied to an objective, published interest rate index.
Agency
Refers to a federally chartered corporation, such as the Federal National
Mortgage Association, or the Federal Home Loan Mortgage Corporation, or an
agency of the
Agency Mortgage-Backed Securities Refers to residential mortgage-backed securities that are issued or guaranteed by an Agency.
Amortization
Liquidation of a debt through installment payments. Amortization also refers to the process of systematically reducing a recognized asset or liability (e.g., a purchase premium or discount for a debt security) with an offset to earnings. Average GAAP Cost of Interest Bearing Liabilities and Average Economic Cost of Interest Bearing Liabilities Average GAAP cost of interest bearing liabilities represents annualized interest expense divided by average interest bearing liabilities. Average interest bearing liabilities reflects the average balances during the period. Average economic cost of interest bearing liabilities represents annualized economic interest expense divided by average interest bearing liabilities. Average Life On a mortgage-backed security, the average time to receipt of each dollar of principal, weighted by the amount of each principal prepayment, based on prepayment assumptions. Average Yield on Interest Earnings Assets and Average Yield on Interest Earnings Assets (excluding PAA) Average yield on interest earning assets represents annualized interest income divided by average interest earning assets. Average interest earning assets reflects the average amortized cost of our investments during the period. Average yield on interest earning assets (excluding PAA) is calculated using annualized interest income (excluding PAA). BBasis Point ("bp") One hundredth of one percent, used in expressing differences in interest rates. One basis point is 0.01% of yield. For example, a bond's yield that changed from 3.00% to 3.50% would be said to have moved 50 basis points.
Benchmark
A bond or an index referencing a basket of bonds whose terms are used for
comparison with other bonds of similar maturity. The global financial market
typically looks to
Beneficial Owner One who benefits from owning a security, even if the security's title of ownership is in the name of a broker or bank.
B-Note
Subordinate mortgage notes and/or subordinate mortgage loan participations.
B-Piece
The most subordinate commercial mortgage-backed security bond class.
Board
Refers to the board of directors of Annaly.
Bond
The written evidence of debt, bearing a stated rate or stated rates of interest, or stating a formula for determining that rate, and maturing on a date certain, on which date and upon presentation a fixed sum of money plus interest (usually represented by interest coupons attached to the bond) is payable to the holder or owner. Bonds are long-term securities with an original maturity of greater than one year.
Book Value Per Share Calculated by summing common stock, additional paid-in capital, accumulated other comprehensive income (loss) and accumulated deficit and dividing that number by the total common shares outstanding.
Broker
Generic name for a securities firm engaged in both buying and selling securities on behalf of customers or its own account.
C
Capital Buffer
Includes unencumbered financial assets which can be either sold or utilized as
collateral to meet liquidity needs.
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ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis
Capital Ratio
Calculated as total stockholders' equity divided by total assets inclusive of
outstanding market value of TBA positions and exclusive of consolidated VIEs.
Carry
The amount an asset earns over its hedging and financing costs. A positive carry happens when the rate on the securities being financed is greater than the rate on the funds borrowed. A negative carry is when the rate on the funds borrowed is greater than the rate on the securities that are being financed.
CMBX
The CMBX index is a synthetic tradable index referencing a basket of 25 CMBS of a particular rating and vintage. The CMBX index allows investors to take a long position (referred to as selling protection) or short position (referred to as purchasing protection) on the respective basket of CMBS securities and is structured as a "pay-as-you-go" contract whereby the protection seller receives and the protection buyer pays a standardized running coupon on the contracted notional amount. Additionally, the protection seller is obligated to pay to the protection buyer the amount of principal losses and/or coupon shortfalls on the underlying CMBS securities as they occur.
Collateral
Securities, cash or property pledged by a borrower or party to a derivative
contract to secure payment of a loan or derivative. If the borrower fails to
repay the loan or defaults under the derivative contract, the secured party may
take ownership of the collateral.
Collateralized Loan Obligation ("CLO")
A securitization collateralized by loans and other debt instruments.
Collateralized Mortgage Obligation ("CMO") A multiclass bond backed by a pool of mortgage pass-through securities or mortgage loans.
