Good morning, and welcome to the Annaly Capital Management Third Quarter 2020 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Purvi Kamdar, Head of Investor Relations. Please go ahead.

Good morning, and welcome to the Third Quarter 2020 Earnings Call for Annaly Capital Management, Inc. Any forward-looking statements made during today's call are subject to certain risks and uncertainties, including with respect to COVID-19 impact, which are outlined in the Risk Factors 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 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 hereof. 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. As a reminder, Annaly routinely posts important information for investors on the company's website at www.annaly.com. Content referenced in today's call can be found in our third quarter 2020 investor presentation and third quarter 2020 financial supplement, both found under the presentation section of our website. Annaly intends to use their web page as a means of disclosing material, nonpublic information for complying with the company's disclosure obligations under Regulation FD and to post and update investor presentations and similar materials on a regular basis. Annaly encourages investors, analysts, the media and other interested parties to monitor their company's website in addition to following Annaly's press releases, SEC filings, public conference calls, presentations, webcasts and other information it posts from time to time on its website. Please also note this event is being recorded. Participants on this morning's call include David Finkelstein, Chief Executive Officer and Chief Investment Officer; Serena Wolfe, Chief Financial Officer; Tim Coffey, Chief Credit Officer; Ilker Ertas, Head of Securitized Products; Mike Fania, Head of Residential Credit; and Michael Quinn, Head of Commercial Investments. And with that, I'll turn the call over to David.

Thank you, Purvi. Good morning, everyone, and thanks for joining us for our third quarter earnings call. I'll briefly provide an update on the broader market and how we manage our portfolios during the quarter. And before Serena reviews the financials, I'll discuss the factors that underscore our business principles and risk posture and have contributed to our performance. The U.S. economy rebounded at a faster pace than many had anticipated in the third quarter, best exemplified by the decline in the unemployment rate to 7.9% in September. Household spending rose sharply in certain sectors of the economy, arguably led by housing, have made a substantial improvement with current activity well above pre-COVID levels. However, momentum is slowing as the service sector is unable to fully recover while the virus persists, the extended unemployment benefits supported under the CARES Act, which meaningfully boosted incomes expired in July, although only half of all jobs lost during the pandemic have been restored. Monetary policy accommodation continues to be critical, especially given challenges on the fiscal front, which is further complicated by the uncertainty around the course of the virus as well as the outcome of next week's presidential election. Similar to the second quarter, the Federal Reserve continues to use all available tools to smooth market functioning while signaling they stand ready to provide more support, if needed. Suppressed interest rate volatility remains a positive backdrop for our agency MBS and credit businesses, contributing to our ability to generate a 6.3% economic return during the quarter and core earnings in our dividend by $0.10. Additionally, we achieved these results while reducing our leverage to 6.2x. It is important to note that historic volatility we faced in March and a pending risk event in the election are reasons for maintaining a cautious approach.…

Thank you, David, and good morning, everyone. I will provide brief financial highlights for the quarter ended September 30, 2020. And while our earnings release discloses both GAAP and non-GAAP core results, I will be focusing this morning primarily on our core results and related metrics all excluding PAA. As David mentioned earlier, the suppressed interest rate environment, continued Fed support, and our active portfolio management has enabled us to do more with less, less leverage that is, as we've generated the best core return per share we've had in 5 years with 6.2x leverage. Our book value per share was $8.70 for the third quarter, a 4% increase from the second quarter, and we generated core earnings per share, excluding PAA, of $0.32, a 19% increase from the prior quarter. Book value increased on GAAP net income of approximately $1 billion or $0.70 per share, which includes a $0.02 benefit related to reversals of CECL and specific reserves that will be addressed in more detail later in my comments, partially offset by common and preferred dividends and lower other comprehensive income of $253 million or $0.18 per share. GAAP net income increased in comparison to the second quarter due to gains on the swap portfolio of $107 million as well as higher GAAP net interest income of $447 million, up from $399 million in the prior quarter, primarily due to lower interest expense from lower average repo rates and balances, partially offset by lower net unrealized gains on instruments measured at fair value through earnings of $121 million, down from $255 million in the prior quarter. Since the disruption in March, we have recovered a large portion of the decline in the fair value of our portfolio. We have included a slide in our investor presentation that provides additional…

[Operator Instructions] The first question today comes from Steve Delaney of JMP Securities.

