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I gave a listen to the call this morning and would use one word to summarize it. Cautious. Annaly is clearly being very cautious in the current environment. Michael Ferrell was not present on the call due to the health issue, and it was run by Wellington Denahan-Norris. The call thus focused a bit more on operational considerations than broad economic prognosticating which can occur with Michael, but then there was more to talk about related to operations this time as well. The opening commentary (not yet posted to the website or comments on it on Youtube) lamented the absence of freedom in the markets due to government involvement. NLY is not a fan of the heavy handed attempts to manage the market (which should surprise no one who has listened to them).

Some items mentioned that give the company pause are the recent Obama speech wherein he pounded the pulpit for additional assistance to homeowners, the election cycle, operation twist flattening the yield curve, and concerns regarding another round of quantitative easing. There was no update on the recent testimony before congress related to whether mREITs should be treated as REITs or investment companies, and it sounded like none is expected soon.

As a result, NLY continues to intentionally trend down in both leverage and return on equity. They have a lot of cash on hand, but not as much as last quarter which was at the time said to be held opportunistically. Some has clearly been deployed, but not all. The company is at a historical low in its reported level of leverage and at a multiyear low in terms of ROE. Annaly has occasionally stated that they target mid to high teens for ROE, and the practice has been to reduce leverage when this is readily achievable i.e. not overreach for current returns in order to remain flexible when the situation changes. So I read an ROE of sub 15% from NLY in a good operating environment (decent spread) to signal a lot of caution.

This is probably a good time for historical context. The table below looks at some key metrics over the past 5 years.

-Leverage - As NLY measures it.
-Annualized interest rate spread during the quarter (though context is often important here).
-Core Earnings (as they used to call it i.e. without the swap unrealized gains/losses)
-Book value (shareholder equity)
-Annualized ROE (core Quarterly earnings *4 divided by book)

I did not use a TTM earnings or average book for ROE calculation as NLY does occasionally raise funds for additional investment. I struggle a bit to appreciate why they did so in Q3 of 2011 and then not put it to work rapidly (as they say they can)*. Again, it seems that a concern / expectation of opportunity they may have had never fully materialized (European blowback).

Quarter Leverage Spread Earnings Book ROE

Q4-2011 5.4 1.71% 525.3 15761 13.3%
Q3-2011 5.5 2.08% 622.8 15910 15.7%
Q2-2011 5.7 2.45% 587.5 13929 16.9%
Q1-2011 6.3 2.17% 530.6 12853 16.5%
Q4-2010 6.7 1.85% 379.3 9865 15.4%
Q3-2010 6.4 2.11% 371.1 9587 15.5%
Q2-2010 5.9 2.16% 335.7 9633 13.9%
Q1-2010 5.6 2.22% 350.8 9581 14.6%
Q4-2009 5.7 2.79% 439.3 9554 18.4%
Q3-2009 6.0 2.65% 413.3 9307 17.8%
Q2-2009 5.9 2.47% 364.5 8668 16.8%
Q1-2009 6.0 2.11% 309.3 8160 15.2%
Q4-2008 6.4 1.71% 261.8 7183 14.6%
Q3-2008 7.2 2.08% 335.0 7035 19.0%
Q2-2008 7.1 1.99% 305.2 7193 17.0%
Q1-2008 8.1 1.46% 233.6 6243 15.0%
Q4-2007 8.7 0.88% 151.1 5205 11.6%
Q3-2007 9.9 0.75% 102.5 3932 10.4%
Q2-2007 11.2 0.60% 79.1 3010 10.5%
Q1-2007 9.8 0.58% 61.7 3306 7.5%

Recall that 2007 was coming off a flat to mildly inverted yield curve and spread was quite small (and from a higher yield on assets and borrowing) so leverage was high. This period saw the collapse of Thornburg Mortgage Inc. for example which operated with less caution than NLY. The company could not deliver on its target ROE during this period, despite the high leverage. As spread improved with rates coming down, NLY could get an ROE back in the mid to higher teens and thus began decreasing leverage. This past quarter the leverage continued to decrease despite a drop in the available spread (thanks largely to twist I believe).

Much of the Q&A in the call related to whether Annaly would begin to increase leverage from here, but the response was largely 'we prefer to be cautious here'. The company was content to point out that even operating at the lower level, they offer as good a current yield as one can reasonably obtain right now, and that the Fed has effectively told everyone that current conditions will continue for awhile. I personally think investors should consider that NLY is likely to stay cautious for awhile as well.

Home Coverage Fool
No current position (but I own CIM and CXS).

* A criticism that has been seen of NLY is that executive bonuses benefit from capital raises (total book), and thus there is concern that capital raises may not always be as fully opportunistic to shareholders as perhaps they should be.
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