Commodity Futures Trading Commission ("CFTC") An independentU.S. federal agency established by the Commodity Futures Trading Commission Act of 1974. The CFTC regulates the swaps, commodity futures and options markets. Its goals include the promotion of competitive and efficient futures markets and the protection of investors against manipulation, abusive trade practices and fraud. Commercial Mortgage-Backed Security Securities collateralized by a pool of mortgages on commercial real estate in which all principal and interest from the mortgages flow to certificate holders in a defined sequence or manner. Constant Prepayment Rate ("CPR") The percentage of outstanding mortgage loan principal that prepays in one year, based on the annualization of the Single
Monthly Mortality, which reflects the outstanding mortgage loan principal that prepays in one month.
Convexity
A measure of the change in a security's duration with respect to changes in interest rates. The more convex a security is, the more its duration will change with interest rate changes.
Core Earnings (excluding PAA) and Core Earnings (excluding PAA) Per Average Common Share Core earnings (excluding PAA) is defined as the sum of (a) economic net interest income, (b) TBA dollar roll income and CMBX coupon income, (c) realized amortization of MSRs, (d) other income (loss) (excluding depreciation expense related to commercial real estate and amortization of intangibles, non-core income allocated to equity method investments and other non-core components of other income (loss)), (e) general and administrative expenses (excluding transaction expenses and non-recurring items), and (f) income taxes (excluding the income tax effect of non-core income (loss) items) and excludes (g) the premium amortization adjustment representing the cumulative impact on prior periods, but not the current period, of quarter-over-quarter changes in estimated long-term prepayment speeds related to our Agency mortgage-backed securities. Core earnings (excluding PAA) per average common share is calculated by dividing core earnings (excluding PAA) by average basic common shares for the period. Corporate Debt Non-government debt instruments issued by corporations. Long-term corporate debt can be issued as bonds or loans.
Counterparty
One of two entities in a transaction. For example, in the bond market a counterparty can be a state or local government, a broker-dealer or a corporation.
Coupon
The interest rate on a bond that is used to compute the amount of interest due on a periodic basis.
Credit and Counterparty Risk
Risk to earnings, capital or business, resulting from an obligor's or
counterparty's failure to meet the terms of any contract or otherwise failure to
perform as agreed. Credit and counterparty risk is present in lending,
investing, funding and hedging activities.
Credit Derivatives
Derivative instruments that have one or more underlyings related to the credit
risk of a specified entity (or group of entities) or an index that exposes the
seller to potential loss from specified credit-risk related events. An example
is credit derivatives referencing the commercial mortgage-backed securities
index.
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--------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis Credit Risk Transfer ("CRT") Securities Credit Risk Transfer securities are risk sharing transactions issued by Fannie Mae and Freddie Mac and similarly structured transactions arranged by third party market participants. The securities issued in the CRT sector are designed to synthetically transfer mortgage credit risk from Fannie Mae, Freddie Mac and/or third parties to private investors. Current Face The current remaining monthly principal on a mortgage security. Current face is computed by multiplying the original face value of the security by the current principal balance factor. D Dealer
Person or organization that underwrites, trades and sells securities, e.g., a principal market-maker in securities.
Default Risk Possibility that a bond issuer will fail to pay principal or interest when due.
Derivative
A financial product that derives its value from the price, price fluctuations and price expectations of an underlying instrument, index or reference pool (e.g. futures contracts, options, interest rate swaps, interest rate swaptions and certain to-be-announced securities).
Discount Price When the dollar price is below face value, it is said to be selling at a discount.
Duration
The weighted maturity of a fixed-income investment's cash flows, used in the estimation of the price sensitivity of fixed-income securities for a given change in interest rates.
EEconomic Capital A measure of the risk a firm is subject to. It is the amount of capital a firm needs as a buffer to protect against risk. It is a probabilistic measure of potential future losses at a given confidence level over a given time horizon. Economic Interest Expense Non-GAAP financial measure that is comprised of GAAP interest expense and the net interest component of interest rate swaps. Economic Leverage Ratio (Economic Debt-to-Equity Ratio) Calculated as the sum of recourse debt, cost basis of TBA and CMBX derivatives outstanding and net forward purchases (sales) of investments divided by total equity. Recourse debt consists of repurchase agreements and other secured financing (excluding certain non-recourse credit facilities). Debt issued by securitization vehicles, certain credit facilities (included within other secured financing) and mortgages payable are non-recourse to us and are excluded from this measure. Economic Net Interest Income Non-GAAP financial measure that is composed of GAAP net interest income less Economic Interest Expense.