A lot of good numbers in this report, but I'd like to just comment that I think from my view, possibly the best number is the 70 basis point drop in expenses to average equity. So we know where that came from. And congratulations on the internalization. Your dividend coverage, obviously, was excellent, strong quarter and 145%. David, we heard your comments that this 3Q may be a little peaky in terms of the near-term cycle. But Serena, I'm wondering if you have available the information to comment on any undistributed retaxable income that Annaly may have had as of September 30.

So we are -- there's obviously a lot of differences, Steve, with regards to core versus taxable income. And one of the -- the largest one of those being the amortization of swap losses, which we do over the term of the original hedging instrument versus for GAAP, we take it all at once and for core we exclude. And so as of the third quarter, we don't have any concerns with not meeting our redistribution requirements for the full year, I would say.

Understood. So it sounds like there's no -- won't be any tax-driven need to either increase the dividend or pay a special dividend that you'll make that decision based on other factors as to where the dividend goes, but not taxed mandated.

That's the correct assumption, Steve.

And David, just on the RMBS activity, can you comment on -- you do several loan products. Can you comment on the specific loan products that were in those third quarter transactions? And maybe give us some color on what your actual risk retention is in those deals above the 5% mandated level?

Sure, Steve, and it's good to hear from you. So in terms of the loans and the securitizations, those were from our expanded prime program and largely [indiscernible] loans. And I think if you look at in totality of the securitizations that we've done, which are over $5 billion, I believe we retained roughly 18% of our overall securitization.

Excellent. And those are nice bonds and I think have the possibility to see ratings upgrades, right, as those loans season? And you'd be...

Yes, definitely. And again, we -- to my earlier point, Steve, about balance sheet leverage, we do apply very minimal leverage to these assets. And the return on our last deal was about 12.5% on the balance sheet.

The next question comes from Rick Shane of JPMorgan.

Look, in a normal environment, you guys faced binary risk in terms of rate direction. But we're in a period now where the distribution of outcomes is more skewed than it's probably ever been. The other risk you normally face is determining the timing of those rate moves. And the Fed is creating an environment through their communications that deliberately diminishes that uncertainty. I think that this creates a setup where there's less uncertainty on a theoretical basis than you guys have ever faced. I'm curious how you balance being able to maximize profitability in that environment with also managing risk. And there was an interesting comment from storing that related to one place where you're enhancing profitability by staying on maintaining exposure to the shorter end of the repo financing curve. Can you talk about how you look at this going forward?

Sure. So to your point, the rate risk is skewed. It's asymmetric. We don't expect the Fed to go to negative rates, and we're at the 0 lower bound for the next number of years, and they've been very deliberate with their forward guidance, which has been encouraging. But that being said, as I mentioned in my prepared remarks, there is always that risk that we could see rates out the curve increase, and there's a lot of uncertainty around that. So our hedge profile is set up as it has been for the last number of quarters with a modest steepening profile because there could be events that do lead to higher rates out the curve. We're very comfortable at the front end of what the Fed has conveyed to us. But you could see volatility at some point out the curve. And so that's why we position hedge profile to reflect that. And that also is why we've added more swaptions to the hedge portfolio to help us mitigate against that tail risk. Now with respect to financing and our average days, which I believe was 72 days at the end of the quarter. We do look at our financing profile relative to the cost of hedging short rates with other instruments. And we are very comfortable with the level of financing rates out the near-term horizon. The curve is relatively flat from one month to a year, we understand that. But there is an incremental cost of turning everything out to a year when we don't think it's necessary to do so, and we can manage those risks and hedge those risks more cheaply with other interest rate instruments. And we do have a fair amount of short-dated swaps that do protect for that.

Got it. And so does that strategy makes sense because the swaps -- cost of swaps are low in a mobile environment. And so that allows you to take the risk on -- a little more risk on the financing? And again, I don't want to overemphasize the risk because it makes sense. But is that the way you sort of look at it?

Sure. There were even periods last quarter where we paid fixed at negative rates. And so it's attractive to do so as opposed to terming out repo from that standpoint. So it's pure relative value.

Okay. And I do have one last question. I apologize to my peers who are waiting in queue. Just given the volatility we've seen in the equity markets headed into election, can you comment on the volatility that you've seen during that same period in your core asset classes as well?

