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NLY > SEC Filings for NLY > Form 10-Q on 6-Nov-2012All Recent SEC Filings

Show all filings for ANNALY CAPITAL MANAGEMENT INC

Form 10-Q for ANNALY CAPITAL MANAGEMENT INC


6-Nov-2012

Quarterly Report


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 the Securities and Exchange Commission (the SEC or the Commission"), in our press releases or in our other public or shareholder communications may not be based on historical facts and are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements, which are based on various assumptions, (some of which are beyond our control) 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, 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 financings, changes in the market value of our assets, changes in business conditions and the general economy, our ability to consummate any contemplated investment opportunities, changes in governmental regulations affecting our business, our ability to maintain our classification as a REIT for federal income tax purposes, our ability to maintain our exemption from registration under the Investment Company Act of 1940, and risks associated with the business of our subsidiaries, including the investment advisory businesses of our subsidiaries, including the removal by their clients of assets they manage, their regulatory requirements, and competition in the investment advisory business, and risks associated with the broker dealer business of our subsidiary. For a discussion of the risks and uncertainties which could cause actual results to differ from those contained in the forward-looking statements, see our most recent Annual Report on Form 10-K and any subsequent Quarterly Reports 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.


All references to "we," "us," or "our" mean Annaly Capital Management, Inc. and all entities owned by us, except where it is made clear that the term means only the parent company. The following defines certain of the commonly used terms in this quarterly report on Form 10-Q: Agency refers to a federally chartered corporation, such as Fannie Mae or Freddie Mac, or an agency of the U.S. Government, such as Ginnie Mae; Agency mortgage-backed securities refers to residential mortgage-backed securities that are issued or guaranteed by an Agency; Investment Securities refers to Agency mortgage-backed securities, Agency debentures and corporate debt securities; and Interest Earning Assets refers to Investment Securities, securities borrowed and U.S. Treasury Securities.

Overview

We own, manage, and finance a portfolio of real estate related investments, including mortgage pass-through certificates, collateralized mortgage obligations (or CMOs), Agency callable debentures, and other securities representing interests in or obligations backed by pools of mortgage loans. Our principal business objective is to generate net income for distribution to our stockholders from the spread between the interest income on our Interest-Earning Assets and the costs of borrowing to finance our acquisition of Interest-Earning Assets and from dividends we receive from our subsidiaries. Our wholly-owned subsidiaries offer diversified real estate, asset management and other financial services.

We are a Maryland corporation that commenced operations on February 18, 1997. We are self-advised and self-managed. We acquired Fixed Income Discount Advisory Company (or FIDAC) on June 4, 2004 and Merganser Capital Management, Inc. (or Merganser) on October 31, 2008. FIDAC and Merganser manage a number of investment vehicles and separate accounts for which they earn fee income. Our subsidiary, RCap Securities, Inc. (or RCap), operates as a broker-dealer, and was granted membership in the Financial Industry Regulatory Authority (or FINRA) in January 2009. In 2010, we established Shannon Funding LLC (or Shannon), which provides warehouse financing to residential mortgage originators in the United States. In 2010, we also established Charlesfort Capital Management LLC (or Charlesfort), which engages in corporate middle market lending transactions. In 2011, FIDAC established FIDAC Europe Limited (or FIDAC Europe), which provides advice on commercial real estate transactions, including sale-leaseback and single tenant net leased properties across Europe. In 2011, we established FIDAC FSI LLC (or FIDAC FSI), which invested in trading securities. FIDAC FSI was liquidated in August 2012.
We also own an additional subsidiary which owns trading securities.

We have elected and believe that we are organized and have operated in a manner that qualifies us to be taxed as a real estate investment trust (or REIT) under the Internal Revenue Code of 1986, as amended (or the Code). If we qualify for taxation as a REIT, we generally will not be subject to federal income tax on our taxable income that is distributed to our stockholders. Therefore, substantially all of our assets, other than FIDAC, Merganser and RCap, which are our taxable REIT subsidiaries, consist of qualified REIT real estate assets (of the type described in Section 856(c)(5)(B) of the Code). We have financed our purchases of Agency mortgage-backed securities and Agency debentures with the net proceeds of equity offerings, convertible notes offerings and borrowings under repurchase agreements whose interest rates adjust based on changes in short-term market interest rates.