Encumbered Assets Assets on the company's balance sheet which have been pledged as collateral against a liability.
Eurodollar
A
F Face Amount The par value (i.e., principal or maturity value) of a security appearing on the face of the instrument.
Factor
A decimal value reflecting the proportion of the outstanding principal balance of a mortgage security, which changes over time, in relation to its original principal value. Fannie Mae Federal National Mortgage Association.Federal Deposit Insurance Corporation ("FDIC") An independent agency created by theU.S. Congress to maintain stability and public confidence in the nation's financial system by insuring deposits, examining and supervising financial institutions for safety and soundness and consumer protection, and managing receiverships. Federal Funds Rate The interest rate charged by banks on overnight loans of their excess reserve funds to other banks.
Federal Home Loan Banks ("FHLB")
Federal Housing Financing Agency ("FHFA") The FHFA is an independent regulatory agency that oversees vital components of the secondary mortgage market 83
--------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis
including Fannie Mae, Freddie Mac and the Federal Home Loan Banks.
Fixed-Rate Mortgage A mortgage featuring level monthly payments, determined at the outset, which remain constant over the life of the mortgage.Fixed Income Clearing Corporation ("FICC") The FICC is an agency that deals with the confirmation, settlement and delivery of fixed-income assets in theU.S. The agency ensures the systematic and efficient settlement ofU.S. Government securities and mortgage-backed security transactions in the market.
Floating Rate Bond A bond for which the interest rate is adjusted periodically according to a predetermined formula, usually linked to an index.
Floating Rate CMO A CMO tranche which pays an adjustable rate of interest tied to a representative interest rate index such as the LIBOR, the Constant Maturity Treasury or the Cost of Funds Index. Freddie Mac Federal Home Loan Mortgage Corporation. Futures Contract A legally binding agreement to buy or sell a commodity or financial instrument in a designated future month at a price agreed upon at the initiation of the contract by the buyer and seller. Futures contracts are standardized according to the quality, quantity, and delivery time and location for each commodity. A futures contract differs from an option in that an option gives one of the counterparties a right and the other an obligation to buy or sell, while a futures contract represents an obligation of both counterparties, one to deliver and the other to accept delivery. A futures contract is part of a class of financial instruments called derivatives. G GAAP
Ginnie Mae Government National Mortgage Association . H Hedge
An investment made with the intention of minimizing the impact of adverse movements in interest rates or securities prices.
I In-the-Money Description for an option that has intrinsic value and can be sold or exercised for a profit; a call option is in-the-money when the strike price (execution price) is below the market price of the underlying security. Interest Bearing Liabilities Refers to repurchase agreements, debt issued by securitization vehicles, FHLBDes Moines advances and credit facilities. Average interest bearing liabilities is based on daily balances. Interest Earning Assets Refers toResidential Securities ,U.S. Treasury securities, reverse repurchase agreements, commercial real estate debt and preferred equity interests, residential mortgage loans and corporate debt. Average interest earning assets is based on daily balances. Interest-Only (IO) Bond The interest portion of mortgage,Treasury or bond payments, which is separated and sold individually from the principal portion of those same payments. Interest Rate Risk The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. As market interest rates rise, the value of current fixed income investment holdings declines. Diversifying, deleveraging and hedging techniques are utilized to mitigate this risk. Interest rate risk is a form of market risk. Interest Rate Swap A binding agreement between counterparties to exchange periodic interest payments on some predetermined dollar principal, which is called the notional principal amount. For example, one party will pay fixed and receive a variable rate . Interest Rate Swaption Options on interest rate swaps. The buyer of a swaption has the right to enter into an interest rate swap agreement at some specified date in the future. The swaption agreement will specify whether the buyer of the swaption will be a fixed-rate receiver or a fixed-rate payer. 84 --------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis
Inverse IO Bond An interest-only bond whose coupon is determined by a formula expressing an inverse relationship to a benchmark rate, such as LIBOR. As the benchmark rate changes, the IO coupon adjusts in the opposite direction. When the benchmark rate is relatively low, the IO pays a relatively high coupon payment, and vice versa. Investment/Market Risk Risk to earnings, capital or business resulting in the decline in value of our assets caused from changes in market variables, such as interest rates, which affect the values ofResidential Securities and other investment instruments. Investment Advisers Act Refers to the Investment Advisers Act of 1940, as amended. Investment Company Act Refers to the Investment Company Act of 1940, as amended. L Leverage
The use of borrowed money to increase investing power and economic returns.