Sure, sure. And look, we do have this risk event next week. I think heading into the latter part of last week and this week, there were expectations of stimulus and the potential for a democratic sweep. So we saw an increase in rates, predicated on the possibility for stimulus. That seems to have subsided, given the lack of progress on the stimulus front. But I will say there are a variety of outcomes that could occur with respect to the election and fiscal policy that does have us relatively cautious. That's why we're hedged well, and that's why our leverage is at the low end of the range over the last number of years. And so we think this conservative approach is appropriate. And it also does happen to more than cover the dividend. And so we're pretty comfortable with our operating environment. We have a lot of latitude, particularly with low leverage right now.

The next question comes from Kenneth Lee of RBC Capital Markets.

Appreciate the discussion of the different types of leverage. Wondering if you could just further expand upon it, perhaps share your appetite for potentially increasing leverage within each of the bucket just given the current attractive environment for investing?

Sure. So I'll just go through the individual asset classes and what's attractive. What type of leverage is attractive, for example. And just starting with -- at the corporate level, I talked about capital structure leverage. Right now, it's not advantageous to add capital structure leverage, given the pricing associated with press, and that's not something we're looking at, certainly. Now with respect to balance sheet leverage versus structural leverage, starting with balance sheet leverage. There is obviously an ample amount of reserves in the system given Fed policy. So as a consequence, balance sheet leverage is relatively cheap, and that most informs our agency business. And so as a result, that's -- the focus in agency is on balance sheet leverage. Now on the credit side, structural leverage is relatively attractive. And you see that through our securitization returns. We use more structural leverage on -- in our credit portfolios. But our balance sheet leverage on those portfolios is roughly 1.5x. And so we think we've stricken the appropriate balance and not layered structural leverage with balance sheet leverage, and we feel good about it. Now in terms of increasing leverage, look, assets have to be cheaper for us to increase leverage. We're very comfortable with where we're at right now. 6.2x of leverage, gives us a lot of flexibility to see how markets evolve. To the extent assets cheapen, you would see some increase in leverage just through equity degradation. But we would still have dry powder to add assets at cheaper levels if we think the cheapening is transitory. That's not our expectation that assets will cheapen given the Fed backdrop. But to the extent that did materialize, we could have the opportunity to add assets. Now conversely, if there's a continued spread tightening, which brings our leverage down from book value appreciation, it's not the case that we would add assets to maintain leverage. We may even be of the mindset that assets are too rich and even further reduce leverage and sell assets. So generally speaking, we just have a lot of latitude to do exactly what we think is appropriate, given the market, given asset pricing and given our current liquidity and leverage profile.

Got you. That was very helpful color. Just one follow-up, if I may. Just on the equity capital allocation, it sounds like some of the increase towards agencies was due to the securitization transaction. But I just wanted to get your -- any kind of updated thoughts on where that equity capital allocation could trend in the near term?

Yes. Sure. And as I said in the prepared comments, we would like to tick up our allocation of credit. But there's still a lot of uncertainty. We don't know the exact course of the virus. We don't know how policy is going to shape out on the physical front. We are still learning about how this economy is evolving. So we have to be very methodical about how we add credit assets. Our pipelines are filling up. We're seeing very good opportunities. But again, it is episodic. And so we'll see how it plays out. And we'd like to get a lot more certainty with how the economy shapes up before we make a stronger commitment. But at the margin, I would say we would like to get our allocation and credit marginally higher.

[Operator Instructions] The next question comes from Doug Harter of Crédit Suisse.

Can you talk about kind of how book value has performed in October so far?

Sure, sure. We're up a few pennies quarter to date. Nothing to write home about, and we have a long way to go left in the quarter.

Understood. Can you -- obviously, next week, is kind of a volatility -- potential volatility event. I guess, can you just talk about kind of how the passage of next week, kind of -- how that kind of might influence kind of your actions versus kind of the remaining kind of unknowns that are out there in the market?

Yes. Well, unfortunately, it's likely the case that the passage of next week may not lead to a resolution in the outcome of the election. And so that's something we're certainly concerned about. But there's different states of the world based on how things evolve. If you get a blue wave, for example, then you could see a continuation of that slight sell-off we saw last week. And before, with the optimism around stimulus. If you get a split Congress, if the President retains the White House and you have a democratic congress that could lead to a moderate stimulus. And if it goes the other way, you potentially, and this is something that concerns us, could see a repeat of what we saw in 2010, where you had austerity coming from Congress from the Senate, and the White House in need of stimulus. So there's a variety of circumstances that could prevail. And again, it does come back to taking a cautious approach as we do figure it all out.

