NEW YORK--(BUSINESS WIRE)--
Annaly Capital Management, Inc. (NYSE: NLY) released its first quarter
2011 market commentary. Through its quarterly commentary Annaly
expresses its thoughts and opinions on issues and events it monitors in
the financial markets. Please visit our website, www.annaly.com,
to view the complete commentary
with charts and graphs.
Washington Watch
The first quarter of 2011 may not have had the fireworks of the third
quarter of 2008, but it certainly ranks among the more eventful for
markets, the economy and policy. Regional events around the world had
global consequences, as Japan suffered a terrible earthquake, tsunami
and nuclear crisis; European peripheral sovereign credit concerns
reemerged, with yields on Greek, Irish, Portuguese and even Spanish debt
reaching new highs amid a slew of rating Agency downgrades; and several
countries in the Middle East and North Africa erupted in revolution and
protest, toppling governments and instigating civil turmoil. Oil prices
responded by rising to over $100/barrel, currency values fluctuated and
commodity prices rose.
Overlaying these events was the execution of a second round of
large-scale asset purchases (otherwise known as Quantitative Easing 2 or
QE2) by the Federal Reserve—and the resulting positive portfolio channel
effects in financial markets—as well as the extraordinary budgetary
imbalances at every level of government in America. On this last point,
the partisan wrangling and brinksmanship over the deficit at the Federal
level brought the government to within an hour of a shutdown. These
developments in Washington will continue to be on the radar screen for
market participants in the quarters ahead. (There will be more partisan
bickering in the debt limit debate. Treasury has said it will run out of
money by May 16 at the latest, and Congress is taking the last two weeks
of April off….so expect this to also go down to the wire.)
But life is what happens to you while you are making other plans (as
John Lennon famously said), and in the case of policymakers the other
plans include a raft of activity related to our nation’s system of
housing finance. First, in February the US Treasury Department released
its white paper on housing finance reform. "Reforming
America's Housing Finance Market" was a summary document that
had some basic thoughts on the short term (ie, lowering the conforming
loan limit for the Government Sponsored Enterprises) and reducing the
government’s role in housing finance, but contained little by way of
prescriptions for the timing and direction for long-term reform of the
housing finance system. Instead, it offered three alternative directions
for reform while expressing no preference for any of them. That said,
the white paper was unequivocal in the government’s support for any
current and future guarantee obligations of Fannie Mae and Freddie Mac.
Second, in March, regulators, as required by the Dodd-Frank Act,
proposed rules on the definition of a Qualified Residential Mortgage
(QRM). In brief, securitizers of QRMs will be exempt from a requirement
to retain 5% of the credit risk. In the process of defining
QRM—currently set at maximum loan-to-value of 80% with standardized
debt-to-income and product requirements—regulators are essentially
trying to align the economic interests of the parties to a
securitization. As this effort to find the right balance between credit
availability and credit risk is tantamount to mortgage credit rationing
(those borrowers who fall within and outside the QRM rules will likely
have differently priced mortgages), we expect to see a lot of discussion
on this topic going forward. As it is currently written, only about 20%
of the Fannie Mae and Freddie Mac pool of borrowers were underwritten to
QRM guidelines (see graph in online
version). The rule will likely not be finalized until this summer at
the earliest.
Third, the House Financial Services Committee, now led by the Republican
majority, began to follow through on its ambitions to tighten the
government’s grip on Fannie Mae and Freddie Mac and introduced eight
different bills to do so. Fannie Mae and Freddie Mac are still operating
in conservatorship and receiving government funding for their losses in
order to maintain positive net worth. Collectively, the bills mostly
codify some of the ideas and themes from the Treasury’s white paper; it
is likely there will be more bills forthcoming from the Committee as it
considers a legislative framework around the Treasury’s white paper
proposals.
In sum, there will likely be more headlines, rulemaking and proposals
with regard to housing finance policy going forward. However, with the
backdrop of a still-weak housing market and a fractious political
environment, not to mention other systemically important issues to
consider, we expect little traction on finding a consensus anytime soon.
The Economy
As discussed above, the first quarter had more than its fair share of
geopolitical and geological disasters, but the markets were resilient
and mostly took these events in stride.
Behind each of these crises was a central bank somewhere providing
support for risk assets: The ECB is supporting the Euro sovereign debt
market, the Bank of Japan has pumped an unprecedented amount of cash
into their markets nearly overnight, and the entire G7 contributed to
holding the Yen down.
