<!DOCTYPE HTML PUBLIC "-//W3C//DTD HTML 4.0 Transitional//EN"> <!-- #include virtual = /includes/mc_header.asp --> <HTML> <HEAD> <META http-equiv=Content-Type content="text/html; charset=unicode"> <style type="text/css"> <!-- .style2 {font-size: xx-small} .style3 { color: #004800; font-weight: bold; } --> </style> </HEAD> <BODY bgcolor="#FFFFFF"> <div align="center"> <h1>Annaly Monthly Market Commentary: September 2004 </h1> </div> <p><span class="style3">FIDAC Focus</span><br> <ul> <li><span class="style3"> The Economy : </span><em> 2Q GDP growth revised upwards reflecting unexpected strength</em></li> <li><span class="style3"> The Mortgage Market : </span><em>Refi Index rises; Fannie Mae headlines dominate but have little effect on MBS prices</em></li> <li><span class="style3"> Interest Rates : </span><em> The Fed follows through and raises another 25 bp, but the bond market has other ideas </em></li> </ul> <p>&nbsp;</p> <p class="style3">The Economy </p> <p>The US economy demonstrated that it had a little more kick to it than previously estimated, as second-quarter GDP growth was revised upward to 3.3% from a previously reported 2.8%. The reason for the change can be attributed to stronger investment by homeowners and businesses as well as a narrower trade gap. Some Wall Street economists are starting to call for a little more strength in the third quarter numbers as data in consumer spending and inventory investment has shown a pickup in activity.</p> <p>While it was important, as always, to stay abreast of the economic data released in September, two other developments stole the spotlight during the month. First, on September 21 the Federal Open Market Committee tightened for the third time in 84 days when it added another 25 basis points to the Fed Funds rate. Reading the FOMC statements for each of the three moves side-by-side reveals increasing concern and caution about a wavering job market, the traction of output growth, inflation expectations and the transitory nature of oil price increases. Yet the rate hikes continue. True to its word, the Fed is raising rates at a  measured pace in an effort to  fulfill its obligation to maintain price stability. Interestingly, despite 75 basis points of tightening, the FOMC still regards its monetary policy as accommodative. Given the process of telegraphing changes in monetary policy that the Fed has executed over the last two years speeches followed by very deliberate wording in FOMC statements followed by rate changes we have to conclude that if the Fed stays consistent it will likely raise rates at least one more time before the end of the year. The Fed has not telegraphed that they are done tightening, and no definitive economic indicators have been released that would convince otherwise. The signal for a pause or stop to rate hikes will be once Fed governors start talking about how they no longer need to be accommodative (they haven t really, yet) and then an FOMC statement comes out that drops the  measured phrase. </p> <p>The interesting aspect to this cycle of rate hikes is that since the Fed began raising rates on June 30, the only point on the yield curve that is now higher is the Fed Funds rate itself. The 2-year, 3-year, 5-year, 10-year and 30-year rates are all significantly lower today than they were on June 29. For example, the 2-year has fallen from 2.815% to 2.609%, the 5-year has fallen from 3.895% to 3.373% and the 10-year has fallen from 4.686% to 4.121%. The 10-year spent several days below 4%, prompting much hand-wringing among market participants. <em>The Wall Street Journal</em> reported that the last time short-term rates were rising and long-term rates were falling was late-summer 1971. There are many ways to read falling long rates. It could have been a growing belief that the US economy is not as strong as previously thought, and growth and inflation expectations are moderating. It could have been short-covering as rates continued to decline. It could have been the result of hedging on the part of mortgage investors hoping to buy duration as the prospects for faster prepayments loomed. It could have been safe-haven buying in times of increased terrorist activity in Russia, Iraq and the Mid-East or increased uncertainty over the US election. It was probably a little bit of all of these things. The fact that the Fed is tightening in the midst of all this only accentuates the fact that when it comes to interest rates, the Fed only controls one point on the yield curve. The bond market, which makes up its own mind, controls the rest. The problem today is that the bond market can t make up its mind even as Greenspan has seemingly made up his. Expect more volatility.