Good morning, and welcome to the First Quarter 2022 Annaly Capital Management Earnings Conference Call. . Please note that today's event is being recorded. Now I would like to turn the conference over to Sean Kensil, Director Investor Relations. Please go ahead, sir.

Good morning, and welcome to the first quarter 2022 earnings call Early Capital Management. Any forward-looking statements made during today's call are subject to certain risks and uncertainties, including with respect to COVID-19 impacts, 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, www.annaly.com. Content referenced in today's call can be found in our first quarter 2022 investor presentation and first quarter 2022 financial supplement, both found under the Presentations section of our website. Annaly intends to use our webpage as a means of disclosing material nonpublic information, for complying with the company's disclosure obligations under Regulation FD, and to post an update in presentations and similar materials on a regular basis. Please also note this event is being recorded. Participants on this morning's call include David Finkelstein, President and Chief Executive Officer; Serena Wolfe, Financial Officer; Ilker Ertas, Chief Investment Officer; and Mike Fania, Head of Residential Credit. And with that, I'll turn the call over to David.

Thank you, Sean. Good morning, everyone, and thanks for joining us on our first quarter earnings call. Today, I'll review the macro backdrop and how it impacted our performance during the quarter. And then I'd like to discuss the sale of our middle market lending portfolio. and the transaction's implications for our capital allocation and our broader strategic direction. Ilker will then provide more detailed commentary on our portfolio activity, and then Serena will go over our financial results. Although growth slowed in the first quarter relative to last year, the U.S. economy remains robust. The strength in inflation in the labor market has demonstrated that the Federal Reserve needs to remove monitor policy accommodation much faster than previously anticipated. This led to a sharp repricing of fixed income assets, with the aggregate U.S. bond market index facing the worst quarterly performance since 1980. Consistent with the broader market, Annaly's portfolio was vulnerable to the exceptional volatility in this environment despite our efforts to defensively position our portfolio, experiencing an economic return of negative 12%, with a reduction in total portfolio size of roughly $5 billion to end the quarter at $84.4 billion in total assets. Now returning to the macro landscape, inflation continued to rise during the first quarter, with headline CPI reaching 8.5% in March, driven by a sharp rise in commodity prices. And even outside of commodities and food, inflation pressures remain elevated and broad-based, as seen for example, in the Federal Reserve Bank of Dallas' estimate that only 10% of PCE components are currently witnessing annualized inflation below 2%. The labor market, however, has arguably been the bigger driver of the Fed's hawkish shift. The employment picture has recovered significantly, with the unemployment rate falling 1.1% over 6 months to 3.6% in March. Consequently, the demand…

Thank you, David. As you discussed, the first quarter was characterized by challenging macroeconomic outlook that led to extreme volatility in fixed income markets. Mortgages underperformed significantly, given the added headwinds of historically high levels of net supply and speculation about asset sales from the Federal Reserve. Normal spreads widened roughly 40 basis points and the primary mortgage rate increased by over 150 basis points, marking one of the sharpest backups in the history of the mortgage market. With respect to how we managed our portfolio in this environment, we began the year with our leverage at its lowest level since 2014 and maintained a stable notional exposure to MBS throughout the quarter. Within the portfolio however, we actively managed our hedges and rebalanced our coupon exposure to better position ourselves considering 3 key market themes. First, there was disparate performance across mortgage stack. Mortgages that were being produced underperformed lower coupons which were largely locked up in Fed and bank portfolios, and therefore more insulated from the consistent selling pressure driven by elevated origination volumes. We use this opportunity to shift up in coupon, selling roughly 7.5 billion lower coupons, predominantly choose and moving into higher purpose. Second, as mortgage rates sharply sold off, prepaid dynamics in the market changed rapidly. With mortgage rates at roughly 5% at quarter end, only a small fraction of borrowers maintain an incentive to refinance their mortgages. At the same time, cash-out activity should remain somewhat elevated due to the recent strong housing market and summer seasonals. As a result, the conversion of our mortgage portfolio improved meaningfully. Speed slowed 22% quarter-over-quarter with the aggregate portfolio paying 16.7% CPR in Q1. In addition, we believe our specified portfolio remains well positioned for a discount environment due to around 4 years of average seasoning,…