The next question comes from Bose George of KBW.

Can you talk about the level of specialness in October versus the last quarter? And then just how do you think about the level of your net TBA position as a percentage of your total MBS exposure? Could we see that increase if returns remain elevated? Just curious how you're thinking about sizing that?

Sure. No, that's a very good question, Bose. So specialness in October is still quite prevalent. It has moved down in coupon into 1.5s and 2s. But generally speaking, the financing rates, implied financing rates on those coupons are negative 60 to negative 80 basis points depending on underlying assumptions. And that compares almost on part to what we experienced in the third quarter. We generally, on average, rolled our portfolio at south of negative 50 basis points on the quarter. As the market does repopulate with new collateral, you should see specialness dissipate somewhat as time passes and the Fed doesn't take all of the lower coupons out of the market, but it should be here for a little while. Now in terms of how we think about it, this is a carry-driven market. In the third quarter, we had about $4.8 billion in portfolio runoff in the agency portfolio. About half of that was allocated to TBAs to grow the TBA position, with the other half, more early on allocated to pools. Now we're at a point where specified pools have gotten to a point where they're pretty fully valued. And so the way we're thinking about it currently is runoff in the fourth quarter will more than, on average, go into TBAs. But we are certainly considerate of what the portfolio looks like, and we have to manage the portfolio, not just for near-term carry, but we have to think about a variety of scenarios as to how markets can evolve. And our specified pool portfolio is the core of our business. And those cash flows, long-term cash flows that we put on the balance sheet are going to remain the core. So to make a long story short, we'll probably grow the TBA portfolio modestly in the fourth quarter. But we do remain focused on our pool portfolio, and we think it's performed quite well, as I talked about in the prepared comments with respect to portfolio speeds.

Okay. Great. That's helpful. And then just in terms of the difference -- incremental sort of difference in the TBA returns versus the spec pools. Can you just cite that as well?

Sure. I would say pools are in the high single digits and the very low double digits in TBAs.

Okay. Great. And actually, just one clarification. The cost of funds that you guys reported, the 93 basis points, does that include the implied funding benefit of the TBAs? Is that's just a balancing number?

No. No, that's a subjective assessment because you'd have to incorporate a prepayment assumption. So when we give you our cost of funds, it's entirely objective data.

The next question comes from Brock Vandervliet of UBS.

David, on the CPR speeds, you remarked, we are kind of in an unusual environment here with low rates for looking like a very long time. But seasonally, there should be a bit of a decel in activity. Help us kind of get our head around the forward look on CPR. And also with respect to the available pool of mortgages that pencil for refinancing? And where that is now versus a couple of months ago?

Sure. So let's start with the available pool of refinanceable mortgages. As of today, roughly 80% of the universe is 50 basis points in the money or more. So it's dropped a little bit, and that's largely because the market has been repopulated with heavy issuance and lower loan rate loans. But nonetheless, the vast majority of the market is in the money. So how we think speeds will evolve over the near term? Speeds will be faster in the fourth quarter, but not by too much, we think roughly 5% to 7% faster. Now to your point about seasonality, one thing to note is that originators are operating at full capacity, and they're adding a lot of capacity. And so when you're at full capacity and supposing we do have lower housing turnover in the winter, which drives that seasonality, you're going to see us shift the resources over to the refinancing side of the spectrum and originators. And so we don't think that seasonality will be a significant -- lead to a significant decline in prepayments in Q1, which is typically when you see it most. If anything, it will be flat to up.

Okay. Got it. And on -- with respect to funding costs, big drop this quarter, how much more room do you sense you may have there? Or is this kind of it?

Well, look, I think when we look at repo rates on the agency side from overnight out to a year, we're talking 13 basis points so thereabouts out to an upwards of 30. And so as the portfolio does roll, we will be resetting the agency portfolio at lower rate. As of today, our average rate is 36 basis points, so where our current repo rates are today. So that's a decline to some extent, and we'll see is more repo rolls.

The next question comes from Mark DeVries of Barclays.

You mentioned looking to start to reallocate back towards credit investments, but the opportunities you're seeing are episodic here. Could you just talk about where you're seeing the most attractive relative value and where we should expect you to kind of reallocate capital?