</p> <p>The second development in the spotlight was the OFHEO report on Fannie Mae and subsequent fallout. It is still very early in the news cycle and therefore hard to handicap any particular outcome. What we do know is that Fannie Mae s regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), released&nbsp;a report on September 17 that focused on accounting irregularities and accounting discrepancies with GAAP requirements. As a result of the report, the ratings agencies reduced the ratings on the company s preferred stock and subordinated debt, and affirmed the AAA ratings of the company s senior unsecured debt. (Fannie Mae and Freddie Mac s obligations under their guarantee fall into this category.) Moody s commented  Fannie Mae s Aaa-rated senior debt& continues to be supported by the benefits associated with its GSE status, strong US Government-implied support, important public policy mission in housing finance, tremendous franchise value, and sound interest rate and credit risk management. Fannie Mae quickly agreed to cooperate with OFHEO, including increasing its capital surplus by 30%. In addition, the Department of Justice has initiated a probe into Fannie Mae s accounting. We also know that there are&nbsp;likely to be more headlines in the coming weeks and months as hearings are held and the discovery process unfolds.</p> <p>To date, although the stock market has punished Fannie Mae based on the latest headlines, the bond market has been much more robust. Fannie Mae debentures widened perhaps&nbsp;5-6 basis&nbsp;points since the OFHEO report. Fannie Mae mortgage-backed securities, on the other hand, have tightened a few basis points, likely driven more by broader moves in interest rates than concerns over Fannie Mae. In the near term, any weakness in spreads will be viewed as a buying opportunity. </p> <p>All this said, in the markets in which we operate the Fannie Mae news has had little effect. After years of periodic headline shocks regarding the Agencies, the market is relatively well-educated about the difference between Fannie and Freddie equity securities and Fannie and Freddie MBS or debentures. The equity holders are skittish about regulatory rumblings which could affect the future profitability and growth of the Agencies, while debtholders are confident in the secured nature of the mortgage-backed securities. As we have said before, if the ultimate outcome of the debate in Washington and the investigations into accounting at Fannie and Freddie is to have a stronger regulator watch over the GSEs, this would likely be seen as beneficial to MBS and debtholders. </p> <p>But let us repeat the following: We believe that <strong>Agency MBS are the premier asset-backed security in the world</strong>, with multiple levels of protection for the MBS-holder, including the homeowner s income, the right to foreclose on the home in the event of nonpayment, the value of the home itself, the monthly amortization of principal and mortgage and property insurance. The Agency guarantee is only given to securities that have in them mortgages which have a loan-to-value of 80% or less, are limited in size to no more than $333,700 and are only offered to prime credit borrowers. Through every bond market cycle and economic cycle since their inceptions, Fannie and Freddie have never failed to make good on their guarantee and have never needed the assistance of the federal government to do so.