Good morning and welcome to the Fourth Quarter 2017 Annaly Capital Management Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] Please note today's event is being recorded. With that, I'd like to turn the conference over to Jessica LaScala of Investor Relations. Please go ahead.

Good morning and welcome to the fourth quarter 2017 earnings call for Annaly Capital Management Inc. Any forward-looking statements made during today's call are subject to risks and uncertainties, which are outlined in the Risk Factor section in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the forward-looking statements disclaimer in our earnings release, in addition to our quarterly and annual filings. Additionally, the content of this conference call may contain time-sensitive information that is accurate only as of the date of the earnings call. We do not undertake and specifically disclaim any obligation to update or revise this information. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our earnings release. Please also note that this event is being recorded. Participants on this morning's call include Kevin Keyes, Chairman, Chief Executive Officer and President; David Finkelstein, Chief Investment Officer; Glenn Votek, Chief Financial Officer; Tim Coffey, Chief Credit Officer and Michael Quinn, Head of Commercial Investments. I will now turn the conference over to Kevin Keyes.

Good morning, everyone. On our last earnings call in November, I ended my introductory comments by saying something has got to give. I was referring to the unsustainable, excessive valuations and record low levels of volatility in the broader markets at the time. Now that some chaos has begun to surface, our market has seemingly rediscovered these same indicators I was talking about a couple of months ago for the first time in years. The VIX Sharpe ratios and various valuation methodologies of risk versus lower risk assets have now been discussed daily and at ad nauseam. So rather than focusing on the causes and measurements of this sudden activity, I'd prefer to take a more in-depth look into the meaning, impact and opportunities this new bull market of volatility presents for Annaly. The recent shocks clearly highlight the relative valuation discrepancies of asset classes and structures in almost every market, which is a healthy occurrence. For instance, the return of volatility not only quickly depreciated the value of high priced equities, the highest risk asset classes, but more importantly for Annaly, the fundamental shift has begun to reverse the long-term credit curve flattening that had occurred between most lower and higher risk fixed income asset classes. Although you'd never know it reading the mainstream press or even most fixed income research, volatility in the equity markets has spilled over into the credit markets, which have yet to bounce back to the same extent as equities. In fact, the effective yield on high-yield bonds has increased by nearly 100 basis points since October to a 14-month high, with half of that increase coming in the last month alone. Additionally, CDS on non-investment grade credit post last Thursday at its widest level since December of 2016. It's also significant to note…

Thank you, Kevin. Amidst the market environment in the fourth quarter that Kevin described, agency spreads were roughly unchanged and our activity in the agency sector focused on rotating in to specified pools and reducing our TBA position. Additionally, we replaced 8 billion of legacy swaps with current rate contracts, which will serve to lower the fixed rate on our swap position going forward. In credit, we continue to grow both our residential whole loan portfolio as well as our middle-market lending portfolio, each of which have eclipsed 1 billion in assets as of January. Our commercial portfolio was roughly unchanged as we remain highly selective in the market, but we were able to reinvest run off in the sector and we maintained an active pipeline. Also of note in the fourth quarter, we reduced economic leverage from 6.9 times to 6.6, which was helped by our capital raise early in the quarter and allowed us to enter into the new year with enhanced liquidity. Now, given the rise in interest rates and elevated volatility experienced thus far in 2018, I will take the opportunity to expand on Kevin's comments as to how we are managing our portfolio in light of the current market landscape. While we are not immune to recent turbulence, as we have demonstrated in the past, we are defensive in rising rate environments and this has certainly been the case as of late. While MBS durations have extended meaningfully since the beginning of the year, we have proactively managed this extension by further adding to our hedge positions, reducing our MBS basis exposure and locking in more fixed rate term repo. As a result, we have maintained the downside protection of the portfolio consistent with year-end shocks through dynamic hedging as well as managing leverage consistent…

Thanks, David. Beginning with our GAAP results, fourth quarter GAAP net income was $747 million or $0.62 per share compared to $0.31 for Q3. Among the factors driving the results were increased net interest income in improved markets and interest rate swaps, partly offset by losses on spot termination and lower gains on trading assets. In terms of core earnings, excluding PAA, we posted 387 million in earnings or $0.31 per share, which was up from last quarter's $0.30. The PAA for the quarter was a cost of approximately $0.01 versus $0.04 in Q3. Our full year results were equally strong with core earnings ex-PAA of $1.22 a share and core ROE of 10.6%, both of which were up from prior year and economic return was approximately 12.4%, more than double last year's performance. Among the key factors contributing to this quarter's core results were higher interest income, largely driven by the growth in the agency portfolio along with increased contributions from our MML and resi loan portfolios. Dollar roll income declined due to the portfolio rotation as David had mentioned earlier, our refill balances were higher, given the increase in the agency portfolio, which coupled with higher rates resulted in increased interest expense. This increase was partially offset by lower net swaps expenses, our net pay rate continue to trend lower and led to a mere one basis point increase in our overall cost of funds, despite another 25 basis points Fed hike in the quarter. We had further improvement across all of our key financial metrics, in addition to core ROE, ex-PAA, increasing to 10.7% for the quarter as Kevin had mentioned. Our net interest margin improved to 151 basis points and our net interest spreads likewise improved to 119 basis points. And our operating efficiency measures continue…