Capital Investment Policy

Under our capital investment policy, at least 75% of our total assets must be comprised of high-quality mortgage-backed securities and short-term investments. High quality securities means securities that (1) are rated within one of the two highest rating categories by at least one of the nationally recognized rating agencies, (2) are unrated but are guaranteed by the United States government or an agency of the United States government, or (3) are unrated but we determine them to be of comparable quality to high-quality rated mortgage-backed securities.

The remainder of our assets, comprising not more than 25% of our total assets, may consist of other qualified REIT real estate assets which are unrated or rated less than high quality, but which are at least "investment grade" (rated "BBB" or better by Standard & Poor's Corporation (or S&P) or the equivalent by another nationally recognized rating agency) or, if not rated, we determine them to be of comparable credit quality to an investment which is rated "BBB" or better. In addition, we may directly or indirectly invest part of this remaining 25% of our assets in other types of securities, including without limitation, unrated debt, equity or derivative securities, to the extent consistent with our REIT qualification requirements. The derivative securities in which we invest may include securities representing the right to receive interest only or a disproportionately large amount of interest, as well as inverse floaters, which may have imbedded leverage as part of their structural characteristics.


We may acquire Agency mortgage-backed securities backed by single-family residential mortgage loans as well as securities backed by loans on multi-family, commercial or other real estate related properties. To date, substantially all of the Agency mortgage-backed securities that we have acquired have been backed by single-family residential mortgage loans.

The results of our operations are affected by various factors, many of which are beyond our control. Our results of operations primarily depend on, among other things, our net interest income, the market value of our assets and the supply of and demand for such assets. Our net interest income, which reflects the amortization of purchase premiums and accretion of discounts, varies primarily as a result of changes in interest rates, borrowing costs and prepayment speeds, the behavior of which involves various risks and uncertainties. Prepayment speeds, as reflected by the Constant Prepayment Rate, or 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 on our Agency mortgage-backed securities portfolio increase, related purchase premium amortization increases, thereby reducing the net yield on such assets. The CPR on our Agency mortgage-backed securities portfolio averaged 20% and 22% for the quarters ended September 30, 2012 and December 31, 2011, respectively. Since changes in interest rates may significantly affect our activities, our operating results depend, in large part, upon our ability to effectively manage interest rate risks and prepayment risks while maintaining our status as a REIT. We continue to explore alternative business strategies, alternative investments and other strategic initiatives to complement our core business strategy of investing, on a leveraged basis, in high quality Investment Securities. No assurance, however, can be provided that any such strategic initiative will or will not be implemented in the future.

The table below provides quarterly and annual information regarding our average interest-earning assets, interest income, yield on average interest-earning assets, average interest-bearing liabilities, economic interest expense, average cost of interest-bearing liabilities, economic net interest income, and net interest rate spreads for the periods presented.

