Annaly Capital Management Announces Monthly Commentary for February

NEW YORK--(BUSINESS WIRE)-- Annaly Capital Management, Inc. (NYSE: NLY) released its monthly commentary for February. With this month's commentary, the company is changing its naming convention to match the month in which it is released. Through its monthly commentary and blog, Annaly Salvos on the Markets and the Economy (Annaly Salvos), Annaly expresses its thoughts and opinions on issues and events in the financial markets. Please visit the Resource Center of our website (www.annaly.com), to see the complete commentary with charts and graphs.

The Economy

On January 29^th, the Bureau of Economic Analysis released the advance reading for GDP in the fourth quarter of 2009: growth of 5.7% on an annualized basis, versus 2.2% in the previous quarter and (5.4%) in the year-ago period. The details of the release were met with mixed reviews. The major contributor to growth, as was widely reported, was the change in private inventories. The adjustment in inventories added 3.4% of the 5.7% total, or very nearly 60%. Inventories didn't actually grow, they simply shrank at a slower pace. Economists, analysts, and investors seem to be split into two camps, and persuasive arguments can be made for either. "Give me a one-handed economist," demanded President Harry Truman, in vain:

    --  On one hand - A slower inventory decline is not the same as a recovery.
        With all this government stimulus, shouldn't we be seeing more robust
        growth? The mighty fiscal and monetary effort has relatively little to
        show for it.
    --  On the other hand - Inventories always lead the rest of the economy, so
        this presages more to come. It doesn't matter where growth comes from,
        it's here.

Both sides have a point. Fortunately, the quarterly release from the BEA comes with other data, including personal income and spending, to help shed light on the headline GDP growth number. Readers of our blog know that we've been watching the labor market closely, and readers of past commentaries will be familiar with real personal income less transfer payments, which we've renamed real organic personal income (ROPI) for our purposes here. In our online version we present a chart that highlights the long-term relationship between ROPI growth and GDP growth (both measured as year-over-year percent change, not the BEA's quarter-over-quarter annualized method).

The relationship has historically been fairly tight--an 88% correlation--but you'll see that we've highlighted recent anomalous behavior. The current spread between year-over-year ROPI growth and GDP growth is a record -417 basis points (bps), meaning that GDP has grown 0.10% while ROPI has shrunk by 4.07%. The next widest historic spread is nearly 100 bps narrower, in the 3^rd quarter of 1983, when the country was several quarters beyond the double dip recession. That spread was between 5.64% GDP growth and 2.46% for income, both positive, and very different than our current situation of growth in GDP coupled with near-record declines in income.

One reason that this income/GDP correlation is so tight is because of the intuitively simple relationship between ROPI and consumption. Lately, however, that relationship has broken down. As the graph in our online version shows, real personal consumption expenditures have not subsided as much as income.

In another post-War first for our country, real consumption is higher than real personal income less transfer payments. The spread between the two is shown on the right hand axis. Considerable government effort has gone towards stimulating consumption, which seems to be having the desired effect. While inventory adjustments grabbed the GDP headlines, personal consumption expenditures added 1.4%, or about 25%, to GDP growth. We doubt that the current relationship between income and consumption is sustainable, but disequilibriums can, and do, sometimes last for much longer than anyone thinks possible.

The Residential Mortgage Market

In December (January release) prepayment speeds for aggregate 30-year Fannie Mae fixed-rate mortgages increased by 28% from 14.5 Constant Prepayment Rate (CPR) to 15.3 CPR. The higher coupons of 6%, 6.5% and 7% led the increase, speeding up by 32%, 42% and 39%, respectively, bringing them back to prepayment speed levels of October. Most analysts are mixed about what to expect in the months ahead. While some believe HAMP modifications and lower rates will easily offset the day count difference from December to January, others suggest that HAMP-related buyouts will be noisy and slow to come, similar to the spike in speeds on 6.5s and 7s that arrived in December after their surprisingly slow November prints.

Today, Freddie Mac announced it would purchase "substantially all" 120 day or more delinquent loans from the company's related fixed-rate and adjustable-rate mortgage-backed securities pools. Freddie further gave a timeline of the buyouts stating that purchases would be fully reflected in next month's factors. Fannie Mae quickly followed suit. It appears the agencies are finally, and swiftly, dealing with a problem. While this release came as no surprise to the market, it nonetheless is worth a brief comment as it will affect short-term prepayment speeds. We will keep our readers up to date with any changes to the program, as well as our analysis, in future commentaries.