[Operator Instructions] And our first question comes from Rick Shane with JPMorgan. Please go ahead.

Thanks guys for taking my question. I just want to make sure I understand David's comments. You didn't really provide an update on book value movements quarter-to-date, other than sort of to say that it was in line with expectations, given the rate move, but I think what you were really describing was that through dynamic hedging, you’ve effectively dampened the duration gap sensitivity that we would have expected associated with a roughly 50 basis point move?

Yes, Rick. I think you understood that correctly. So if you look at the rate shocks, it tends to get elevated as rates move further and further out of favor, and I think what we've done by dynamically hedging is making small interest rate, the effects from small interest rate moves linear as you go out the rating spectrum. Does that make sense?

It absolutely does. And is there -- when we think about the hedging strategy, is there anything -- you talk about linear for small moves. Is there anything to -- in the portfolio to dampen it if the moves become more of a shock, so that it becomes not linear at a certain point?

We do continue to hold swaptions, but I think the day to day management is the best tool for us right now and we continue to dynamically hedge the portfolio. So for example, beginning in the first week of January, as rates did increase, we continued to sell assets or increased hedges. Quarter-to-date, we've added about 8 billion in swaps and futures and we've reduced the TBA position by about 4 billion. So that hedge ratio that the market seems to look at which we think is a very big instrument to gauge our interest rate exposure, given the fact that it doesn't consider the quality of the hedges, in terms of duration of those hedges nor on the asset side, the fact that we do hold a lot of very short duration arms and floating rate arms as well as residential credit, we don't think it's the best measure, but that hedge ratio through dynamic hedging has gone from 70% to about 87% today.

And Rick, I would just say over the top as we said before, the best way to manage in these environments is to reduce leverage, and that's what we've done as you see in our results while we've enhanced our liquidity profile as things have steepened back up and gotten cheaper. So that's the overlay over the hedging strategy.

Our next question comes from Doug Harter with Credit Suisse.

Thanks. Can you talk about what agency spreads have done in the first quarter to date and how that would impact book value?

Yeah, Doug. This is David. I would say if you look at nominal spreads just regarding the impact from volatility on OAS as well as the curve steepening, it's roughly above 10 basis points wider quarter-to-date.

If you were to look at OAS for bringing in those other impacts?

Sure. OAS has benefited from the steeper curve, which reduces the value, the option widens OAS, but the spike in volatility we've experienced over the last couple of weeks has served to tighten OAS. So it's a little ambiguous when you look at OAS, but it's a touch wider.

All right. And then back to -- if you guys have been rightfully reducing leverage into this volatility, I guess what are the signs you would be looking forward to sort of put those assets back on and take advantage of the opportunity. I guess how do you factor in kind of when is the right time to start that versus more in a longer period of a challenging environment?

Well, Doug, I'll do the big picture and then David can dig in if he'd like. I mean we answer that question differently than everybody else, because we have four businesses, right. So, when we look at the floating rate opportunities out there in our credit businesses, our pipeline today for RESI credit, commercial real estate and middle-market lending within our shared capital model, we have a pipeline that is north of the credit that we underwrote last year. Last year, we did about 3.1 billion gross in credit assets. So this is a very competitive place that we're in. So when it comes to the catalyst for levering up in the agency strategy, frankly, we've obviously shown our ability to do that over the past four years, quite effectively at the right time. But for us, it's really not a timing game. It's a relative valuation game and a relative risk-adjusted returns game. So it's not just the catalysts for increasing repo on agency to get return. For us, what's the best cash flow metrics we can create, not just every quarter or every month, but over the longer-term. So when you have competing capital, it's two basic things I think you've heard us talk about. It's a risk mitigate because no one here is paid just to grow their strategy, even if there is a short-term opportunity, right. And the second thing is what it’s equated to is a balance of a risk adjusted return and a cash flow that's insulated us from the shock of what the market has felt, albeit not entirely, but a heck of a lot better than most. So I think that's how we look at it. I think David can probably speak to your single question on leverage and when we would tick it up?

