Annaly Capital Management Releases Monthly Commentary for December, Providing a Review of the Economy and the Residential Mortgage, Commercial Mortgage, Corporate Credit and Treasury Markets

NEW YORK--(BUSINESS WIRE)-- Annaly Capital Management, Inc. (NYSE: NLY) released its monthly commentary for December. Through its monthly commentary and blog, Annaly Salvos, Annaly expresses its thoughts and opinions on issues and events in the financial markets. Please visit our website, www.annaly.com, to check out all of the new features and to view the complete commentary with charts and graphs.

The Economy

We are currently accepting reader submissions for new synonyms for “choppy” or “uneven,” which is still the operative description for the US economy. On the positive side, ISM manufacturing and non-manufacturing surveys were both better than expected, initial unemployment claims began to decline into the low 400,000 range, the initial read on retail sales for the holiday season were seen as solid, and the University of Michigan consumer confidence index rose. As the month wore on most data continued to beat expectations but there were still reasons to be skeptical. Housing data continued to disappoint, with sales and prices both tipping back into declines. Interest rates on Treasurys rose despite the resumption of the Federal Reserve’s large scale asset purchases (QE2), and equities reversed gains from earlier in the month. Europe is undergoing an existential crisis and North Korea and Iran are rattling their sabers.

The real disappointing data point was the November nonfarm payroll report. The headline increase of only 39,000 jobs was well below expectations of an increase of 150,000 jobs. Reinforcing the weakness was the rise in the unemployment rate from 9.6% to 9.8%, the rise in the median duration of unemployment to 21.6 weeks and the drop in full-time employment for the sixth month in a row. Most importantly, the employment-to-population ratio declined to its lowest level since December 2009, and August of 1983 before that. The number of people who are no longer in the labor force has risen to a new record of 84.7 million, with an increase of over 2 million people since just April 2010. It’s no wonder that Fed Chairman Bernanke and President Obama have been so vocal about job creation. President Obama recently agreed to a compromise on extending tax cuts and unemployment benefits in the hope that jobs would be created (click here for our recent blog post on the subject).

On several occasions now, Chairman Bernanke has estimated that it takes about 2.5% real economic growth just to keep unemployment at current levels. He is referring to Okun’s Law, which is a rule-of-thumb measure of the effects on GDP of rising or falling unemployment. Potential GDP, measured here by the Congressional Budget Office, is an estimate of maximum sustainable GDP. “Maximum” because it assumes full employment and full utilization of productive resources available in the economy. “Sustainable” because it assumes a level of labor and capital utilization that is consistent with price stability, i.e. not so much activity as to produce inflation. The graphs available in our online version show, current real GDP growth falls short of potential GDP.

Typically, as the economy catches up to its potential, above-trend growth puts unemployed people back to work. Estimates vary, but Okun’s Law holds that GDP growth of 1% above trend results in a 0.7% change in unemployment. The graphs available in our online version illustrate what Bernanke means when he says we need 2.5% growth (roughly the average potential GDP growth of the last decade) just to keep the unemployment rate steady: if the US economy simply grew at trend from here and no higher, it would never catch up to potential production levels and the millions of people who lost jobs would remain jobless. Another way to put it, if the economy recovered sufficiently to actually zero out the output gap, the unemployment rate would be around 5%. Currently, this is an economy that simply doesn’t require as many workers as before to meet current demand.

The Residential Mortgage Market

November prepayment speeds (December release) for the universe of 30-year Fannie Mae mortgage-backed securities (MBS) increased 6% month over month to a 27% Constant Prepayment Rate (CPR). Similarly, prepayment speeds on 30-year Freddie Mac collateral inched up 8% month over month to 31% CPR. The majority of the month-over-month increases came from the better credit borrowers at lower coupons prepaying faster than the worse credit borrowers at higher coupons, a behavior which has been present in the mortgage market for the past several months. However, given the 28 basis points (bps) backup in the 30-year Fannie Mae commitment rate during November, and expectations for higher mortgage rates in December and January, prepayment speeds on lower coupon mortgages are expected to gradually decrease as borrowers in these coupons typically show greater sensitivity to rates. Looking ahead, speeds in the near term should continue to be tame relative to rates, especially higher coupons, with January’s release estimated to be slow on weak seasonality, day count and mortgage originator capacity constraints.

Looking ahead to 2011, the key themes for agency MBS will be delinquencies, low supply on weak credit and tighter underwriting standards and continued demand. In general, delinquency rates peaked in early 2010, but according to analysts at Morgan Stanley a trend is developing where the transition rates from current to delinquent seem to be on the rise again, particularly on vintages originated during the peak of the housing boom. While some borrowers may eventually become current again, the vast majority of current delinquencies likely will lead to either foreclosures or another form of forced sales. Increased foreclosures and/or forced sales will further exacerbate home price depreciation and lead to further delinquencies and “involuntary prepayments.”

Offsetting any pressure that MBS may experience in 2011 from increased delinquencies or prepayments should be the ongoing positive supply/demand characteristics of the market. Underwriting standards, as measured by loan-to-value at origination and FICO requirements, have tightened dramatically since 2007, and they will likely continue to price out many borrowers. (Long gone are the days of zero down and cash back at closing!) At the same time that supply may decrease throughout 2011, demand should remain robust, as the usual suspects—money managers, overseas buyers and banks flush with deposits and declining loan portfolios—eye the relatively attractive yields of agency MBS.