                                                            Yield on                                             Average
                            Average                          Average          Average                            Cost of         Economic          Net
                           Interest-          Total         Interest-        Interest-         Economic         Interest-           Net          Interest
                            Earning         Interest         Earning          Bearing          Interest          Bearing         Interest          Rate
                           Assets(1)         Income          Assets         Liabilities      Expense (2)       Liabilities       Income(3)        Spread
                                                       (ratios for the quarters have been annualized, dollars in thousands)
Quarter Ended
September 30, 2012       $ 119,880,120     $   761,265            2.54 %   $ 106,973,056     $    406,165              1.52 %   $   355,100           1.02 %
Quarter Ended June 30,
2012                     $ 116,458,864     $   886,324            3.04 %   $ 103,668,465     $    388,445              1.50 %   $   497,879           1.54 %
Quarter Ended March
31, 2012                 $ 105,706,554     $   854,895            3.23 %   $  92,552,175     $    352,685              1.52 %   $   502,210           1.71 %
Year Ended December
31, 2011                 $  96,675,016     $ 3,579,618            3.70 %   $  84,595,933     $  1,362,721              1.61 %   $ 2,216,897           2.09 %
Quarter Ended December
31, 2011                 $ 102,339,797     $   847,700            3.31 %   $  89,488,111     $    357,771              1.60 %   $   489,929           1.71 %
Quarter Ended
September 30, 2011       $ 100,473,505     $   930,802            3.71 %   $  86,671,908     $    353,266              1.63 %   $   577,536           2.08 %
Quarter Ended June 30,
2011                     $  94,696,473     $   957,068            4.04 %   $  83,042,390     $    330,080              1.59 %   $   626,988           2.45 %
Quarter Ended March
31, 2011                 $  89,190,290     $   844,048            3.79 %   $  79,235,324     $    321,604              1.62 %   $   522,444           2.17 %

(1) Does not reflect unrealized gains (losses) or premium (discount).

(2) Economic interest expense includes interest expense on interest rate swaps.

(3) Economic net interest income includes interest expense on interest rate swaps.

Our net interest rate spread has declined since the quarter ended June 30, 2011. The declining net interest rate spread is primarily attributable to the continuing low interest rate environment and marginally higher CPR which, as discussed above, reduces the net yield on our Agency mortgage-backed securities portfolio.


The following table presents the CPR experienced on our Agency mortgage-backed securities portfolio, on an annualized basis, for the quarterly periods presented.

Quarter Ended        CPR
September 30, 2012     20 %
June 30, 2012          19 %
March 31, 2012         19 %
December 31, 2011      22 %
September 30, 2011     18 %

For the purpose of calculating average interest-earning assets and interest-bearing liabilities, daily balances are used. For the purposes of computing ratios relating to equity measures throughout this report, equity includes Series B preferred stock, which has been treated under GAAP as temporary equity. For the purpose of computing net interest income and ratios relating to cost of funds measures throughout this report, interest expense includes interest expense on interest rate swaps, which is classified in the Consolidated Statements of Comprehensive Income as Realized gains (losses) on interest rate swaps. Interest rate swaps are used to hedge the increase in interest expense on repurchase agreements in a rising rate environment. Presenting the contractual interest payments on interest rate swaps with the interest expense on interest-bearing liabilities reflects total contractual interest payments. This presentation depicts the economic value of our investment strategy. Interest expense, including interest expense on interest rate swaps, is referred to as economic interest expense. Net interest income, including interest expense on interest rate swaps, is referred to as economic net interest income.

The following table compares the GAAP and non-GAAP measurements reflected in the Management's Discussion and Analysis of Financial Condition and Results of Operations. Non-GAAP measurements include non-GAAP total stockholders' equity, economic interest expense and economic net interest income.

                                                    Non-GAAP
                               GAAP Total             Total             GAAP         Economic        GAAP Net          Economic
                             Stockholders'        Stockholders'       Interest       Interest        Interest        Net interest
                                 Equity              Equity           Expense         Expense         Income            Income
                                                                    (dollars in thousands)
For the Quarter Ended
September 30, 2012          $     17,090,663     $    17,090,663     $  188,893     $   406,165     $   579,372     $      355,100
For the Quarter Ended
June 30, 2012               $     16,284,586     $    16,284,586     $  166,443     $   388,445     $   719,881     $      497,879
For the Quarter Ended
March 31, 2012              $     15,940,605     $    15,940,605     $  133,345     $   352,685     $   721,550     $      502,210
For the Year Ended
December 31, 2011           $     15,760,642     $    15,792,914     $  480,326     $ 1,362,721     $ 3,099,292     $    2,216,897
For the Quarter
Ended December 31, 2011     $     15,760,642     $    15,792,914     $  130,133     $   357,771     $   717,567     $      489,929
For the Quarter Ended
September 30, 2011          $     15,910,022     $    15,943,686     $  121,417     $   353,266     $   809,385     $      577,536
For the Quarter Ended
June 30, 2011               $     13,929,362     $    13,969,321     $  113,320     $   330,080     $   843,748     $      626,988
For the Quarter Ended
March 31, 2011              $     12,853,017     $    12,893,000     $  115,456     $   321,604     $   728,592     $      522,444

