Annaly Monthly Market Commentary: March 2005 (posted 4/13/05)

FOCUS

• The Mortgage Market : Prepayment outlook improves, GSE headline risk will persist
• The Economy : The economy signals strength and the Fed acts accordingly. What does this mean for our investors?
• The Markets : Bonds continue to sell-off, and stocks have a weak quarter. Oil pushes close to $60

The Mortgage Market

Aggregate fixed-rate and hybrid ARM prepayments came in as expected for February as they increased about 4% over January’s numbers. Looking forward, dealer forecasts are looking for a pickup in prepayments in March as seasonal slowdowns abate and lower rates of early 2005 work their way through the mortgage origination pipeline. After the brief bump up in speeds in March, prepayments should slow over the coming months as the recent increase in US Treasury yields has led to a decline in the MBA Refinancing Index to below 2000. There is typically a lag of two to three months between changes in the MBA Refinancing Index, which measures refinancing applications, and the change in prepayment speeds in mortgage portfolios.

Despite improving prepayment fundamentals, MBS spreads have widened to Treasuries in recent weeks as investors digested the new macroeconomic developments in the marketplace and as the GSEs have remained in the headlines. It was this same time last year that we talked about how the changing macroeconomic fundamentals that pointed to rising interest rates could lead to a change in the composition of the mortgage market and the prepayment landscape.  As refinancing slows, the composition of the mortgage universe may change from one where most securities are backed by loans that have been refinanced to loans that are from purchases. A change to a purchase-dominated mortgage market can have varying effects on the prepayment speeds for mortgage-backed securities. Also, with the robust housing price appreciation experienced across most of the United States in 2004 (11.2% year-over-year appreciation according to OFHEO’s Housing Price Index in the 4th quarter) it is important to monitor how a continuing rise in interest rates will affect the housing market and mortgage prepayments. It is conventional wisdom that as rates rise mortgage borrowing becomes more expensive and thus leads to slower housing appreciation as the marginal buyer’s ability to afford a house becomes lower. However, with the recent prevalence of “affordability” type mortgage loans (interest-only loans, hybrid ARMs, etc…) housing appreciation may be able to continue at an above average pace despite rising interest rates. As 2005 unfolds, it will be important for us to monitor and analyze both of the aforementioned phenomena and their effects on our portfolio allocation decisions.

As we write this Commentary, new Fannie Mae and Freddie Mac headlines are being printed. Chief among these are the new Baker bill and testimony by senior government officials on the regulation of the GSEs. The market for Agency MBS is virtually unchanged as a result of these developments, as there is nothing contained in the news which would lead an investor to conclude that the ratings agencies would change their rating of the senior unsecured debt obligations—which includes the MBS guarantee—of the companies.

The Economy

Economic data released during the month was generally strong, reinforcing market expectations for continued Fed tightening and higher interest rates. Nonfarm productivity was up, factory orders came in better than expected, capacity utilization increased over the prior month, and inflation numbers met or beat generally higher expectations: PPI, CPI and the PCE deflators, headline and core, are trending stronger. Non-farm payrolls, which came in at +262 thousand for February cooled somewhat to +110 thousand in March. A few other data points, while potential danger signals from a fiscal standpoint, also signaled potentially higher rates: The Federal monthly budget statement showed a deficit of -$113.9 billion in February, the single largest monthly deficit since at least WWII; the trade balance for January was one of the highest in history; net US security purchases by foreigners was second highest ever; and the -$187.9 billion current account balance for the fourth quarter set a record. At the end of the month, the Fed raised the Fed funds rate for the seventh time in 10 months, to 2.75%, and signaled a more urgent concern over inflation.

The result of these indicators was that the market volatility to which we have become accustomed continued in March. Most participants, interpreting the data and parsing the various speeches, testimonies and statements of Federal Reserve officials to mean that the tightening regimen will continue, if not quicken, before it ends, and that long term rates will continue to rise. Since June of last year, we have seen the Fed boost the Fed Funds rate from 1% to 2.75%, pulling up rates at the short end of the curve with it. In the last month, following Alan Greenspan’s “conundrum” comment and the more hawkish FOMC statement, the long end of the curve has followed suit as the 10-year Treasury yield has risen from just under 4% to over 4.6%, with a slight pullback in the last week of the month to about 4.5%.

The fall in securities' prices as rates have risen gives our portfolio management team the opportunity to purchase the same unit of yield at a lower price. For example, a 6% FNMA MBS generates the same cash flow regardless of price. If we can buy the same cash flow at a cheaper price, current yields improve and return on equity improves. Buying an adjustable-rate MBS in a rising rate environment means we can buy cash flows that will increase over time at a cheaper price. Market conditions today are, we believe, much improved. We like the market today much better than the market of three months ago. To us, today’s sell-off is tomorrow’s buying opportunity.

The Markets

During March, interest rates across the yield curve rose. Stocks were down and finished a weak quarter. The US dollar strengthened and oil continued its recent rise. After the March tightening, Fed Funds are now 175% higher than a year ago; bear in mind that each 25 bp move is now lower on a percentage basis than the prior one.

This commentary is neither an offer to sell, nor a solicitation of an offer to buy, any securities of Annaly Capital Management, Inc. (“ Annaly”), FIDAC or any other company. Such an offer can only be made by a properly authorized offering document, which enumerates the fees, expenses, and risks associated with investing in this strategy, including the loss of some or all principal. All information contained herein is obtained from sources believed to be accurate and reliable. However, such information is presented “as is” without warranty of any kind, and we make no representation or warranty, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use. While we have attempted to make the information current at the time of its release, it may well be or become outdated, stale or otherwise subject to a variety of legal qualifications by the time you actually read it. No representation is made that we will or are likely to achieve results comparable to those shown if results are shown. Results for the fund, if shown, include dividends (when appropriate) and are net of fees. ©2005 by Annaly Capital Management, Inc./FIDAC. All rights reserved. No part of this commentary may be reproduced in any form and/or any medium, without express written permission.