</p> <p class="style3">The Mortgage Market </p> <p> As expected, aggregate mortgage prepayments increased slightly in August posting speeds that were about 5% quicker than July s numbers. However, the increase in speeds for August seems somewhat muted in the context of a 15% increase in the MBA refinancing index as well as a 25bps decrease in the Freddie Mac Primary Mortgage Market Commitment Rate for the 4-6 week period effecting August s prepayment rates. Perhaps this shows a more benign response by the borrower to lower mortgage rates. In fact, the refinance index is lower than previous levels given similar levels of interest rates. For instance, the last time the FHLMC Survey Rate hovered around 5.70% the refinance index, currently at about 2200, posted levels above 3000. Therefore, despite the 30% increase in the refinancing index and a 27bps decrease in the Freddie Mac Commitment Rate since the beginning of August dealers are only expecting about a 5-10% increase in prepayments for September with continued slight upswings in speeds through the Fall of 2004 if the 10yr stays around 4.00%. </a></p> <p>&nbsp;</p> <p align="center"><img src="mc_sept_04_clip_image002.gif" alt="FHLMC Survey Rate versus MBA Refinance Index" width="576" height="334"></p> <p>&nbsp; </p> <p> Even though prepayments came in as expected and the FOMC had no surprises when they hiked interest rates for the third time this year, the month of September was anything but quiet for mortgage market participants. First, the 10yr treasury slowly grinded toward 4% most of the month and actually dipped below that level, sparking fears of a new refinancing wave. This of course put pressure on mortgage spreads in the near term but as the yield on the 10yr has made its way safely above 4.0% (month end close of 4.12%) fears of large increases in prepayments have subsided. Second, and as detailed above, Fannie Mae s regulator, OFHEO, released a report detailing accounting mismanagement at the firm. As part of an agreement with OFHEO Fannie Mae has agreed to achieve a 30% capital surplus within the next 270 days. Currently FNMA is short of this target and some market participants have feared that FNMA would have to sell mortgage securities in order to meet such a capital requirement. However, the MBS market as a whole has not succumbed to such fears yet and is currently content that the current headlines do not weaken the superior credit quality mortgage backed securities represent. </p> <p> <span class="style3">The Markets</span></p> <p> In September, the yield curve flattened with the short end rising. The 10-year Treasury yield was essentially unchanged while the 2-year Treasury fell in price, resulting in an 8.9% increase in yield. The 2/10s spread fell from 172 to 151 basis points. Stocks moved sideways, but oil and gold saw big jumps. The MBA Refi Index hit its highest level since April. </p> <table align="center" border="3" cellpadding="0" cellspacing="0"> <tr> <td width="192" valign="bottom"><p>&nbsp; </p></td> <td width="73" valign="bottom"><p align="center"><strong> 30-Sep-04</strong></p></td> <td width="74" valign="bottom"><p align="center"><strong> 31-Aug-04</strong></p></td> <td width="67" valign="bottom"><p align="center"><strong> % change </strong></p></td> <td width="63" valign="bottom"><p align="center"><strong> Hi Close </strong></p></td> <td width="71" valign="bottom"><p align="center"><strong> Lo Close </strong></p></td> </tr> <tr> <td width="192" valign="bottom"><p align="right"><strong> 2-year Treasury </strong></p></td> <td width="73" valign="bottom"><p align="right"> 2.609% </p></td> <td width="74" valign="bottom"><p align="right"> 2.395% </p></td> <td width="67" valign="bottom"><p align="right"> 8.9% </p></td> <td width="63" valign="bottom"><p align="right"> 2.609% </p></td> <td width="71" valign="bottom"><p align="right"> 2.387% </p></td> </tr> <tr> <td width="192" valign="bottom"><p align="right"><strong> 10-year Treasury </strong></p></td> <td width="73" valign="bottom"><p align="right"> 4.121% </p></td> <td width="74" valign="bottom"><p align="right"> 4.119% </p></td> <td width="67" valign="bottom"><p align="right"> 0.0% </p></td> <td width="63" valign="bottom"><p align="right"> 4.296% </p></td> <td width="71" valign="bottom"><p align="right"> 3.980% </p></td> </tr> <tr> <td width="192" valign="bottom"><p align="right"><strong> 