We believe that the non-GAAP total stockholders' equity, economic interest expense and economic net interest income provides meaningful information to consider, in addition to the respective amounts prepared in accordance with GAAP. The non-GAAP measures help us to evaluate our financial position and performance without the effects of certain transactions and GAAP adjustments that are not necessarily indicative of our current investment portfolio, operations, capitalization, or stockholders' equity.

Exposure to European Financial Counterparties

A significant portion of our Agency mortgage-backed securities are financed with repurchase agreements. We secure our borrowings under these agreements by pledging our Agency mortgage-backed securities as collateral to the lender. The collateral we pledge exceeds the amount of the borrowings under each agreement, typically with the extent of over-collateralization being at least 3% of the amount borrowed. If the counterparty to the repurchase agreement defaults on its obligations and we are not able to recover our pledged assets, we are at risk of losing the over-collateralized amount. 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 to manage our interest rate risks. Under these swap agreements, we pledge Agency mortgage-backed securities as collateral as part of a margin arrangement for interest rate swaps that are in an unrealized loss position. If a counterparty were to default on its obligation, we would be exposed to a loss to a swap counterparty to the extent that the amount of our Agency mortgage-backed securities pledged exceeded the unrealized loss on the associated swaps and we were not able to recover the excess collateral.


Over the past several years, several large European financial institutions have experienced financial difficulty and have been either rescued by government assistance or by other large European banks or institutions. Some of these financial institutions or their U.S. subsidiaries have provided us financing under repurchase agreements or we have entered into interest rate swaps with such institutions. We have entered into repurchase agreements and/or interest rate swaps with 12 financial institution counterparties that are either domiciled in Europe or a U.S. based subsidiary of a European domiciled financial institution. The following table summarizes our exposure to such counterparties at September 30, 2012:

                                              Repurchase       Interest Rate                             Exposure as a
                                               Agreement           Swaps                              Percentage of Total
  Country      Number of Counterparties        Financing       at Fair Value       Exposure(1)              Assets
                                                  (dollars in thousands)

France                                 4     $   4,192,183     $     (208,648 )   $      234,696                      0.17 %
Germany                                1         3,134,682           (428,785 )          221,602                      0.16 %
Netherlands                            2         4,726,558            (43,567 )          291,556                      0.21 %
Scotland                               1           771,970                  -             44,583                      0.03 %
Switzerland                            2         6,399,330           (456,502 )          424,191                      0.30 %
England                                2        10,827,589           (144,133 )          545,946                      0.39 %
Total                                 12     $  30,052,312     $   (1,281,635 )   $    1,762,574                      1.24 %

(1) Represents the amount of cash and/or securities pledged as collateral to each counterparty less the aggregate of repurchase agreement financing and unrelated loss on swaps for each counterparty..

At September 30, 2012, we did not use credit default swaps or other forms of credit protection to hedge the exposures summarized in the table above.

If the European credit crisis continues to impact these major European financial institutions, it is possible that it will also impact the operations of their U.S. subsidiaries. Our financings and operations could be adversely affected by such events. We monitor our exposure to our repurchase agreement and swap counterparties on a regular basis, using various methods, including review of recent rating agency actions, financial relief plans, credit spreads or other developments and by monitoring the amount of cash and securities collateral pledged and the associated loan amount under repurchase agreements and/or the fair value of swaps with our counterparties. We make reverse margin calls on our counterparties to recover excess collateral as permitted by the agreements governing our financing arrangements or interest rate swaps, or may try to take other actions to reduce the amount of our exposure to a counterparty when necessary.

