Annaly/FIDAC Monthly Market Commentary: May 2005
(posted 6/9/05; edited 6/10/05 to fix typographical error at the end of 6th paragraph)

FOCUS

• The Mortgage Market : Lower ten-year Treasury rates put prepayment speeds under the microscope
• The Economy : The yield curve flattening spawns many questions—but few answers—about the economy
• The Markets : Bonds rally, stocks rally, the dollar rallies

The Mortgage Market

As expected, mortgage prepayment speeds fell in the month of April (May reporting period) as refinancing activity dropped in March and early April. Looking forward, May prepayments are expected to be somewhat flat; however, the recent rally of the 10 year US Treasury to under 4.00% has caused dealer prepayment forecasts to be adjusted upwards for the summer months. As rates remain at these low levels a pickup in refinancing activity can be expected, and the MBA Refinancing Index, which has recently posted an above 2100 level after averaging closer to 1900 for the month of April, has already begun to show signs of increased prepayment activity. UBS mortgage research has indicated that at current rates 33% of the mortgage universe is refinanceable. However, they believe it would take a sustained yield on the 10 year of under 3.65% for prepayments to reach the levels seen in 2004, when the MBA Refinancing Index hit 5000, and a sustained yield of below 2.80% for prepayments to approach the peak levels of prepayments we saw in 2003, when the MBA Refinancing Index approached 10,000.

May provided more news on the GSE reform front as a bill was passed by the House Financial Services Committee. This bill gives a new regulator the ability to approve new product lines; set minimum capital levels; limit GSE business activities; and adjust portfolio holdings when safety and soundness issues arise or in order to fulfill housing missions. However, the bill does not call for explicit portfolio limits on the GSEs, despite the increased rhetoric by Treasury Secretary John Snow and Federal Reserve Chairman Alan Greenspan asking for such regulation over the past few weeks.

Undoubtedly the debate over portfolio limits will continue as the bill makes its way to the Senate, where tougher legislation is expected. As of now the effect of this news on the mortgage market has been benign and we view the situation so far as debt-investor friendly since the proposed legislation does not seem to reduce government support for the GSEs, but rather fortifies their safety and soundness.

The Economy

Even without an FOMC meeting it was a busy month in the credit markets, and investors struggled to reconcile economic reports with market performance. May saw a continuation of mixed economic signals—a below-consensus nonfarm payrolls report on June 3, strong PPI, CPI and import price results (although not as strong as the prior month), weak industrial production, stellar housing data. The month also brought the minutes from the last FOMC meeting, several speeches by Fed officials, a downgrade to junk status of Ford and GM, continued political pressure on the Chinese to revalue, and a “Non!” vote by the French on the European Union Constitution (followed by a resounding “Nee!” vote by the Dutch).

The investment discussion centers around the two ends of the yield curve—when would the Fed finish its tightening regimen and what would happen to long rates. We’ve read convincing arguments forecasting almost any outcome: a) The Fed will stop after just one or two more raises because the economy is slowing, interest rate futures are calling for just two more raises in 2005 and inflation is well-contained; b) The Fed will continue to tighten until the Funds rate reaches 4.25% or 4.5%, because Greenspan said that it was likely the Fed would overshoot the “neutral” rate, the Fed wants to slow down the housing market, and growth and inflationary pressures lurk below the surface in the economy; c) Yields at the long end of the curve will stay at the low end of their recent trading range because the tightening had done its job of quelling not only inflationary pressures but growth as well, the continuing strong bid for dollar-based investments by overseas and retirement-age investors and the flight to quality in uncertain times; d) Yields at the long end of the curve will rise because the economy is still relatively strong, levels of debt issuance and structural deficits in America are high, and foreign investors need to continue to be attracted to American securities.

These are all forward-looking hypotheses. Regardless of where one stands on these issues, the fact remains that even as the Fed has tripled the Federal Funds rate since June 30, 2004 to 3%, the 10-year Treasury yield has fallen from 4.6% to below 4%. As the graph illustrates, on June 3, 2005, the spread between yields on the 2-year Treasury and the 10-year Treasury narrowed to 41 basis points and the spread between 1 month LIBOR and the 10-year Treasury narrowed to 81 basis points, making this the flattest yield curve since early 2001.

We are not dogmatic about what to expect in interest rates. While all of the arguments listed above have an element of truth to them, we don’t believe that at this point in the cycle there is any one argument that is more persuasive than another. From observing the market activity of the past week, it appears that the bond market isn’t persuaded either. Friday June 3 saw the 10-year Treasury go from 101-21/32 to 102-20/32 and back to 101-4/32. Moreover, after months of outflows, high yield bond mutual funds have seen significant inflows lately.

In addition to the level of interest rates, prepayment speeds and market volatility, the shape of the yield curve is an important driver of returns in our strategy. In assessing the yield curve’s potential effect on our portfolio returns, it is important to remember two things: First, in every yield curve scenario we maintain essentially the same portfolio breakdown between the two ends of our “barbell strategy”—adjustable- and floating-rate MBS and fixed-rate MBS. We do this because we are not compiling a portfolio that will do well in only a few scenarios, but one which is designed to perform in a wide range of interest rate environments—including today’s flattening yield curve. Thus, our portfolios are constructed to be a blend of floating-rate, adjustable-rate and fixed-rate assets, with some expected to perform better in a rising interest rate environment via increased spread income and lower NAV volatility and some that perform better in a falling interest rate environment via capital gains.

Second, while the 10-year Treasury rate is important for us to watch as it is the principal reference rate for mortgages and thus refinancing activity in the United States, our assets have a much shorter duration than a 10-year Treasury. In a flat yield curve, the yield on our short duration floating-rate and adjustable-rate assets are priced at a spread to a short-term reference rate—typically one-month LIBOR in the case of floating rate MBS and the one-year Treasury in the case of ARMs. While a flattening yield curve has its challenges, we have operated through such an environment before. For example, the challenge in 2000 was an inverted yield curve and the raising of the Fed Funds rate, with short term rates higher than long-term rates. In that environment, investments in floating-rate and adjustable-rate assets provided a consistent spread over funding costs and helped maintain positive spread income. The same mechanism would be at work today. (In all environments, our position as low-cost provider ensures that we have lower return hurdles.)

 The Markets

During May, interest rates rallied and the curve continued to flatten. US stocks gained, oil rose and gold eased. The dollar strengthened as investors fled the euro.

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.