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NLY > SEC Filings for NLY > Form 10-Q on 7-Nov-2013All Recent SEC Filings

Show all filings for ANNALY CAPITAL MANAGEMENT INC

Form 10-Q for ANNALY CAPITAL MANAGEMENT INC


7-Nov-2013

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 financing, changes in the market value of our assets, changes in business conditions and the general economy, our ability to integrate and grow the commercial mortgage business, our ability to consummate any contemplated investment opportunities and other corporate transactions, changes in governmental regulations affecting our business, our ability to maintain our classification as a real estate investment trust (or 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 subsidiary, including the removal by its clients of assets it manages, its 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 the Federal National Mortgage Association (or Fannie Mae) or the Federal Home Loan Mortgage Corporation (or Freddie Mac), or an agency of the U.S. Government, such as the Government National Mortgage Association (or 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; Interest Earning Assets refers to Investment Securities, securities borrowed, U.S. Treasury securities, reverse repurchase agreements, cash and cash equivalents and commercial real estate loans and preferred equity interests; and Interest Bearing Liabilities refers to repurchase agreements, participation sold, convertible senior notes, securities loaned and U.S. Treasury securities sold, not yet purchased.

Overview

We are a Maryland corporation that commenced operations on February 18, 1997. We are a leading mortgage REIT externally managed by Annaly Management Company LLC.

We own a portfolio of real estate related investments, including mortgage pass-through certificates, collateralized mortgage obligations (or CMOs), Agency callable debentures, other securities representing interests in or obligations backed by pools of mortgage loans and commercial real estate assets. Our principal business objective is to generate net income for distribution to our stockholders from our investments. 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 by 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 generally consist of other qualified REIT real estate assets. 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. While we remain committed to the Agency market, given the current environment, we believe it is prudent to diversify a portion of our investment portfolio. Therefore, we may allocate up to 25% of our stockholders' equity to real estate assets other than Agency mortgage-backed securities.

Our business operations are primarily comprised of the following:

- Annaly Capital Management, Inc., the parent company, which invests primarily in various types of Agency mortgage-backed securities and related derivatives to hedge these investments.

- Fixed Income Discount Advisory Company (or FIDAC), a subsidiary which manages an investment vehicle for which it earns fee income.

- RCap Securities, Inc. (or RCap), a subsidiary which operates as a broker-dealer, and is a member in the Financial Industry Regulatory Authority.

- Shannon Funding LLC, a subsidiary which provides warehouse financing to residential mortgage originators in the United States.

- Annaly Middle Market Lending LLC (formerly known as Charlesfort Capital Management LLC), a subsidiary which engages in corporate middle market lending transactions.

- Annaly Commercial Real Estate Group, Inc. (formerly known as CreXus Investment Corp. (or CreXus)), a subsidiary that is a recently acquired business which specializes in acquiring, financing and managing commercial mortgage loans and other commercial real estate debt, commercial mortgage-backed securities and other commercial real estate-related assets.

We have elected and believe that we are organized and have operated in a manner that qualifies us to be taxed as a REIT under the Internal Revenue Code of 1986, as amended, and regulations promulgated thereunder (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. Furthermore, substantially all of our assets, other than our taxable REIT subsidiaries, consist of qualified REIT real estate assets (of the type described in Section 856(c)(5) of the Code).

We calculate that at least 75% of our assets were qualified REIT assets, as defined in the Code for the quarter ended September 30, 2013 and for the year ended December 31, 2012. We also calculate that our revenues qualified for the 75% REIT income test and for the 95% REIT income test for the quarter ended September 30, 2013 and the year ended December 31, 2012 and for each quarter therein. We also met all REIT requirements regarding the ownership of our common stock and the distribution of our REIT taxable income. Therefore, for the quarter ended September 30, 2013 and the year ended December 31, 2012, we believe that we qualified as a REIT under the Code.

Business Environment

We have been decreasing leverage quarter-over-quarter amid sustained government intervention in the Agency mortgage-backed securities market and in the interest rate markets. We have also been cautious because we believe increased financial regulatory reform is possible, but it is unclear how such reform may affect us.