Sure. So we can go around the room here. We do have the full room of all our business heads. And again, opportunities are episodic. We have started to rebuild our residential whole loan pipeline, and we're seeing our other businesses pick up in activity in terms of at least looking at a lot of opportunities. But again, we do have to take the backdrop of what the uncertainty entails with respect to the economy and how credit could evolve. So we're certainly cautious, but let's just start with Mike Fania on the resi side.

Sure. Thanks, David. I would say within residential credit, we do think non-QM securitizations have levered IRRs in the low mid-double digits to mid-double digits. And I think to your point, a lot of it is just -- there is a certain element of scarcity of supply. Supply has been relatively nascent. Agency pipelines are full high gross margin. And you also had a redaction of programs going in April. So we like the sector. We continue to build back up our originator network and our strategic alliances. And I think another area of the market that we find attractive is the unrated NPL or RPL security sector. We see one, senior securities, 3.125% to 3.25% unlevered yields, and we see the senior support securities. 5.25% to 5.50% unlevered yields. And we think levered IRRs within that space are high single digits on the senior securities. And low mid-double digits to mid-double digits on the senior support.

Mark, this is Mike Quinn. So on the commercial side, I would say, the most attractive things that we're seeing today are in the transitional whole loan space. And I think that's for a couple of reasons: One, obviously, we're being cautious just given the uncertainty going forward. But assets have repriced. And I think we're seeing opportunities where we're able to lend to borrowers at lower levels today than we saw, call it, 12 months ago. In addition, spreads are quite a bit wider today than they were. I think all-in coupons are probably pretty similar, maybe a little bit higher, but the credit quality of those loans is quite a bit better. So we are seeing opportunities to make new investments on the whole loan side.

Mark, it's Tim Coffey. I think on the middle market side, we will just continue the pattern of what we've been able to accomplish to date. The portfolio remains very clean. So we expect to see continued tack on acquisition activity on our existing book. You'll see it in the number of issuers that we've been able to maintain, if it continues to be at 50 on the head. And so I think the benefit of having a clean portfolio is that those names have the ability to go out and execute with tack-on acquisition activity, thus resulting in financing needs to which we can obviously leverage our past success. So the bulk will be coming from what we've done today. And continue to increase our exposures on our existing stable of names.

And Mark, we do also have Ilker Ertas here on the agency side, but it looks as though I've already stolen all this thunder in prior comments, I think, where we stand on that front.

Okay. Great. That's very helpful. Could you just provide us an update on kind of the efforts to manage whether retroactively on existing portfolio perspective and the new underwriting kind of COVID exposure in the commercial and middle market lending?

Sure. Mike can start...

Yes. So Mark, this is Mike Quinn again. I think the COVID exposure in the commercial portfolio, I think, hits us most in 2 places: One is the hotel space and two is in retail. So first, on the hotel side, we've really got 5 positions in the hotel space. And in every one of those positions, sponsors are contributing capital to those deals to support those assets. And 4 out of our 5 hotel positions are currently paying. In the retail side, I think we've been hit as well. I think similar themes in that space in that the positions we have, sponsors are supporting those deals and infusing capital. I think in some instances, those loans will need to be extended in order to get through this kind of low liquidity period. But we like our basis in those assets, and we feel comfortable with the outcomes going forward.

Mark, on the MML side, I think it's pretty clear to us that we've been ironically, a pretty big beneficiary in our portfolio of what's going on with COVID. And certainly, we don't like to say that too loudly, but the portfolio has certainly been able to take advantage of the last 6 or 7 months. So I think [indiscernible] to a lot of things that have been going on with our peers, our portfolio has actually been able to witness a fundamental improvement across the portfolio name by name. And I would also tell you, to the extent that we have seen a select marrow group of names see softness over the past 6 or 7 months. I can also tell you that just in the last couple of months, those names that did see softness in the initial phases of COVID has seen substantial progression in the last few months, as they may have been the first -- they may have witnessed the first order effects of COVID, but they've certainly seen the second order return from [indiscernible]. So again, we feel pretty good about how the portfolio stands after the latest sort of volatility in the general market.

This concludes our question-and-answer session. I would like to turn the conference back over to David Finkelstein for any closing remarks.

Thank you, Elissa, and thanks to everybody for joining us. We hope everybody is staying healthy in these times. And in line with my earlier commentary around purpose and impact in this environment, irrespective of your political affiliation, just want to conclude by reminding everyone to get out and vote next week, if you haven't already. And we'll talk to you soon. Thanks.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.