30 yr conventional mortgage </strong></p></td> <td width="73" valign="bottom"><p align="right"> 5.51% </p></td> <td width="74" valign="bottom"><p align="right"> 5.55% </p></td> <td width="67" valign="bottom"><p align="right"> -0.7% </p></td> <td width="63" valign="bottom"><p align="right"> 5.63% </p></td> <td width="71" valign="bottom"><p align="right"> 5.40% </p></td> </tr> <tr> <td width="192" valign="bottom"><p align="right"><strong> Dollar Index </strong></p></td> <td width="73" valign="bottom"><p align="right"> 87.37 </p></td> <td width="74" valign="bottom"><p align="right"> 88.94 </p></td> <td width="67" valign="bottom"><p align="right"> -1.8% </p></td> <td width="63" valign="bottom"><p align="right"> 89.63 </p></td> <td width="71" valign="bottom"><p align="right"> 87.37 </p></td> </tr> <tr> <td width="192" valign="bottom"><p align="right"><strong> Japanese Yen </strong></p></td> <td width="73" valign="bottom"><p align="right"> 109.93 </p></td> <td width="74" valign="bottom"><p align="right"> 108.89 </p></td> <td width="67" valign="bottom"><p align="right"> 1.0% </p></td> <td width="63" valign="bottom"><p align="right"> 111.42 </p></td> <td width="71" valign="bottom"><p align="right"> 108.89 </p></td> </tr> <tr> <td width="192" valign="bottom"><p align="right"><strong> S&amp;P 500 </strong></p></td> <td width="73" valign="bottom"><p align="right"> 1114.58 </p></td> <td width="74" valign="bottom"><p align="right"> 1104.24 </p></td> <td width="67" valign="bottom"><p align="right"> 0.9% </p></td> <td width="63" valign="bottom"><p align="right"> 1129.30 </p></td> <td width="71" valign="bottom"><p align="right"> 1103.52 </p></td> </tr> <tr> <td width="192" valign="bottom"><p align="right"><strong> Nasdaq Composite </strong></p></td> <td width="73" valign="bottom"><p align="right"> 1896.84 </p></td> <td width="74" valign="bottom"><p align="right"> 1838.10 </p></td> <td width="67" valign="bottom"><p align="right"> 3.2% </p></td> <td width="63" valign="bottom"><p align="right"> 1921.18 </p></td> <td width="71" valign="bottom"><p align="right"> 1838.10 </p></td> </tr> <tr> <td width="192" valign="bottom"><p align="right"><strong> Gold $/oz (nearby contract) </strong></p></td> <td width="73" valign="bottom"><p align="right"> $418.70 </p></td> <td width="74" valign="bottom"><p align="right"> $410.90 </p></td> <td width="67" valign="bottom"><p align="right"> 1.9% </p></td> <td width="63" valign="bottom"><p align="right"> $418.70 </p></td> <td width="71" valign="bottom"><p align="right"> $397.90 </p></td> </tr> <tr> <td width="192" valign="bottom"><p align="right"><strong> Oil $/bbl (nearby contract) </strong></p></td> <td width="73" valign="bottom"><p align="right"> $49.64 </p></td> <td width="74" valign="bottom"><p align="right"> $42.12 </p></td> <td width="67" valign="bottom"><p align="right"> 17.9% </p></td> <td width="63" valign="bottom"><p align="right"> $49.90 </p></td> <td width="71" valign="bottom"><p align="right"> $42.12 </p></td> </tr> <tr> <td width="192" valign="bottom"><p align="right"><strong> MBA Refi Index (month-end value) </strong></p></td> <td width="73" valign="bottom"><p align="right"> 2211.1 </p></td> <td width="74" valign="bottom"><p align="right"> 1804.1 </p></td> <td width="67" valign="bottom"><p align="right"> 22.6% </p></td> <td width="63" valign="bottom"><p align="right"> 2211.1 </p></td> <td width="71" valign="bottom"><p align="right"> 1804.1 </p></td> </tr> </table> <p><strong> &nbsp;</strong></p> <p><img width="818" height="8" src="mc_sept_04_clip_image003.gif"> &nbsp;</p> <p> <span class="style2">This commentary is neither an offer to sell, nor a solicitation of an offer to buy, any securities of Annaly Mortgage Management, Inc. ( Annaly ), FIDAC or any other company. All information contained herein is obtained from sources believed by it 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 posting on the site, 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 Annaly Mortgage Management, Inc./FIDAC. <strong>All rights reserved. No part of this commentary may be reproduced in any form and/or any medium, without express written permission.</strong></span></p> </BODY> </HTML>