With the majority of the MBS purchase program complete and due to wind up by March 31, the overall effectiveness of the program can now be debated with hard facts. What has the American taxpayer received for the $1.25 trillion that ultimately will be spent on the program? The Fannie Mae current coupon rate, or par coupon, has tightened in from a wide of 6.146% on July 18, 2008 to the current 4.329%, or 181.7 bps. Additionally, the mortgage basis, or the spread of the yield on the current coupon over the 10-year Treasury yield, has ratcheted in from a wide of 237 bps on March 4, 2008 to the present 73 bps. This significant move in absolute and relative yields should have sparked a refinancing wave directed squarely at the individuals who needed it most, the high coupon mortgage borrowers. As illustrated by the graph in our online version, from the February 2, 2010, Bank of America Merrill Lynch "Convexity Maven" newsletter, it just didn't happen. Typically, mortgages that are 200 bps "in the money," or that are refinanceable with a 2% reduction in coupon, refinance at very fast speeds. This was last observed during the 2003-2004 refinancing wave. Currently, however, the same collateral is refinancing at much tamer speeds. As the Convexity Maven said, "[M]ost truly distressed homeowners have failed to benefit from lower rates created from the MBS purchase program."

Bank of America Merrill Lynch further estimates that there are roughly $810 billion of Fannie Mae and Freddie Mac 6% to 7% mortgage-backed securities, and had this universe been refinanced into a 4.5% rate (similar to the main coupon that the Fed has been buying through the MBS purchase program as we noted in a recent blog post), and assuming a $150,000 average loan balance, the average homeowner would have saved almost $1,700 annually. This $1,700 average annual savings would have not only added $9 billion in potential consumer spending, but would have also reduced the overall credit risk exposure of Fannie Mae and Freddie Mac since the default rate on the lower coupon mortgages is substantially less than that of the original higher coupon. In essence, the MBS purchase program has benefitted MBS bondholders through tightened spreads, but it probably did not help out the homeowners who needed it most.

Once the program ends, will MBS spreads widen out? It's difficult to forecast, but while there may be volatility, it is possible that spread widening is kept in check by demand. Barclays Capital points out that most money managers have been underweight MBS during the purchase program. For example, bond fund managers with $344 billion in assets under management collectively decreased their MBS allocations by 23% from December 2008 to December 2009, including PIMCO's $185 billion Total Return Fund which reduced its allocation 40% from 62% to 22%. Barclays suggests that a rotation back into MBS from fund managers, as well as demand from banks and foreign investors, will be more than enough to meet any reasonably modest spread widening.

The Commercial Mortgage Market

By now, the commercial real estate community and most of the greater population in the New York Metro area are aware that the owners of Peter Cooper Village & Stuyvesant Town ("Stuy Town") apartments have defaulted on their $3 billion mortgage and turned the project over to the lenders. It's a mess, as politicians have rallied behind the tenants, the J-51 tax verdict is being implemented (which held that building owners can't raise rents when they are receiving tax benefits), mezzanine lenders are threatening to foreclose and pools of private equity are looking to acquire the project. But to a CMBS investor, the greatest effect of the Stuy Town default and foreclosure will be the designation of the new Directing Certificate Holder (DCH) for each CMBS transaction. The DCH is responsible for approving special servicer recommendations.

For CMBS, an investor in the lowest rated certificates, referred to as the B-piece buyer, became the DCH in the event of default. In nearly all transactions, the DCH was also the special servicer. Therefore, if a loan became 'specially serviced,' loan actions developed by the special servicer were basically presented to himself for approval. Naturally, the special servicer's recommendations were always for the benefit of all certificate holders.

The B-piece buyer retained the DCH designation provided his certificate balance was not reduced by losses. While CMBS documents provided mechanisms to designate new DCHs in the event more than one institution owns a certificate, never was it foreseen by the architects of CMBS that holders of investment grade CMBS would become the DCH. The magnitude of the loss is so great (over $1.5 billion), that this is the story in Stuy Town.

Generally, investment grade certificate holders are fixed income investors who invest in CMBS for relative value and as a substitute for commercial real estate exposure. While they possess desktop analytics such as Trepp and Intex to stress cash flows, an institution that has been designated as the DCH will now have to approve special servicer actions. This is a role that such investors may not be well-suited to play. For example, do they possess the property specific knowledge to deal with commercial property workouts? How quickly can they respond to the special servicer's recommendations? Will those recommendations be subject to the DCH's own internal investment committee oversight? How does their institution feel about exposing itself to potential lawsuits involving "willful misfeasance, bad faith or negligence in the performance of duties or by reason of reckless disregard of obligations or duties?" Does the institution still have an investment outstanding for the certificate or has it written it off internally in which case staff may be hard pressed to expend significant time on it?

