<!DOCTYPE HTML PUBLIC "-//W3C//DTD HTML 4.0 Transitional//EN"> <!-- #include virtual = /includes/mc_header.asp --> <!-- Page Title - Change Date --> <HTML> <HEAD> <META http-equiv=Content-Type content="text/html; charset=unicode"> <style type="text/css"> <!-- body { margin-left: 20px; margin-top: 20px; margin-right: 15%; margin-bottom: 20px; } --> </style></HEAD> <BODY bgcolor="#FFFFFF"> <div align="center"> <h1>Annaly Monthly Market Commentary: November 2004 (posted 12/14/04)</h1> </div> <!-- End Title --> <p><b>FIDAC Focus</b><br> <ul> <li><b>The Economy:</b> <SPAN style="COLOR: black"><EM>With the election over, markets buzz about the declining dollar</EM></SPAN> <li><b>The Mortgage Market:</b> <SPAN style="COLOR: black"><EM>Refinancing activity comes in as expected-about flat</EM></SPAN> <LI><b>Interest Rates:</b> <SPAN style="COLOR: black"><EM>WWe expect the Fed to keep hoisting the short end of the curve, and for the long end to follow suit</EM></SPAN></LI> </ul> <p><b>The Economy</b><br> The 2004 presidential election concluded barely a month ago and is already little more than a speck in the rearview mirror. With the Bush Administration firmly entrenched for four more years, financial markets participants have moved on to bigger issues, handicapping their outcome and their potential effect on investment returns. </p> <br> <!-- image --> <div align="center"> <IMG alt="US Dollar loses 10% vs. pound Sterling since October" src="./12_14_1.jpg" border=0 ></div> <!-- end image --> <br> <br> <!-- image --> <div align="center"> <IMG alt="US dollar loses 9% vs Yen since October" src="./12_14_2.jpg" border=0 ></div> <!-- end image --> <br> <br> <!-- image --> <div align="center"> <IMG alt="US dollar loses ten percent vs. the euro since October" src="./12_14_3.jpg" border=0 ></div> <!-- end image --> <br> <p>We have been reading research reports, official economic releases, the text of economic speeches and the popular press. We have recently concluded a series of visits to clients in Canada, Asia and Europe. We have been engaged in internal discussions. Everyone, it seems, is having the same conversation: What is driving the currency market right now? Will the dollar continue to weaken? What will it mean for interest rates? </p> <p>We have reviewed many of these issues before (in our monthly commentaries, particularly February 2004, as well as more in-depth in "It's a Big World After All," and "The Dollar Riddle" on our website under the Commentary button), but the recent swoon in the dollar's value against every major currency has gotten everybody's attention. Alan Greenspan diplomatically summed up the conundrum in his speech to the European Banking Congress in Frankfurt, Germany, on November 19. He said, "It seems persuasive that, given the size of the U.S current account deficit, a diminished appetite for adding to dollar balances must occur at some point." Or, to put it more bluntly, there is not an insignificant chance of a run on the dollar.</p> <p>There are many perspectives on this issue, with no single answer. As Chairman Greenspan said later in his speech, one would be just as successful flipping a coin trying to forecast foreign exchange rates. This hasn't kept economists from trying. Stephen Roach, chief economist at Morgan Stanley, is bearish on the potential outcome. Quoted in the December 6, 2004 Barron's, Roach said, "We all hope for a well-managed revaluation of the dollar and a measured rebalancing of the world economy, but the margin for error is so slim since the imbalances are so huge." The imbalances he refers to are the US federal budget deficit, the current account deficit, the investment balance and the paltry US overall savings rate. On the other side of the argument are those who argue that the interlocking relationships of the US and its financiers around the world will continue to keep the value of the dollar from a "crash". John Plender, writing in the Financial Times, summed it up neatly. "[T]here is the curious mercantilist exchange rate policy that encourages those already in a hole to keep digging," he says. "That is, if Japan or China sell 5 per cent of their dollar assets, they might take a loss of 10 per cent or more on the rest of their portfolios as they break their currencies' links with the dollar."</p> <p>Indeed, the question of continued dollar appetite has been raised with central bankers around the world. A brief dip in the dollar was corrected when an official of the Chinese central bank said he was misinterpreted-please excuse, he hadn't said China intended to reduce their holdings of dollars, only that the value of their holdings had been reduced. Masatsuga Asakawa manages the reserve portfolio for the Bank of Japan. Interviewed in the New York Times on December 4, he stated that the central bank intends to continue its dollar buying program. "Imagine that tomorrow people hear, 'Hey, Japan has decided to divert from U.S. dollars to euros.' That would create a hugely undesirable impact on the U.S. Treasury market, and we have no intention at all to make an unfortunate impact on the U.S. Treasury market." In Europe, policy makers have stated that a euro above 1.30 would be "brutal" and a move to 1.40 would be "catastrophic." The ECB, however, talks more about raising its overnight rate to battle incipient inflation, a move that would only bolster the value of the euro. </p> <p>On December 6, the euro closed at 1.34, the yen closed at 103.16 and the renminbi closed virtually where it closed the day, week, month and year before. Like Rashoman, the dollar means different things to Europe, Japan, China and the U.S. In China, they want a strong dollar in order to keep their