Sure. So we could see a little bit more widening in the agency sector, given the Fed is increasing its run-off and we are also approaching the spring and summer months where you do see a little bit more net supply. But we think that spread widening would be contained, just given the attractiveness of the sector, the convexity profile and the fact that there is money on the sideline that we think could go into the agency sector. So if we got 5 to 10 basis points of widening, we'd certainly look at adding to the agency portfolio. But right now, we are at a defensive mode as we see how this plays out.

Our next question comes from Fred Small with Compass Point.

Just on the sort of non-mortgage credit side, how much impact do you think that the widening of credit spreads has had on book value this quarter?

I would say, Fred, a pretty negligible amount. What we saw in credit, just giving you some on the run metrics, for example, credit risk transfer at the end of the year, we are about 190 off and it got as wide as 225 and then retraced back to about 200. The CMBX market is a barometer for credit, down the credit stack went from 390 on 11 newly issued 11s, 390 to 460 and then back to 435. So there's been certainly some turbulence, but I wouldn't consider credit to add a meaningful impact on book.

And then either at the end of the quarter, what was the net rate on the forward starting swaps?

186 pay rate.

Our next question comes from Bose George with KBW. Please go ahead.

Just one more question on book value, just wanted to tie the different comments on credit, on rate, because spreads widened a little bit on agencies, credit is flat. So if I tie all that together, does it suggest book value down maybe one-ish percent or little in that range, 1% to 2%?

Bose, this is David. I'll just tell you at the end of January, book was up a little over 3%.

And then in terms of your leverage, after the capital raise, is your leverage down a little further since -- from where it was at the end of 4Q?

I would say it's reasonably close to unchanged.

Bose, I think what is kind of lost in the market is just our overall economic leverage for the firm and by business, and I think one of the levers pun intended that we have that others is don’t is not just the diversification on the asset side, but the financing side. And right now, we are very conservative in our positioning in terms of leverage of the credit businesses. All in, we're still at about 1.5 times levered on a blended basis for those three businesses, which is I would argue comparatively very low. So when it comes to our earnings generation capability and capacity, this year, all things being equal, we have the ability, because we have the dedicated financing in place to more optimally put to work our capital and finance that capital. So we can increase these leverage ratios across the board, not even close to what the peers are as high as they are, but we can increase that leverage to generate higher returns and higher earnings without even making an incremental investment. So when we look at the overall leverage for the firm, again, it's not just to a repo, there's 10 other financing sources that we have across the four businesses that we can calibrate in order to create the income that we’re distributing.

And then just a question on buybacks, the stock is below book, how does share buybacks rank among the investment opportunities.

Well, the last count, I had, I think we have 42 investment options in the four businesses in terms of different assets and structures and buybacks. The buyback question that we've gotten over the years is always, it's always a relative value comparison. Bose, I think you and I have had that conversation. But again like I said in my prepared remarks, I think today looks a lot like February of 2016 and well, I would much rather buy a company on an accretive basis to book in earnings and add an asset base that's complementary. So you kind of hit – you checked three boxes there with an acquisition versus buy my own stock back. And also I think personally that the credit -- our credit businesses, specifically resi credit and middle market lending with the partnerships we’ve formed and the sponsors that we’ve financed, even in this volatile market, especially in this volatile market, that's where you'll see us gain more market share. So it's part of the equation, but we have ways to grow our capital base and appreciate externally as well as internally without buying back stock.

Our next question comes from Ken Bruce with Bank of America Merrill Lynch.

I guess with the defensive position that you've taken in the current market, which is understandable, the obvious question is what do you need to see what factors need to be introduced into the market for you to be less defensive.

Well, Ken, it's a relevant question of defensiveness, because we're always defensive. I think in terms of the catalysts, I would step back, I'm kind of surprised that the mortgage reactions, for instance, the fiscal policy, I mean it was favorable, what needed to be issued late last year into this year in terms of how to pay for, what the government's plan is. So I'm just kind of surprised on a look-back basis as to how the market has reacted. Looking forward, that just tells you, no one here is [indiscernible]. So what we've done is, I think it's really episodic. I think we grow our businesses literally on a week-to-week basis as well as we strength them. So we don't look at, if it’s three hikes or four hikes, how that impacts what we do. And I will ask David to comment as well, but the overlay here is, I'm assuming this market thankfully is going to return to some data dependency, you can see that with the preoccupation yesterday and today, which is the numbers because we have a Federal Reserve with a different person in the seat that is probably going to be more like that than the predecessor. So that in tune means a more market focused on fundamentals and I think the market that’s focused on more fundamentals was a market that just had a severe shock to it. So we like this volatility, which is the output I think for people stepping back and taking a look at the fundamentals, which really hasn’t been done that -- I think that deeply in the past couple of years. So there is a confluence of events. I don't think we look at any one event as the one that flashes green for us, we have fiscal policy, we have tax policy, we have a new Fed share and not to mention, the global risks that are always out there. So I think we're just built to anticipate, not to speculate and that's kind of how we've delivered. We don't have to be the smartest guy in the room every month, because of our options. Our options by definition make us very competitive.