Thank you, Ilker, and good morning, everyone. Today, I'll provide brief financial highlights for the quarter ended March 31, 2022, and discuss select quarter-to-date metrics. Consistent with prior quarters, while our earnings release discloses GAAP and non-GAAP earnings metrics, my comments will focus on our non-GAAP EAD and related key performance metrics, which exclude PAA. As David and Ilker have touched on, Q1 was a challenging quarter for economic return given the extreme volatility in fixed income markets. Notwithstanding with challenging market environment, we continue to deliver solid earnings and ample coverage, approximately 125% of our dividend. To set the stage with some summary information, our book value per share was $6.77 for Q1, and we generated earnings available for distribution per share of $0.28. Book value decreased by $1.20 for the quarter, primarily due to lower other comprehensive income of $3.4 billion or $2.34 per share on higher rates and spread widening, and the related declining valuations on our agency positions as well as the common and preferred dividend declarations of $349 million or $0.24 per share, partially offset by GAAP net income of $2 billion or $1.37 per share. . Consistent with the prior quarter, our multifaceted hedging strategy supported book value, providing a partial offset to the agency declines due to the basis widening mentioned above, with swaps, futures and MSR valuations contributing $1.98 per share to the book value during the quarter. MSR valuations alone were $0.12 per share higher in the quarter than in Q4 2021. Combining our book value performance at our first quarter dividend of $0.22, our quarterly economic return was negative 12.3%. Diving deeper into the GAAP results. As I noted above, we generated GAAP net income for Q1 of $2 billion or $1.37 per common share, net of preferred dividends, up…

. Today's first question comes from Rick Shane with JPMorgan.

And now that you've sold the middle -- or selling the middle market business, I'm not necessarily sure I have that much to ask. That seems to be my routine question. I do want to double a little into Serena's comment related to dividend coverage in the near term. That's helpful context. I'd love to get your thoughts longer term about what the opportunity is and your confidence around the dividend. When we look at things, obviously we're looking at the margin expansion opportunity, but the trade-off there being potentially less specialists on the role. And just curious, as you roll out further how you think about dividend coverage. .

Sure. So look, as we've said in the past, we set the dividend based on what we think is an appropriate level, consistent with our historical yield and competitive in the market. And we always look at it with our board quarter-by-quarter. We have outearned the dividend really since the second quarter of 2020 post-COVID. I think we've ranged between $0.27 and $0.30 in terms of earnings available for distribution. Coming into this year, we did think that EAD would be a touch lower in the first quarter. But with dollar roll income increasing and a couple of other areas that benefited earnings, we matched that last quarter. $0.28 going forward, we continue to think that it's going to moderate towards the dividend. This coming quarter, we're going to well cover it, although $0.28 is certainly ambitious. And how we think about it over the long run is we have to assess what the returns are across the businesses, what the capital allocation is and determine what we think to be a little that we can consistently earn out the horizon. Right now, we feel good about our dividend. The returns on agencies, as both Ilker and I discussed, have increased a fair amount. We're in the low to mid-teens in terms of levered returns on agencies and so we feel good about that. But the Fed is raising rates. Out the horizon, it's a little bit difficult to predict exactly how earnings are going to evolve, but we feel good about it right now. .

Great. And again, just to sort of be clear about this, there's no implication about some specific concern. It's just a reflection of the uncertainty you're willing to sort of make a near-term call, but given what's sort of an unprecedented environment, less certain further out?

Yes. And you're speaking with respect to the fact that we're out earning the dividend right now and what our intention is, why we're being conservative with the dividend? Is that your question?

That's exactly it.

Yes. And look, I think as I've said, we do think that earnings available for distribution will moderate towards the dividend, but we're comfortable that we're going to outearn it in Q2, for example. But we do think that when we look at the forwards, EAD will moderate. .

The next question comes from Bose George with KBW.

Just in terms of returns, so you mentioned low to mid-teens on agencies. Can you just talk about how that compares to credit? And also just in the returns on the MSR, what's the return on the invested capital there?

Sure. So yes, agencies are, as we said, close to the mid-teens, low to mid-teens as David said. And in fact, if you look at the headline numbers, it will be higher than that. But this is an environment that you need to be hedging a little bit more and then you need to pay more hedging costs. So let's call it low to mid-teens on agencies. And on the residential credit, it will be very similar, low to mid-teens because they also widened. And in terms of MSR, as you know, we always evaluate MSR on an unlevered basis and unlevered returns are very high singles right now.