Leverage Ratio (Debt-to-Equity Ratio)
Calculated as total debt to total stockholders' equity. For purposes of
calculating this ratio total debt includes repurchase agreements, other secured
financing, debt issued by securitization vehicles and mortgages payable. Certain
credit facilities (included within other secured financing), debt issued by
securitization vehicles and mortgages payable are non-recourse to us.
LIBOR (London Interbank Offered Rate)
The rate banks charge each other for short-term Eurodollar loans. LIBOR is
frequently used as the base for resetting rates on floating-rate securities and
the floating-rate legs of interest rate swaps.
Liquidity Risk
Risk to earnings, capital or business arising from our inability to meet our
obligations when they come due without incurring unacceptable losses because of
inability to liquidate assets or obtain adequate funding.
Long-Term CPR
Our projected prepayment speeds for certain Agency mortgage-backed securities
using third-party model and market information. Our prepayment speed projections
incorporate underlying loan characteristics (e.g., coupon, term, original loan
size, original loan-to-value ratio, etc.) and market data, including interest
rate and home price index forecasts. Changes to model assumptions, including
interest rates and other market data, as well as periodic revisions to the model
will cause changes in the results.
Long-Term Debt
Debt which matures in more than one year.
M
Market Agreed Coupon ("MAC") Interest Rate Swap
An interest rate swap contract structure with pre-defined, market agreed terms,
developed by SIFMA and ISDA with the purpose of promoting liquidity and
simplified administration.
Monetary Policy
Action taken by the Federal Open Market Committee of the Federal Reserve System
to influence the money supply or interest rates.
Mortgage-Backed Security ("MBS")
A security representing a direct interest in a pool of mortgage loans. The
pass-through issuer or servicer collects the payments on the loans in the pool
and "passes through" the principal and interest to the security holders on a pro
rata basis.
Mortgage Loan
A mortgage loan granted by a bank, thrift or other financial institution that is
based solely on real estate as security and is not insured or guaranteed by a
government agency.
Mortgage Servicing Rights ("MSRs")
Contractual agreements constituting the right to service an existing mortgage
where the holder receives the benefits and bears the costs and risks of
servicing the mortgage.
N
NAV
Net asset value.
Net Interest Income
Represents interest income earned on our portfolio investments, less interest
expense paid for borrowings.
Net Interest Margin and Net Interest Margin (excluding PAA)
Net interest margin represents our interest income less interest expense divided
by average interest earning assets. Net interest margin (excluding PAA)
represents the sum of our interest income (excluding PAA) plus TBA dollar roll
income and CMBX coupon income less interest expense and
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ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis
the net interest component of interest rate swaps divided by the sum of average interest earning assets plus average outstanding TBA contract and CMBX balances.
Net Interest Spread and Net Interest Spread (excluding PAA) Net interest spread represents the average yield on interest earning assets less the average GAAP cost of interest bearing liabilities. Net interest spread (excluding PAA) represents the average yield on interest earning assets (excluding PAA) less the average economic cost of interest bearing liabilities.
Non-Performing Loan ("NPL")
A loan that is close to defaulting or is in default.
Notional Amount A stated principal amount in a derivative contract on which the contract is based.
O Operational Risk Risk to earnings, capital, reputation or business arising from inadequate or failed internal processes or systems, human factors or external events. Option Contract A contract in which the buyer has the right, but not the obligation, to buy or sell an asset at a set price on or before a given date. Buyers of call options bet that a security will be worth more than the price set by the option (the strike price), plus the price they pay for the option itself. Buyers of put options bet that the security's price will drop below the price set by the option. An option is part of a class of financial instruments called derivatives, which means these financial instruments derive their value from the worth of an underlying investment.