goods competitive. The world believes China no longer needs that crutch and wants the Chinese to let their currency strengthen versus the dollar. Only when it suits them is the answer, and it doesn't suit them now. In Europe and Great Britain, which has also seen a significant rally in its currency versus the dollar, they are afraid that a weaker dollar will dampen whatever recent economic growth they have been able to muster. However it is unlikely that we will see any significant intervention-just isn't their style ("As Dollar Declines, Europeans See US as Big Half-Off Sale," read a recent headline in the Wall Street Journal). In Japan, where intervention in the dollar market has become the national pastime, Finance Minister Sadakazu Tanigaki indicated that his government is ready to do what is necessary to weaken the yen. And in America, the benign neglect of the dollar is the unofficial currency policy of the US Treasury, notwithstanding the rote recitation to the contrary by John Snow.</p> <p>We believe the dollar will decline in value quickly if our friendly foreign lenders slow down or stop their purchase of dollars and dollar-denominated assets. However, we believe that this is unlikely to occur, not least because we don't see any viable alternative of significant size. Therefore, we believe that the dollar decline will merely be gradual. Because the Federal government should not be relied on to stop spending more than it earns, and because the US economy still shows few definitive signs of growth (and more definitive signs of weakness, such as the recent disappointing non-farm payroll number, relatively weak retail sales and the fifth straight month of declines in the Leading Indicator Index), the weaker dollar seems the most convenient way out for policymakers. This would help make American products more competitive, but it will also lead to the prices of imports rising at a faster pace in the future, which would fan the flames of inflation. This inflationary risk to a declining dollar will likely give the Fed more reason to keep raising rates. </p> <p>The Chairman himself agrees. In the Q&A session to his Frankfurt speech, Greenspan said, "Rising interest rates have been advertised so long and in so many places that anyone who has not appropriately hedged this position by now obviously is desirous of losing money." [This is ironic coming from the same Alan Greenspan who in February was encouraging American homeowners to take out adjustable rate mortgages. "American consumers might benefit," he said, "if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home." (We added italics for emphasis).] We do not desire to lose money for our investors. In our strategy, a significant portion of our portfolio is comprised of floating-rate and adjustable-rate mortgage-backed securities which are designed to outperform in a rising rate environment. </p> <p><b>The Mortgage Market</b><br> Aggregate fixed rate mortgage prepayments came in as expected for the month of October (November reporting period), posting speeds that were about 5% higher than last month's numbers. Elsewhere, aggregate Hybrid Adjustable Rate Mortgage Speeds, although still exhibiting faster baseline speeds than fixed rates, came in flat when compared to last month's prepayments. November speeds for fixed rates and hybrids are forecasted to be flat to slightly higher as a seasonal slowdown in mortgage activity should offset the rise in refinancing activity that we experienced during the lower rate periods of October. Looking forward, as long as mortgage rates remain at or above current levels, expectations for any large pick up in prepayment speeds for the rest of 2004 and early 2005 remain relatively muted. The MBA Refinancing Index supports this view as it experienced a 12% drop to below 2000 in its latest release. </p> <p>On November 30, 2004 Fannie Mae and Freddie Mac's regulator, OFHEO, released the new conforming loan limit for 2005. The maximum size mortgage loans that both Fannie Mae and Freddie Mac will be able to buy starting in January 2005 is $359,650, a 7.8% increase over the 2004 limit of $333,700. This maximum loan limit is adjusted each year and is based on the percentage change in house price from October to October as reported by the Federal Housing Finance Board. The increased loan limit size is expected to have only a mild impact on the mortgage market and on prepayment speeds. The biggest effect will be seen in the jumbo mortgage arena as the refinancing incentive for jumbo borrowers' with loan sizes between the old limit and new limit will increase by about 20-25bps, or the difference between conforming and jumbo mortgage rates. </p> <p><b>The Mortgage Market</b><br> In November, the yield curve flattened as the short end rose ahead of the Fed. Stocks rallied after the election and the strong November employment report. The dollar continued to slip, and gold rose. Oil was volatile and ended the month near its high. The MBA Refi Index fell as rates rose.</p> <br> <!-- image --> <div align="center"> <IMG alt="" src="./12_14_chart.gif" border=0 ></div> <!-- end image --> <br> <span style="font-size: 7.5pt;">This commentary is neither an offer to sell, nor a solicitation of an offer to buy, any securities of <st1:personname w:st="on">Annaly Mortgage Management, Inc. ( <st1:personname w:st="on">Annaly ), FIDAC or any other company. Such an offer can only be made by a properly authorized offering document, which enumerates the 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. ©2005 by <st1:personname w:st="on">Annaly Mortgage Management, Inc./FIDAC.<b> All rights reserved. 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