Okay, great. And then can you just give an update on your book value quarter-to-date?

Sure, Bose. So it's been a little bit of volatile start to the quarter. Rates are up 30 to 50 basis points across the curve and mortgages are about 10 to 12 wider. I'm a little hesitant to put an exact pin in it just given that things are moving around, but it's off roughly mid- to upper single digits on the quarter thus far. But things, mortgages have found their footing, it seems like this week, and we got 2 months left to go in the quarter.

The next question comes from Eric Hagen with BTIG.

Maybe just one on the market to start. How much connectivity do you guys see between higher Fed funds and mortgage spreads? In other words, we know that there's this tight connection between the Fed securities portfolio and mortgage spreads. But do you see the strong linkage between Fed funds and spreads? Or is there anything specific in this tightening cycle that could change that relationship?

That's an excellent question. So the way that we look at it, it's not the level of Fed funds, but how fast it's raising, namely the velocity of the Fed funds. So this will affect the yield curve and overall monetary tightness in the system. And we have these 2 channels, it has indirect but very strong effect on MBS valuations and MBS spreads. Having said that, when we look at the market today, to is imported in the forward space. And mortgage spreads are close to the historical wide with the exception of like a funding problem days. So one would think that most of these things have been priced in, and that's what we believe right now. But that's a very good observation. So this time around, it's how fast it's raising, but it seems like market is already prepared for like, for example, coming 50 and another 50. So most of that velocity has been priced in. .

And Eric, I'll just add, 1 thing to note really since the onset of COVID and the intervention by the Fed markets have been very fast at pricing in the eventual policy in the markets, and you saw that in the first quarter. The yield curve is inverted 1-year forward between 2s and 10s were like negative 15 basis points and mortgage spreads are obviously quite a bit wider. So it does feel like the market has done an effective job of pricing in a considerable amount of policy tightening. .

That's really helpful, guys. One on the portfolio, just what kind of ratio, I think you mentioned this in your prepared remarks, but maybe some more color. Just the ratio that you see yourselves being comfortable with between pass-throughs financed with repo and then TBAs financed with the role. And then when you reinvest the capital from the middle market portfolio, if nothing else changes, where do you see yourselves kind of leaning with respect to that breakdown?

Yes. Again, as you know, we have been elevated on TBA levels. And we think in the short term, we will still be able to be elevated on the TBA levels because the production coupon TBAs are very, very special. But you can see us going more into pulls down the road. But we will still be maintaining like, let's call it, 20% TBA type thing that we'll be getting the more long run average on that. But in the short term, we will be held a bit heavy on the TBA side. .

Yes. And Eric, we're not constrained by limits on TBAs versus pools in light of the fact that there's ample liquidity in the market and financing, while the Fed's tightening policy still remains quite ample. And so really, it's a pure relative value play between TBAs and pools and whatever offers the best value. There's always limits with respect to being a REIT and the like, but we have ample latitude within those 2 buckets. And then on your question on overall capital allocation post-MML, in my prepared remarks, I did discuss the fact that we will expect to increase our MSR position over time. And the way we look at it with the 3 buckets, 3 verticals between agency, resi credit and MSR, we would like to get better balance over the long term into residential credit and MSR and reduce our exposure to agency, but we're not in a hurry to do that by any stretch. In fact, if you fast forward this quarter, you will see the capital allocation to agency modestly higher with the return of that capital. Agency serves as a good placeholder. And then episodically, we'll reallocate into both the MSR and residential credit, but we're in no rush, we'll be patient, and we'll invest as we see it appropriate.

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

Wondering if you could just share with us your thoughts about how funding costs would trend in the near term and consequently, implications for investment spreads?

Sure. I'll start, and Serena, feel free to jump in here. But in spite of the volatility in short rates, funding costs on a spread basis have actually been rather stable. So if you look out the curve in the front end of the curve out to 3 months versus OIS, you can term for 2 to 4 basis points or thereabouts on top of OIS and then it spreads out to about 5 to 7 basis points on top of OIS out the curve. So there's still a considerable amount of liquidity in financing markets. Rates are volatile, but spreads have been reasonably consistent. And Ilker, did you have anything to add there?

