A Primer on Leverage

Summary:

• Investment objective
• To generate high current income consistent with a relatively stable net asset value
• Objective achieved through the use of leverage to enhance returns
• Leverage in context
• Leverage strategies are commonplace-financial institutions, insurance companies, investment funds and individuals are leveraged
• Our strategy does not take the same risks as other leveraged strategies-no credit risk, debt fully secured by high quality assets
• Prudent leverage level (8-12:1) lower than most financial institutions
• We are a "Thrift without walls"
• Managing cash flows on assets and liabilities
• Always maintain positive spread-majority of portfolio floating- or adjustable-rate coupons
• Leveraging the right assets
• Short duration assets (typically less than 1 year)-has less price volatility
• "Leveraged" duration -less than typical unleveraged fixed income products
• Highly liquid, guaranteed by Fannie Mae, Freddie Mac, Ginnie Mae
• Triple-A rated
• Easily priced therefore easily financed by multiple sources
• Using the right liability structure
• Match reset on assets to reset on liabilities to maintain positive spread
• Over 25 different lenders
• Experienced management has excellent track record of executing strategy through wide range of interest rate environments
• No performance fees to encourage bad decisions by management

Background:

The investment objective of FIDAC and Annaly Capital Management is to generate high current income consistent with a relatively stable net asset value. The strategy we use to achieve that objective is to invest in a portfolio of highly liquid, highly rated securities using equity capital that we receive from investors and debt capital borrowed in the repurchase markets. This borrowing, called leverage, amplifies the return on investors' capital. The average leverage ratio in our strategy is typically 8 to 9 dollars from the repurchase markets for every one dollar from investors. The return we pay out to investors is derived from the spread between what we earn on our assets and what we pay on our borrowings.

The purpose of this paper is to review our use of leverage-to explain how it works and to address how we manage it. But to understand how we manage leverage, an investor must understand it the way we do: we don't see ourselves as managing debt per se; rather, we see ourselves as managing cash flows-the cash flows we receive from our assets and the cash flows we pay to our lenders. Hopefully by the end of this primer the simplicity of our strategy will make that clear. We also want to explode a myth about leverage, the myth that our strategy of using borrowed funds to enhance returns is unusual or loaded with exceptional risks. It is neither. The use of leverage is a critical part of the business models of virtually every financial institution in the world. Just to give a few examples of the scale of leverage being employed around us, consider that at the latest reporting dates for each firm, the on-balance-sheet debt to equity ratios of Citigroup, JP Morgan Chase and Washington Mutual were 11.9:1, 15.7:1, and 12.9:1 respectively. The debt to equity ratios of AIG and Prudential were 8.5:1 and 14.6:1, with 18.3:1 for Goldman Sachs and 23.9:1 for Morgan Stanley. General Electric, one of the few remaining natural triple-A rated corporate credits, had an on-balance sheet debt-equity ratio of 7.65:1 at September 30, 2003.

We deliberately compare our strategy to financial institutions, because our business models have basic similarities. Like a savings and loan, for example, our strategy has a balance sheet with assets, liabilities and equity capital, and the source of our earnings is net interest income. To go one step further in this analogy, the assets and liabilities of an S&L and our investment funds are essentially the same. Like an S&L, our assets are mortgages-albeit in MBS form and purchased in the secondary market-and our liabilities are deposits-generally derived from cash invested in money market funds. The similarities with financial institutions have prompted investors to call us a "thrift without walls". Our ability to structure ourselves in this way is a reflection of the disintermediation of the banking system that has taken place in the US by the creation of a secondary market for securitized mortgages and the replacement of the bank deposit by money markets.

While there are similarities between our model and financial institutions, there are also some significant differences worth noting. First, the balance sheets of other financial institutions (which by and large have higher leverage ratios) contain many embedded risks that we do not incur, primarily credit risk. We avoid credit risk by buying only the highest rated MBS, generally issued and guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. Second, financial institutions have off-balance sheet leverage which is not captured in a debt-to-equity ratio (typically derivatives exposure, contingent claims, etc.). One could argue that if one were to capture the off-balance sheet leverage of a modern financial institution, its debt-to-equity ratio would be higher. We, on the other hand, have not engaged in off-balance sheet financing or hedging activities. Third, we are operationally different: we don't take directional "bets" in our portfolio management, we don't take performance bonuses in any of our investment funds, and we maintain a low cost structure.

Before we dive into the details of our assets and liabilities, let's review the basics of how leverage works in our business model. Let's say we raise $1 million from investors. We would then borrow $10 million so that we could buy $11 million of securities (for a debt:equity ratio of 10:1). Let's further say that the securities we buy earn 6%, and the rate we pay on our borrowings is 5.25%. (The interest rates used in this example are for illustration purposes only. They are not indicative of rates currently available.)