Original Face The face value or original principal amount of a security on its issue date.
Out-of-the-Money
Description for an option that has no intrinsic value and would be worthless if it expired today; for a call option, this situation occurs when the strike price is higher than the market price of the underlying security; for a put option, this situation occurs when the strike price is less than the market price of the underlying security.
Overnight Index Swaps ("OIS") An interest rate swap in which a fixed rate is exchanged for an overnight floating rate.
Over-The-Counter ("OTC") Market
A securities market that is conducted by dealers throughout the country through
negotiation of price rather than through
the use of an auction system as represented by a stock exchange.
P Par
Price equal to the face amount of a security; 100%.
Par Amount The principal amount of a bond or note due at maturity. Also known as par value.
Pass-Through Security A securitization structure where a GSE or other entity "passes" the amount collected from the borrowers every month to the investor, after deducting fees and expenses.
Pool
A collection of mortgage loans assembled by an originator or master servicer as the basis for a security. In the case ofGinnie Mae , Fannie Mae, or Freddie Mac mortgage pass-through securities, pools are identified by a number assigned by the issuing agency.
Premium
The amount by which the price of a security exceeds its principal amount. When
the dollar price of a bond is above its face value, it is said to be selling at
a premium.
Premium Amortization Adjustment ("PAA")
The cumulative impact on prior periods, but not the current period, of
quarter-over-quarter changes in estimated long-term prepayment speeds related to
our Agency mortgage-backed securities.
Prepayment
The unscheduled partial or complete payment of the principal amount outstanding on a mortgage loan or other debt before it is due.
Prepayment Risk The risk that falling interest rates will lead to increased prepayments of mortgage or other loans, forcing the investor to reinvest at lower prevailing rates. Prepayment Speed The estimated rate at which mortgage borrowers will pay off the mortgages that underlie an MBS. Prime Rate The indicative interest rate on loans that banks quote to their best commercial customers.
Principal and Interest The term used to refer to regularly scheduled payments or prepayments of principal and payments of interest on a mortgage or other security.
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ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis
R
Rate Reset
The adjustment of the interest rate on a floating-rate security according to a
prescribed formula.
Real Estate Investment Trust ("REIT")
A special purpose investment vehicle that provides investors with the ability to
participate directly in the ownership or financing of real-estate related assets
by pooling their capital to purchase and manage mortgage loans and/or income
property.
Recourse Debt
Debt on which the economic borrower is obligated to repay the entire balance
regardless of the value of the pledged collateral. By contrast, the economic
borrower's obligation to repay non-recourse debt is limited to the value of the
pledged collateral. Recourse debt consists of repurchase agreements and other
secured financing (excluding certain non-recourse credit facilities). Debt
issued by securitization vehicles, certain credit facilities (included within
other secured financing) and mortgages payable are non-recourse to us and are
excluded from this measure.
Reinvestment Risk
The risk that interest income or principal repayments will have to be reinvested
at lower rates in a declining rate environment.
Re-Performing Loan ("RPL")
A type of loan in which payments were previously delinquent by at least 90 days
but have resumed.
Repurchase Agreement
The sale of securities to investors with the agreement to buy them back at a
higher price after a specified time period; a form of short-term borrowing. For
the party on the other end of the transaction (buying the security and agreeing
to sell in the future) it is a reverse repurchase agreement.
Residential Securities Refers to Agency mortgage-backed securities, CRT securities and non-Agency mortgage-backed securities.
Residual
In securitizations, the residual is the tranche that collects any cash flow from
the collateral that remains after obligations to the other tranches have been
met.
Return on Average Equity
Calculated by taking earnings divided by average stockholders' equity.
Reverse Repurchase Agreement
Refer to Repurchase Agreement. The buyer of securities effectively provides a
collateralized loan to the seller.
Risk Appetite Statement
Defines the types and levels of risk we are willing to take in order to achieve
our business objectives, and reflects our risk management philosophy.
S
Secondary Market
Ongoing market for bonds previously offered or sold in the primary market.
Secured Overnight Financing Rate ("SOFR")
Broad measure of the cost of borrowing cash overnight collateralized by Treasury
securities and was chosen by the Alternative Reference Rate Committee as the
preferred benchmark rate to replace dollar LIBOR in coming years.