Actually, David, as you said, yes, funding is available at the spread to the curve of OIS or at very attractive levels. And this was our point, as you and I have been discussing. That's why MBS looks very, very attractive right now. This kind of MBS valuations only happens when there's like an extreme stress in the funding markets and lack of balance sheet. Where funding markets are a bit stable, I have never seen MBS this wide in nominal spreads. .

And Ken, thanks for your question. When we're looking forward with regards to cost of funds and agency repo rates, our expectations are that agency repo rates will be about 20 basis points higher for the second quarter. So you should think about that when you think about our cost of funds as well.

Great. Very helpful there. And 1 follow-up, if I may. Just wondering if you could just talk a little bit more about some of the growth opportunities around the prime jumbo expanded credit MBS assets.

Sure. Thanks, Ken. Prime jumbo, I'll say that we have a number of strategic partners that we've utilized over the past year, 1.5 years. We don't necessarily take balance sheet risk with prime jumbo due to those deals with our partners. On the expanded credit non-QM side, we feel very strongly that, that market will continue to have solid origination activity. I think if you to where banks are down 30% origination volume we do think non-QM will be more stable in terms of origination volumes. About 60% of that market is purchased money. About 25% of the market is cash out. So 85% of non-QM originations in 2021 were not with rate and term refi. If you look at the agency market, that's closer to 40% in terms of purchase. And Dave and Ilker both mentioned this in the script, but you have also seen a number of the nonbank community start to originate and start to roll out non-QM platforms and underwriting guidelines and products. And this has been very beneficial in terms of bringing supply. So year-to-date, we've locked over $800 million through our correspondent channel of non-QM, and I'll say in Q1, we locked $520 million. It was our highest quarter to date. So there's fierce competition on the agency side. Origination volumes are down and margins are down, and you have seen originators come to the non-QM market to fill that gap. .

The next question comes from Doug Harter with Credit Suisse.

Mike, I was wondering if you see opportunities kind of on the bulk purchase side in non-QM, especially in light of the middle market sale and kind of having additional capital deployed.

Yes. Sure, Doug. What I'll see, well in terms of transaction activity, in January, in the bulk market, we saw $2 billion of flow and available for us to bid. In March, that number was $750 million. And a lot of what's transpired is origination volumes are down, but you're also seeing these smaller nonbank originators and some of the larger nonbank originators move away from the bulk market to delivering best efforts and wanting to deliver through our correspondent channel. So we certainly have seen a number of opportunities. I think the challenge that the market is going through, and it's more on the originator side, is non-QM rates have increased so fast that originators have been caught off guard, not necessarily having appropriate hedging strategies, and they continue to sell discount loans. So since the end of the year, we've seen non-QM rates go from 425. We think the 102 rate walking in here today is 6 3/4, and unfortunately, for a lot of these originators, they've been trying to sell that bulk through the market, but it continues to be out of the money. So we've evaluated our preferences for at-the-money collateral and not necessarily continuing to buy discount pools on the way up. But I'll say that the bulk market, you have seen less supply and you are seeing more originators willing to engage and lock best efforts given the dynamics and given the hedging practices of those originators. .

And Doug, just to add to that, the silver lining in the volatility we experienced year-to-date is the fact that we have deep capital base and can provide a lot of liquidity, and so when you look at bulk versus flow and originators, not wanting to warehouse loans, rather opting for that certainty of execution, we've been open for business and it's helped build Mike's correspondent channel. We're very happy about that.

Great. And David, you talked about being willing to take kind of beyond the 10%. Any way to dimension kind of how much beyond 10% you're willing to go on that?

Sure. So looking at the less liquid bucket, obviously middle market lending off balance sheet, that was roughly 10% of capital. And I would think about that MSR over time could make up that balance and get to an upwards of 20% of capital over time.

The next question comes from Kevin Barker with Piper Sandler.

I just wanted to follow up on the proceeds from the middle market portfolio. You touched on it earlier. Could you talk to us about how you weigh the differences between reallocating that capital between MSRs, agency mortgage backs or maybe even look at other sources, whether it's M&A or other things that are out there as potential proceeds from the middle market?