In this example, by using funds from the repurchase market, the return on equity in our strategy increased from 6% to 13.50%. A financial institution uses the same basic model with the same basic return drivers-the yield that is earned on the assets, the rate that is paid on liabilities and the amount of leverage that is used. Again, the similarities end there. On the asset side, while financial institutions may invest in many different types of assets, we invest exclusively in high quality assets that have either an actual or implied AAA rating. We do not have to worry about our assets becoming impaired like a lender or an owner of equities, or corporate bonds. In our strategy, we invest primarily in Freddie Mac, Fannie Mae and Ginnie Mae mortgage-backed securities that not only carry the implied or actual guarantee of the US Government, but are also secured by a low loan-to-value mortgage on a residential home, the creditworthiness of the borrower, monthly principal amortization and property & casualty, mortgage or life insurance. The US mortgage-backed securities market is one of the largest and most liquid markets in the world. Therefore, our worry as investors isn't IF we will get our principal and interest payments, but WHEN we will get them.

Moreover, in our strategy we invest primarily in floating- and adjustable-rate mortgage-backed securities that are less susceptible to severe movements in market price due to their short durations. (Duration is a measure of a bond's price sensitivity to market interest rate movements. For a given movement in interest rates, a short duration bond's price will move less than that of a long duration bond.) This is important for two reasons. First, in a leveraged strategy where the collateral for the borrowings is securities, shorter duration means less volatility in price, and less volatility means more manageable margin calls. Second, our strategy of applying leverage to a portfolio of short duration assets-in which duration is multiplied by leverage-results in a portfolio that has a shorter duration than a 10-year Treasury, as well as a higher return. For example, the 10-year Treasury currently has a duration of 7.88 and yields approximately 4.18%. Our strategies, on the other hand, with an average duration of approximately 0.7 and leverage of approximately 9 equals an effective duration of 6.3, typically have returns which significantly exceed the yield on the 10-year Treasury.

On the liability side, we carefully manage our lending relationships. It is imperative that when using leverage you are able to secure numerous sources of financing so as not to be subject to the whims of any one lender. FIDAC and Annaly have borrowing capabilities with over 25 different counterparties. We limit our exposure to any one lender so as not to be over-reliant on any single firm. Our securities can be financed by multiple lenders on similar terms. Moreover, we only utilize about half of the borrowing lines available to us. All of our lending counterparties conduct continual due diligence on us.

Repurchase agreements are collateralized loans. In a collateralized loan, the loan is secured by the assets being purchased. In other words, just like a residential mortgage is secured by a house, in a repurchase agreement the loan is secured by the securities we buy. A home owner pays his mortgage payments out of his salary; we make our payments on repurchase agreements from what we earn on our assets. We have always earned more on our assets than what we owe on our borrowings-we call this "positive carry"- through all kinds of interest rate environments. Our typical repurchase agreement is for a term of one month, although we can borrow as short as overnight or, in some cases, up to three years. At the end of the term, the repurchase agreement is usually "rolled" for another agreed-upon term at an agree-upon rate. Our securities are of such high quality and fundability that we are charged very low "haircuts" of 2%-which means that we can borrow up to 98% of the value of the securities, similar in concept to a homebuyer being able to borrow up to, say, 80% of the value of the home-and very low rates, typically close to Fed Funds on the overnight borrowings.

These repurchase transactions, governed by an industry-standard agreement, are conducted on a bankruptcy remote basis, which means that in the event of a default by a counterparty, we have complete and unfettered access to our assets without having to go through the bankruptcy process (and remember that we have the counterparties' cash!). Using reverse repurchase transactions as a source of financing also means that the counterparty only has access to the securities pledged for the borrowing. Therefore, investors in our strategy never have the risk of losing more than their equity investment in the fund.

Investors often ask us how we decide what our leverage ratio should be. After all, the quality of our securities is such that our lenders would allow us to run at much higher leverage levels than we use. Further, if a bank were to execute this strategy, they would be able to use a much higher leverage ratio. Banks have both absolute capital requirements and risk-based capital requirements. Since Agency MBS have a 20% risk weighting, this means that banks must hold capital equal to 20% of 8%, or 1.6% against those assets. Expressing this as a debt:equity ratio, this would be 61:1x. This does not infer that banks actually do this, or even look at their own mortgage-backed securities portfolio this way, but is further illustration of the conservative amount of leverage we use. We tend to run at much more prudent leverage levels. In all of our strategies we generally operate between a debt-to-equity band of 7:1 and 12:1 by prospectus. We have found that this range is sufficient to achieve our objective of providing high current income consistent with a relatively stable book value.

In summary, leverage is prevalent in virtually every aspect of our financial lives. The use of leverage is not without its risks, but the simplicity of our business model helps us to manage them. Management has successfully guided this strategy through a wide range of interest rate environments, including some of the most challenging bond markets ever experienced. Moreover, without performance fees in our structure, management's interests are more in line with investors. Our track record proves this out.