Results of Operations:

Net Income Summary

For the quarter ended September 30, 2012, our net income was $224.8 million or $0.22 per average share, as compared to our net loss of $921.8 million or $0.98 per average share for the quarter ended September 30, 2011. Net income increased $1.1 billion for the quarter ended September 30, 2012, when compared to the quarter ended September 30, 2011. We attribute the increase in net income for the quarter ended September 30, 2012 from the quarter ended September 30, 2011 to the decline in unrealized losses on interest rate swaps of $1.4 billion. The decline in unrealized losses on interest rate swaps was partially offset by the decline in economic net interest income of $222.4 million for the quarter ended September 30, 2012, when compared to the quarter ended September 30, 2011.

For the nine months ended September 30, 2012, our net income was $1.0 billion, or $1.04 per average share, as compared to our net loss of $101.1 million, or $0.14 per average share for the nine months ended September 30, 2011. Net income increased $1.1 billion for the nine months ended September 30, 2012, when compared to the nine months ended September 30, 2011. We attribute the increase in net income for the nine months ended September 30, 2012 from the nine months ended September 30, 2011 to the decline in unrealized losses on interest rate swaps of $1.4 billion. The decline in unrealized losses on interest rate swaps was partially offset for the nine months ended September 30, 2012 from the nine months ended September 30, 2011 by the decline in economic net interest income of $371.8 million and the increase in total expenses of $21.2 million.


The table below presents the net income summary for the quarters and nine months ended September 30, 2012 and 2011.

                               Net Income Summary
               (dollars in thousands, except for per share data)

                                                For the Quarters Ended                For the Nine Months Ended
                                           September 30,      September 30,        September 30,      September 30,
                                                2012               2011                2012                2011
Interest income:
Investments                                $      754,096     $      926,558      $     2,481,284     $    2,713,141
U.S. Treasury Securities                            4,588              2,302               13,403             13,624
Securities loaned                                   2,581              1,942                7,797              5,153
Total interest income                             761,265            930,802            2,502,484          2,731,918

Interest expense:
Repurchase agreements                             158,150            109,014              411,643            311,780
Convertible Senior Notes                           18,026              8,798               51,718             22,465
U.S. Treasury Securities sold, not yet
purchased                                           3,739              2,109               12,184             11,867
Securities borrowed                                 1,978              1,496                6,136              4,081
Total interest expense                            181,893            121,417              481,681            350,193

Net interest income                               579,372            809,385            2,020,803          2,381,725

Other income (loss):
Investment advisory and other fee income           21,034             20,828               63,729             58,745
Net gains (losses) on disposal of
investments                                       142,172             91,668              317,308            126,189
Net loss on extinguishment of
Convertible Senior Notes                         (87, 328 )                -              (87,328 )                -
Dividend income from affiliates                     7,097              8,706               21,239             23,233
Net gains (losses) on trading assets                1,368              1,942                7,729             15,042
Net unrealized gains (losses) on
interest-only Agency mortgage-backed
securities                                        (33,563 )          (39,321 )            (28,789 )          (39,045 )
Income from underwriting                                -              2,772                    -              5,599
Subtotal                                           50,780             86,595              293,888            189,763
Realized gains (losses) on interest rate
swaps(1)                                         (224,272 )         (231,849 )           (665,614 )         (654,757 )
Realized gains (losses) on termination
of interest rate swaps                                  -                  -               (2,385 )                -
Unrealized gains (losses) on interest
rate swaps                                       (104,197 )       (1,505,333 )           (373,773 )       (1,802,968 )
Subtotal                                         (328,469 )       (1,737,182 )         (1,041,772 )       (2,457,725 )
Total other income (loss)                        (277,689 )       (1,650,587 )           (747,884 )       (2,267,962 )

Expenses:
Compensation expense                               52,310             57,629              164,860            151,911
Other general and administrative
expenses                                           10,694              7,565               30,615             22,339
Total expenses                                     63,004             65,194              195,475            174,250
Income (loss) before income taxes and
income from equity method investment in
affiliate                                         238,679           (906,396 )          1,077,444            (60,487 )
. . .
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