Sure. So with respect to the actual $1 billion in capital, as I mentioned, the placeholder's agency MBS, but we will look to redeploy it episodically in resi and/or MSR over time. And ultimately, the longer-term objective is to get those 2 non-agency and MSR buckets up to a higher percentage of capital. But we're perfectly comfortable with agency taking on that responsibility of redeployment over the near term. And then in terms of other opportunities out the horizon, we're always looking at everything, whether it's M&A or new sectors. We're consistently evaluating different opportunities in the market. And as Serena mentioned, in terms of liquidity on the balance sheet, cash and Agency MBS, $4 billion, another $1 billion coming in, we can engage in a lot of potential strategies should the opportunity materialize. M&A has been tough over the past couple of years after some pretty high price points in the sector. We're not actively seeking to buy another company, but it's always something we look at.

So when you think about the opportunity set for other companies, I mean you indicated a pretty broad range of different things you're looking at. Is there anything in particular, any sectors that screen as particularly attractive just given your overall strategy today?

Yes, hopefully, it fits within the 3 verticals that we're looking at. With agency, you're looking largely at price. With MSR, it's potentially in the realm of other portfolio companies or origination, which we do not need. We've been very successful with respect to partnerships with large originators. So we're not looking at the origination market right now. And then in the resi credit space, we have looked at smaller originators in the past, but the development of the correspondent channel and actually partnering with originators as opposed to competing with originators has worked out quite well. And again, we're relied on for that certainty of execution. So to paint a broad picture, if there is a need for liquidity in the mortgage REIT space, and it's at the right price and it presents a strategic fit, we certainly evaluate it, and we have the liquidity to execute on it. But outside of the portfolio management sector, we don't have aspirations to do anything at this time. .

. Our next question comes from Mark DeVries with Barclays.

David, Annaly's been on quite the journey over the years, building out its businesses, creating the most diversified mortgage REIT platform and then kind of under your leadership, narrowing that focus back to residential mortgage. So can you just talk more about kind of the strategic benefits you expect to realize from this more narrow focus?

You bet. So look, I've always, I've known Annaly really since the beginning well before I came to work here, and Annaly has always been residential housing finance and has always been a market leader in it.that I've known. And that's my background. And as I laid out 2 years ago in terms of the strategic direction, that we are going, it is refocusing on the roots of the company, but being broader within housing finance and creating a platform whereby we don't just invest in securities. We invest across the loan, whether it's the rate and convexity component of the loan in agency MBS, the credit component in residential credit or the IO in MSR, we want to look at the loan and allocate capital across the cheapest component of the loan. And there's considerable synergies across these 3 functions as we've talked about in the past, whether it's MSR hedging, agency or residential credit having less correlated returns with both MSR and agency. And we think it leads to the best risk-adjusted returns for this company. Now the question is, is those are the ingredients but making sure you get the measurements appropriate so that you're liquid and that you're generating the best risk-adjusted return. And so longer term, agency is always going to be the anchor of the company and the mother ship, but increasing these other 2 ingredients we think will create a better balance in the overall portfolio, better risk-adjusted returns, lower leverage and actually more liquidity because of these lower levered sectors, and we think that's the optimal direction for the company. Is that okay?

Yes, that's helpful. And then with agencies kind of near their wides, what's the greatest risk that's keeping you from levering up more? Is it just concern that the Fed may need to tighten conditions even more than currently expected and become a seller as opposed to just letting the portfolio run off? And do you see kind of risk of that at least as great as tightening here?

Yes. We don't see that risk in 2022. And I think, look, the Fed has talked about the possibility of selling mortgages, although they recently said QT is well underway. They don't want to sell mortgages. They've never sold mortgages in the past other than test trades, and it's not an optimal approach. They would love to just let the portfolio run off naturally. But nonetheless, it could be an eventuality out the horizon. We just don't think it's in 2022. The other risk in the market, and Ilker can expand on this is that there is still volatility in the rates markets, and that gives us a little bit of hesitation. We got pretty meaningful risks in the system, whether it's geopolitical or economic uncertainty. And so we're waiting for a little bit more calmness to prevail. But the other point to note is that with agency spreads where they're at, you don't need to add a lot of leverage to really get ample returns, and we will certainly benefit from spread tightening. But between the volatility in the market and the supply picture, we're comfortable.

At this time, there are no further questioners in the queue. And this concludes our question-and-answer session. I would now like to turn the conference back over to David Finkelstein, President and Chief Executive Officer, for any closing remarks.

Well, thank you, everybody, and we will talk to you in the summer.

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