Monetary Policy

On September 13, 2012, the Federal Open Market Committee (FOMC or the Committee) announced an increase in its quantitative easing program of large scale asset purchases, commonly known as QE3. QE3 entails monthly purchases of U.S. Treasury securities and Agency mortgage-backed securities at the pace of $45 billion and $40 billion, respectively. In addition, the FOMC announced that it would maintain its existing accommodative policy of reinvesting principal payments from its holdings of Agency mortgage-backed securities into new Agency mortgage-backed securities purchases in order to reduce long-term interest rates and support mortgage markets. The program is open-ended in nature, and the FOMC noted that it would continue or expand the program as necessary until the outlook for the labor market improved substantially.


To further enhance their accommodative policy, in December 2012, the FOMC began implementation of "forward guidance" regarding the future path of short-term rates. In this guidance, the FOMC announced it anticipates its current target for the federal funds rate, at 0-1/4%, would be appropriate until the unemployment rate remained about 6-1/2%, inflation is projected to be no more than a half percentage point above the Committee's 2% longer-run goal, and longer-term inflation expectations continue to be stabilized.

In May 2013, after a string of moderately stronger employment reports, the FOMC announced that it was prepared to increase or reduce its purchases under QE3. In addition, in June 2013 Chairman Bernanke noted that if upcoming economic data are consistent with the FOMC's forecast, the FOMC believed it may moderate the pace of purchases. The possibility for a change in the execution of QE3 this year coincided with the beginning of a sharp rise in interest rates. The 10-year Treasury, which closed at a price to yield 1.63% on May 2, 2013, had fallen in price to yield 2.49% on September 30, 2013.

Despite many investors anticipating the FOMC to follow through on the "tapering" of QE3 purchases, during the meeting concluded September 18, 2013 the Committee decided to keep the program in place at its current size. The Committee noted tightening financial conditions which could slow the pace of economic improvement. The Committee also noted that federal fiscal policy remained an important restraint on economic growth. The meeting also showed a strengthened commitment to lower short-term rates, with the majority not expecting a hike in the Fed Funds target rate until 2015.

Interest Rate Environment

Volatility, as measured by the Merrill Lynch MOVE index, remained elevated throughout the third quarter in anticipation of the September 18, 2013 Federal Reserve meeting. Despite a strong market perception that the FOMC would initiate a "taper" of purchases at their September meeting, as noted above, the FOMC continued its accommodative policies.

Amid the increased volatility, long term rates, as measured by the 10-year US Treasury, increased dramatically throughout the quarter resulting in lower mortgage originations, a higher percentage share of Federal Reserve mortgage-backed securities purchases relative to origination, decreased prepayment speeds and ultimately a lengthening of the duration of the overall Agency mortgage-backed securities universe.

Financial Regulatory Reform

Uncertainty remains surrounding financial regulatory reform and its impact on the markets and the broader economy. In particular, the government is attempting to change its involvement through the Agencies in the mortgage market. There have been conflicting legislative initiatives regarding the Agencies, and it is unclear which approach, if any, may become law. In addition, regulators remain focused on the wholesale funding markets, bank capital levels and shadow banking. It is difficult to predict the ultimate legislative and other regulatory outcomes of these efforts. We continue to monitor these legislative and regulatory developments and evaluate their potential impact on our business.

Critical Accounting Policies

Our critical accounting policies are as follows:

Valuation of Financial Instruments

Agency mortgage-backed securities and debentures

There is an active market for Agency mortgage-backed securities and debentures. Since we primarily invest in securities that can be measured from actively quoted prices, there is a high degree of observable inputs and less subjectivity in measuring fair value. Internal market values are determined using quoted prices from the To-Be-Announced (or TBA) security market, the Treasury curve and the underlying characteristics of the individual securities, which may include coupon, periodic and life caps, reset dates and the expected life of the security. All internal market values are compared to external sources or dealer quotes to determine reasonableness. Additionally, securities used as collateral for repurchase agreements are priced daily by counterparties to ensure sufficient collateralization, providing additional verification of our internal pricing.