Settlement Date The date securities must be delivered and paid for to complete a transaction.
Short-Term Debt Generally, debt which matures in one year or less. However, certain securities that mature in up to three years may be considered short-term debt.
Spread
When buying or selling a bond through a brokerage firm, investors will be charged a commission or spread, which is the difference between the market price and cost of purchase, and sometimes a service fee. Spreads differ based on several factors including liquidity.
T Target AssetsIncludes Agency mortgage-backed securities, to-be-announced forward contracts, CRT securities, MSRs, non-Agency mortgage-backed securities, residential mortgage loans, commercial real estate investments, and corporate debt. Taxable REIT Subsidiary ("TRS") An entity that is owned directly or indirectly by a REIT and has jointly elected with the REIT to be treated as a TRS for tax purposes. Annaly and certain of its direct and indirect subsidiaries have made separate joint elections to treat these subsidiaries as TRSs.To-Be-Announced Securities ("TBAs") A contract for the purchase or sale of a mortgage-backed security to be delivered at a predetermined price, face amount, issuer, coupon and stated maturity on an agreed-upon future date but does not include a specified pool number and number of pools. 87
--------------------------------------------------------------------------------ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis TBA Dollar Roll Income TBA dollar roll income is defined as the difference in price between two TBA contracts with the same terms but different settlement dates. The TBA contract settling in the later month typically prices at a discount to the earlier month contract with the difference in price commonly referred to as the "drop". TBA dollar roll income represents the equivalent of interest income on the underlying security less an implied cost of financing. Total Return Investment performance measure over a stated time period which includes coupon interest, interest on interest, and any realized and unrealized gains or losses. Total Return Swap A derivative instrument where one party makes payments at a predetermined rate (either fixed or variable) while receiving a return on a specific asset (generally an equity index, loan or bond) held by the counterparty. U Unencumbered Assets Assets on our balance sheet which have not been pledged as collateral against an existing liability.U.S. Government-Sponsored Enterprise ("GSE") Obligations Obligations of Agencies originally established or chartered by theU.S. government to serve public purposes as specified by theU.S. Congress , such as Fannie Mae and Freddie Mac; these obligations are not explicitly guaranteed as to the timely payment of principal and interest by the full faith and credit of theU.S. government. V Value-at-Risk ("VaR") A statistical technique which measures the potential loss in value of an asset or portfolio over a defined period for a given confidence interval. Variable Interest Entity ("VIE") An entity in which equity investors (i) do not have the characteristics of a controlling financial interest, and/or (ii) do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Variation Margin Cash or securities provided by a party to collateralize its obligations under a transaction as a result of a change in value of such transaction since the trade was executed or the last time collateral was provided.
Volatility
A statistical measure of the variance of price or yield over time. Volatility is
low if the price does not change very much over a short period of time, and high
if there is a greater change.
Voting Interest Entity ("VOE")
An entity that has sufficient equity to finance its activities without
additional subordinated financial support from other parties and in which equity
investors have a controlling financial interest.
W
Warehouse Lending
A line of credit extended to a loan originator to fund mortgages extended by the
loan originators to property purchasers. The loan typically lasts from the time
the mortgage is originated to when the mortgage is sold into the secondary
market, whether directly or through a securitization. Warehouse lending can
provide liquidity to the loan origination market.
Weighted Average Coupon
The weighted average interest rate of the underlying mortgage loans or pools
that serve as collateral for a security, weighted by the size of the principal
loan balances.
Weighted Average Life ("WAL")
The assumed weighted average amount of time that will elapse from the date of a
security's issuance until each dollar of principal is repaid to the investor.
The WAL will change as the security ages and depending on the actual realized
rate at which principal, scheduled and unscheduled, is paid on the loans
underlying the MBS.
Y
Yield-to-MaturityThe expected rate of return of a bond if it is held to its maturity date; calculated by taking into account the current market price, stated redemption value, coupon payments and time to maturity and assuming all coupons are reinvested at the same rate; equivalent to the internal rate of return.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Quantitative and qualitative disclosures about market risk are contained within the section titled "Risk Management" of Item 2. "Management's Discussion and Analysis of Financial Condition and Results of Operations."
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