And Ken, I would just add that the first priority in times of volatility is liquidity of the portfolio, but considerate of that liquidity, what we look for obviously is cheaper asset prices, not just cheaper asset prices, but also greater clarity. We have gotten good clarity out of the Fed through a lot of transparency, but to Kevin's point, there's not a lot of clarity out of DC as to really what the supply picture is going to look like, and how that's going to channel through markets, etcetera. So when we have a better sense of how that is going to play out as well as potentially cheaper asset prices, then we would hopefully be able to get back in the market.

Right. I guess part of the question -- loaded question is that, you've pointed out you've produced roughly $0.30 in core earnings per quarter for quite a while now and you obviously highlighted your ability to potentially lever up, if in fact you wanted to do so. So I'm trying to gauge in my own mind as to kind of what the potential is for that $0.30 to go higher and what may do that if it's just a matter of spread widening that kind of works its way into the equation and into the portfolio over time or if it’s something specific that you guys can do to obviously increase that and in fact if -- what would be necessary in the market to do it and/or whether the market maybe just rerates the earnings from the current level, which I think we've all been a little frustrated by over the past couple of years, but whether that gets rerated lower. So I’m trying to understand kind of what the risk dynamic may look like for you guys as a firm.

I think it's a question that we've talked about before and I think I mentioned in my comments, I went back to two years, which was the start of the Fed hiking, you go back four years, 17 quarters is the $0.30 dividend, but just looking, our core earnings have ranged from 280 million to 350 million, $0.29 of $0.34 over the last 15 quarters and that's been a combination of things every quarter, which is kind of the beauty of the recipe. In terms of risk-on or risk-off, I mean I think we're clearly in a market where it doesn't pay to take more risk. And the flip side of this company and the recognition of this stability of this cash flow is that the market's always kind of worried about something else, as it relates to the mortgage REIT sector. So for us, our whole goal is to step out from that lens, our whole goal is compare ourselves versus the cash flow enterprises out there and that's how we measure our performance and that's how we look for our return. We don't do a $0.30 top-down every quarter. We do a bottoms-up and I think what the model has proved over time is what the market has second guessed, which is very, very stable and durable earnings, while we protected book two or three times better than others and that's what we've built. So do we need to take more risk to produce more? I certainly don't think that tradeoff is -- it has been worth it in the past and we don't think it's really worth it now. I would like to say frankly that we have a chance this year to just more efficiently use our capital, in terms of how we finance it and we have a way with our partners to be more opportunistic to access flow that others can’t access. We pay a little bit of wage for, but we don't have to run a manufacturing facility to originate what we buy. And the third part of it is the external comments I made. I mean, I think, all industries that over expand need to consolidate and we are in one of those industries. So we look forward to doing that if this volatility continues.

Thanks for the segue. My last question is just looking through the post of mortgage REITs that are to the right of Annaly on this chart 10 or page 10 in the presentation, are there kind of obvious complementary assets that you see in the crop of mortgage REITs out there. Feel free.

[indiscernible] Look, we’ve had that chart out there for, as you know two or three years and it's meant to just show scale as well as on both ends of the spectrum. Look, I think anything we do externally, we’ve said three things, the assets, number one, have to make sense right for our current portfolio. And given the size and diversity of our portfolio, most companies' assets will fit and it's not just companies on that page, there is the entire BDC sector that frankly needs to consolidate, so which is as fragmented. So the assets have to fit. It has to be accretive to earnings, it has to be accretive to book. We don't have to make an acquisition in order for us to maintain what we've been maintaining for four years. But all things being equal, if we can do, if we did like we did in Hatteras, which was an extremely successful deal, not just for us, but for the sector in terms of shareholder value creation, then we'll do it. So there's a lot of names on that page, most of them could fit well within our role.

Okay. Well, I guess maybe just lastly, congratulations on your latest title, like, we will refer to you now as Mr. Chairman.

Thank you. But please don't do that.

This will conclude our question-and-answer session. I'd like to now turn the conference back over to Kevin Keyes for any closing remarks.

Thank you everyone for your interest in Annaly Capital and we will speak to you all next quarter.