Interest rate swaps

We use the overnight indexed swap (or OIS) curve as an input to value substantially all of our interest rate swaps. We believe using the OIS curve, which reflects the interest rate typically paid on cash collateral, enables us to most accurately determine the fair value of interest rate swaps. Consistent with market practice, we have negotiated agreements with certain counterparties to exchange collateral (or margining) based on the level of fair values of the interest rate swaps. Through this margining process, one party or each party to a derivative contract provides the other party with information about the fair value of the derivative contract to calculate the amount of collateral required, providing additional verification of our recorded fair value of the interest rate swaps.

Revenue Recognition

Interest income on Agency mortgage-backed securities and debentures is recognized over the projected life of the securities using the interest method. The projected life of the securities is determined based on expected prepayment speeds, past prepayment history of the security, government initiatives that would affect the Agency mortgage-backed securities market and market consensus. Adjustments are made for actual prepayment activity as it relates to calculating the effective yield. Gains or losses on investment securities are recorded on trade date based on the average cost of the security.

Results of Operations

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 from our Agency mortgage-backed securities portfolio, 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 yield on such assets. The CPR on our Agency mortgage-backed securities portfolio averaged 13% and 20% for the quarters ended September 30, 2013 and September 30, 2012, 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. Additionally, our returns on our commercial real estate assets are affected by the extent and impact of any credit deterioration associated with the underlying property as well as the financial condition of the borrower/sponsor of the loan. 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 and in commercial real estate assets. No assurance, however, can be provided that any such strategic initiative will or will not be implemented in the future.

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, 2013 13%
June 30, 2013      16%
March 31, 2013     18%
December 31, 2012  19%

September 30, 2012 20%


Net Income Summary

For the quarter ended September 30, 2013, our net income was $192.5 million, or $0.18 per average basic common share, as compared to a $224.8 million, or $0.22 per average basic common share, for the quarter ended September 30, 2012. We attribute the majority of the decrease in net income (loss) for the quarter ended September 30, 2013 from the quarter ended September 30, 2012 to the decline in net interest income of $27.7 million for the quarter ended September 30, 2013 compared to the same period in 2012. The decline in net interest income was primarily attributable to a decline in average Interest Earning Assets.

For the nine months ended September 30, 2013, our net income was $2.7 billion, or $2.79 per average basic common share, as compared to $1.0 billion, or $1.04 per average basic common share, for the nine months ended September 30, 2012. Net income per average basic common share increased by $1.75 and total net income increased by $1.7 billion for the nine months ended September 30, 2013, when compared to the nine months ended September 30, 2012. We attribute the majority of the increase in net income for the nine months ended September 30, 2013 from the nine months ended September 30, 2012 to the change in unrealized gains (losses) on interest rate swaps, which resulted in a gain of $1.4 billion for the nine months ended September 30, 2013 compared to a loss of $373.8 million for the same period in 2012. The change in the fair value of interest rate swaps was primarily attributable to the rise in interest rates experienced during the nine months ended September 30, 2013.

The table below presents the net income summary for the quarters and nine months ended September 30, 2013 and 2012.

                               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,
                                                2013               2012               2013               2012

   Total interest income                          697,160            761,265          2,147,313           2,502,484

   Total interest expense                         145,476            181,893            487,321             481,681

Net interest income                               551,684            579,372          1,659,992           2,020,803

   Other income (loss)                           (299,925 )         (277,689 )        1,223,200            (747,884 )

   General and administrative expenses             58,744             63,004            175,787             195,475

Income (loss) before income taxes                 193,015            238,679          2,707,405           1,077,444

Income taxes                                          557             13,921              6,456              42,039

Net income (loss)                                 192,458            224,758          2,700,949           1,035,405

Dividends on preferred stock                       17,992              9,367             53,976              19,813

Net income (loss) available (related) to
common shareholders                        $      174,466     $      215,391     $    2,646,973     $     1,015,592