Back in the spring of 2009, a consortium of 15 of the largest senior CMBS certificate holders and the special servicers couldn't complete a compromise resolution to extend, amend and pretend. It is doubtful that they will do a better job working together developing and approving workout solutions. As more Stuy Towns ripple through the commercial real estate market, we think the workout process could end up being as challenging as the investment losses.

The Corporate Credit Market

The negative surprises of policy uncertainty have offset the positive surprises of the corporate earnings season. As disconnected as these two topics may seem, they are, in fact, linked. Year-to-date spread performance has been erratic as the strong early January rally has since faded. Credit investors and dealers started the year with an overweight position following a spectacular 2009. While expectations of a plummeting default rate underpinned allocations, the early-year reminder is that risk and liquidity premiums are also important drivers of valuations. Even against the backdrop of balance sheet deleveraging, credit investors must heed the macro.

Together with the ongoing topic of Federal Reserve exit strategy, several newly emerging unknowns on the policy front have contributed to the recent weakness. They are global in scope. First, the China growth engine may lose some torque. Some forecasters had predicted that the country would account for as much as one-third of 2010 global GDP growth. In January, policy makers in China raised reserve requirements and employed other measures to curb excessive credit expansion. Second, the surprise loss of Ted Kennedy's senate seat to a Republican suggests a crisis of confidence among the citizenry. Third, Greece's large fiscal shortfall called attention to more widespread budgetary problems among peripheral members of the European Union. Just how budget gaps and debt maturities will be funded presents a test to the solidarity of the Union. As a result, the euro has declined 9% versus the dollar from its recent high in November. Furthermore, one could argue that the acute attention on Greece is a red herring: with the release of the 2010 budget, the U.S. deficit will equate to 9.2% of GDP (CBO estimate). This compares to Greece's 12 %. Last week, Moody's said the U.S. government's triple-A rating was in jeopardy "unless it takes radical action to curb soaring healthcare and social security spending." It's a bit of a relief that the dollar enjoys reserve currency status.

Concurrent with these global policy uncertainties, U.S. companies have been busy reporting fourth quarter results. On a year-over-year basis, fourth quarter 2009 S&P 500 earnings grew 209% with 65% of firms reporting. Excluding financials, the earnings growth number is a less eye-popping 13%. Easy comparisons were a contributing factor behind the growth. Nevertheless, the "positive surprise" ratio is running at a record 74%. In our view, the thematic drivers of earnings are just as important as the numbers. They include: China/emerging focus, "operational efficiencies," uneven top-line growth, and tax benefits. In recognition that U.S. and Europe recoveries were likely to be tepid, the Chinese market is a component of many U.S. companies' growth strategies (e.g. Nike, Alcoa, GE). Any shock to China could derail earnings growth predicated on this theme. Moving west, due to a weaker dollar, companies with a high percentage of foreign sales expressed favorable earnings from currency translation in Q4. Furthermore, a weak dollar contributed to a Q4 narrowing of the persistent trade imbalance. Domestically, due to prior losses, tax benefits have been a favorable contributor to earnings and cash flow. For example, most homebuilders expect material tax refunds this year.

Low effective tax rates have depressed Federal revenues, thereby contributing to the deficit. Interestingly, few companies mentioned federal stimulus spending as an important component of future sales. It's easy to be a bit miffed just how the U.S. deficit ballooned so quickly. Interestingly, unemployment benefits which have surged 105% from last year are helping to drive the gap. Many pundits have described the recovery as "jobless" and our micro assessment has yet to indicate anything that conflicts with official data from the BLS. A number of firms reiterated their focus on operational efficiency-- a euphemism for cost management. One can't help but conclude that policy uncertainty with respect to health care and taxes has been delaying corporate hiring decisions.

The good news for corporate credit is that defensive behavior equals cash flow. One earnings theme remains the same: firms continue to grow cash balances. As a result, net leverage by one metric is at a 12-year low. The chart in our online version shows that net debt to EBITDA (earnings before interest, taxes, depreciation and amortization, a proxy for cash flow) for the S&P 500 has collapsed to just over 3x. In sum, if the policy mix can't be recalibrated to the economic problems de jour, at the least, uncertainty over policy changes needs to abate before the corporate sector will take the driver's seat in terms of growth.

February 10, 2010

Jeremy Diamond

Managing Director

Robert Calhoun

Vice President

Ryan O'Hagan

Senior Vice President

Mary Rooney

Executive Vice President

*Please direct media inquiries to Jeremy Diamond at (212)696-0100

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. (C)2009 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 our express written permission.

    Source: Annaly Capital Management, Inc.