The Commercial Mortgage Market

The commercial mortgage lending market has been picking up traction. Market conditions, notably spread compression driven by strong demand by bond buyers desiring excess spread, are driving issuance. For example, as we discussed last month the CMBS market has priced five multi-borrower conduit transactions totaling $4.2 billion through November 30, 2010, and there are also four conduit CMBS transactions totaling $6 billion in the offing, which would bring the total for 2010 to $10 billion, up from $1.3 billion in 2009. Market participants are forecasting $35 billion of issuance for 2011.

Not to miss out on the market revival, the life companies are stepping up their commercial mortgage lending activities both in terms of loan volumes and asset selection. During November, the American Council of Life Insurers released its third quarter 2010 Commercial Mortgage Commitments bulletin. As we can see in the graph available in our online version, the life companies increased their loan commitment volume by approximately 60% over the second quarter 2010.

The increased production, however, has come at a price of lower coupons for various reasons, but primarily because of overall spread tightening to record low Treasury rates. The chart in our online version also implies that life companies are clearly getting more comfortable with commercial real estate at these levels, but this may simply be because there are fewer investable options that generate acceptable returns. Thus, these lower coupons are coming at a cost. As the graph in our online version shows, the excess spread over high-grade (HG) corporates has narrowed significantly to approximately 100 bps. This excess spread is required compensation for commercial mortgage investors because of the added costs of origination—personnel, regulation, illiquidity, etc. There is a floor as to how low mortgage coupons can be originated given these costs, and they are getting very close to that floor. At this juncture, in order to meet their return requirements life companies will either have to change their risk profile or, if they can’t, restart securitization vehicles. Either way, 2011 should be productive for the commercial real estate mortgage market.

The Corporate Credit Market

Risk premia rose across the credit spectrum in November: The corporate credit markets staged a modest correction in step with rising fears of municipal and sovereign contagion. Investment Grade (IG) and High Yield (HY) bond returns declined for the first time since May. IG returns were most affected by the backup in Treasury rates that greeted the official launch of QE2. HY spreads widened 18 bps due to indigestion from a heavy calendar and mutual fund outflows. In contrast, loan fund flows remain robust, a technical which contributed to leveraged loans’ standout relative performance of a 0.35% return. However, the liquid sector, as measured by S&P’s LCD flow-name index, witnessed a 0.4% decline in price.

November also marked the revival of two market phenomena widely associated with the last cycle’s peak: collateralized loan obligations (CLOs) and leveraged buyouts (LBOs). Over the course of the month, four CLOs were priced and a number of LBOs were either announced or financed. The casual observer may be thinking “short memory,” however, it is different this time.

To understand how CLOs could return so soon after triple-A note holders experienced spreads in excess of 600 bps just over a year ago (see the graph in our online version), requires a bit of compare and contrast. CDO leverage was significantly lower than structured finance CDO leverage. Moreover, post recession collateral performance trends have reversed course, unlike non-agency mortgage collateral. The loan default rate has dropped to 2.3% from a peak of 9.6% and surviving triple-C’s are edging up into single-B-land. As a result of these underlying collateral trends, the secondary CLO market has turned the corner both in price performance and rating agency trends. Current new issue structure is more conservative than its predecessor. Namely, deal leverage is lower and collateral quality constraints are higher. Even with improved structural tweaks, new issue triple-A CLO paper stands out as one of the cheapest assets for the rating in the fixed income universe, significantly lagging behind ABS and CMBS. For example, primary market triple-As are pricing in the Libor +160/170 area, versus mid-2006 levels of Libor+25 bps.

Financial sponsors have been busy creating supply for CLOs. This, of course, is not intentional but debt market capacity is the linchpin to a LBO. Both loan and bond investors have become more comfortable reaching down the risk spectrum, making LBOs more viable. Unlike CLOs, the performance of legacy LBO debt is highly varied, specific to each transaction. However, like new CLOs, the current crop of LBOs is less leveraged than their peak-cycle counterparts. Interestingly, even though bank debt and bond spreads are materially wider than 2005-07, all-in debt financing costs are in a similar ball park due to depressed LIBOR and Treasury rates. With the Treasury market in reversal mode for the time being, stay tuned.

The Treasury/Rates Market

With all of the scary headlines out there, one could have expected Treasury yields to continue their move to record lows but that was not the case. The weakness that had crept into the long end of the market during late September/October finally made its way down the curve as we saw higher yields across all maturities.

Auction sizes stayed steady for the month, as the total of $171 billion nominal issues that came to market was about the same as the prior month. The results were mixed as accounts favored the short end with the two-year and three-year auctions seeing the strongest demand. The 30-year auction seemed to be the toughest as market participants continue to shy away from that sector which resulted in a weak bid to cover reading. The 5-year and 7-year auctions also stood out; they both had weak results because the amount of indirect bidders has been trending lower over that last two months. Indirect bids are usually a good gauge of foreign demand and the 5-year and 7-year sector had seen increasingly strong readings during the summer/fall period as the market rallied, but as you can see on the chart in our online version below the trend has reversed course in October and November. We will continue to monitor the level of indirect bids in the coming auctions to gain a sense of whether or not this dip is temporary.

On November 3, the FOMC announced the widely expected QE2. The market had rallied in anticipation of this next round of purchases but the announcement turned out to be more of a Sell-the-News event. The belly of the curve (5-10 year sector) had led the way higher (lower yield) into November as the Fed had concentrated the majority of its purchases in that area. The actual announcement was not enough to keep the market bid as the 5-year hit its record low yield on November 4^th but has yet to see that level again. As you can see in the chart, available in our online version, the Fed has significantly increased the size of its purchases in November while the yield on the 5-year has also increased. The 5-year to 7-year sector had outperformed the market on the way up and is now underperforming on the way down as inflation worries and concerns over the efficacy of QE2 have outweighed the Fed’s ability to buy Treasurys.

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. ©2010 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.