Net income (loss) per share available
(related) to common shareholders:
 Basic                                     $         0.18     $         0.22     $         2.79     $          1.04
 Diluted                                   $         0.18     $         0.22     $         2.69     $          1.00

Weighted average number of common shares
outstanding:
 Basic                                        947,303,205        974,729,078        947,321,691         973,674,586
 Diluted                                      955,690,471        997,007,829        995,319,670       1,035,365,251

Average total assets                       $   97,950,871     $  134,940,586     $  113,713,973     $   124,948,178
Average equity                             $   13,104,514     $   16,687,625     $   14,359,960     $    16,277,192

Return on average total assets                       0.79 %             0.67 %             3.17 %              1.10 %
Return on average equity                             5.87 %             5.39 %            25.08 %              8.48 %

We use daily balances to calculate average Interest Earning Assets and Interest Bearing Liabilities. 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 recorded in the Consolidated Statements of Operations and Comprehensive Income (Loss) as Realized gains (losses) on interest rate swaps.


Non-GAAP Financial Measures

This Management Discussion and Analysis section contains analysis and discussion of non-GAAP measurements. The non-GAAP measurements are core earnings, core earnings per average basic common share, economic interest expense and economic net interest income. Core earnings is defined as net income (loss) excluding gains or losses on disposals of investments and termination of interest rate swaps, unrealized gains or losses on interest rate swaps and Agency interest-only mortgage-backed securities, net loss on extinguishment of the 4% Convertible Senior Notes due 2015, net gains and losses on trading assets, impairment losses and loss on previously held equity interest in CreXus.

We believe that core earnings, core earnings per average basic common share, economic interest expense and economic net interest income provide 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 and operations.

Our presentation of the economic value of our investment strategy has important limitations. Other market participants may calculate core earnings, core earnings per average basic common share, economic interest expense and economic net interest income differently than we calculate them.

Although we believe that the calculation of the economic value of our investment strategy described above helps measure our financial position and performance without the effects of certain transactions, it is of limited usefulness as an analytical tool. Therefore, the economic value of our investment strategy should not be viewed in isolation and is not a substitute for net income (loss), net income (loss) per basic share available to common shareholders, interest expense and net interest income computed in accordance with GAAP.

The following table provides GAAP measures of net income (loss) and net income
(loss) per basic share available to common shareholders for the quarters and nine months ended September 30, 2013 and September 30, 2012 and details with respect to reconciling the aforementioned line items on a non-GAAP basis:

                                                 For the Quarters Ended                For the Nine Months Ended
                                            September 30,       September 30,      September 30,       September 30,
                                                2013                2012                2013               2012
                                                       (dollars in thousands, except for per share data)

GAAP net income (loss)                     $       192,458     $       224,758     $    2,700,949     $     1,035,405
Adjustments:
  Net (gains) losses on disposal of
investments                                        (43,602 )          (142,172 )         (374,443 )          (317,308 )
  Net loss on extinguishment of 4%
Convertible Senior Notes                                 -              87,328                  -              87,328
  Net (gains) losses on trading assets              96,022              (1,368 )           40,427              (7,729 )
  Net unrealized (gains) losses on
interest-only Agency mortgage-backed
securities                                           7,099              33,563           (184,549 )            28,789
  Impairment of goodwill                                 -                   -             23,987                   -
  Loss on previously held equity
interest in CreXus                                       -                   -             18,896                   -
  Realized (gains) losses on termination
of interest rate swaps                              36,658                   -             88,685               2,385
  Unrealized (gains) losses on interest
rate swaps                                          (6,343 )           104,197         (1,441,099 )           373,773
Core earnings                              $       282,292     $       306,306     $      872,853     $     1,202,643

GAAP net income (loss) available
(related) to average basic common
shareholders                               $          0.18     $          0.22     $         2.79     $          1.04
Adjustment to exclude certain items        $          0.10     $          0.08     $        (1.93 )   $          0.17
Core earnings per average basic common
share                                      $          0.28     $          0.30     $         0.86     $          1.21


Core Earnings Summary

Our core earnings were $282.3 million, or $0.28 per average basic common share, . . .

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