Here in the US, the Federal Reserve (the Fed) continues its $600 billion
large scale asset purchase program which is supporting bond and equity
markets alike. The obvious worry is that this brand of monetary policy
could stoke inflation. Beyond record gold prices, certain measures of
inflation expectations have moved up recently. The chart in our online
version shows the 5-year breakeven inflation rate as expected by the
TIPS market.
Despite its relatively low levels, the trend is not the Fed’s friend in
this case, and some members of the FOMC seem to have noticed. In fact,
several governors have taken the discussion of monetary policy to the
public stage in recent weeks and the lively internal debate over the
future of QE2 and monetary policy is spilling out through the various
channels of Fedspeak. This is confusing but healthy; few things are more
dangerous than an intellectual consensus.
Based on the Fed’s preferred measure of Core PCE, inflation has yet to
show itself in any meaningful way, and the committee expects it to
remain so. Even if you drive and eat, headline CPI is currently 2.1% and
the index only just broke through its July 2008 high in January of 2011
(meaning that its 2.5 year growth rate is essentially zero). However,
recent commodity price action suggests that it may not remain so benign.
Chairman Bernanke calls this inflation transitory,
but Wal-Mart
CEO Bill Simon disagrees: “Every single retailer has and is paying
more for the items they sell, and retailers will be passing some of
these costs along. Except for fuel costs, U.S. consumers haven’t seen
much in the way of inflation for almost a decade, so a broad-based
increase in prices will be unprecedented in recent memory.” He goes on
to say, “No retailer is going to be able to wish this new cost reality
away.”
Inflation worriers also look at excess reserves held at the Fed as being
the dry tinder that will combust into an inflationary pyre. Under the
money multiplier theory, banks will sharply increase credit creation and
thus inflation when it puts those reserves out into the economy. Jan
Hatzius of Goldman Sachs differs on this point. “[M]ost bank loans have
long been primarily funded from sources other than deposits subject to
minimum reserve requirements,” he wrote. “This means that bank lending
was not constrained by the availability of reserves even prior to the
increase in excess reserves. Relieving a non-existent constraint cannot
be important for credit creation or inflation.”
Another salve to inflationists is that wage growth has remained well
behaved in recent months, as the graph in our online
version illustrates.
Weekly earnings growth has stayed relatively well anchored to below 3%
in recent months. While this is not a positive outcome for American
households, a breakout in inflation while wage growth is so low would be
a truly unique event in our short economic history. Nevertheless, we are
staying tuned to measures of inflation expectations.
The Residential Mortgage Market
Amidst the various potentially market-moving headlines during the
quarter, Agency mortgage-backed securities proved to be resilient. As
illustrated by the graph in our online
version, any widening of the spread between the par-coupon mortgage
and the yield on the 10 year U.S. Treasury was short-lived.
In the mortgage market, market participants react to any new headline
with an estimate of its effects on prepayment speeds and convexity. The
contents of the Treasury’s white paper were generally in line with
market expectations, and were thus ultimately a non-event, although
participants focused on the potential ramifications of lower conforming
loan limits and higher guarantee fees. The second significant headline
this quarter was related to FHFA extending Homeowner’s Affordable
Refinance Program, or HARP. HARP was an initiative by the Obama
administration designed to assist in lowering homeowner’s mortgage
payments via rate reduction or principal forbearance. The program was
scheduled to expire on June 30, 2011; however, on March 11 it
was extended by one year with minor changes. A HARP-induced acceleration
in prepayment speeds has long been a concern of mortgage investors since
the implementation of the program, yet HARP has been largely
unsuccessful to date: of the 6.3 million refinances since the program’s
inception only 564 thousand, or 9%, can be attributed to HARP
refinances. Thus the market largely shrugged this off as well.
Mortgage spreads narrowed even after the March 21 announcement by the
Treasury that it would begin winding down its portfolio of approximately
$142 billion of Agency mortgage-backed securities at a rate of $10
billion per month. The tightening can be attributed to basic technical
factors. The Treasury’s portfolio is still considered relatively small,
and net issuance continues to remain low.
The Commercial Mortgage Market
The release of the notice of potential rulemaking on qualified
commercial real estate mortgages gave the market a case study in the
possible ramifications of legislation.
For months, commercial mortgage-backed securities (CMBS) participants
lobbied Congress and regulators to permit the B-piece or equity tranche
investors to satisfy the 5% risk retention requirement for newly issued
transactions, the theory being that the B-piece buyer is the
retainer of risk. Ultimately, the proposed rule contained this
provision. The requirement could be satisfied provided the buyer paid in
cash for the bottom horizontal position, and the buyer had to perform a
credit review of each asset in the pool. There were a few other
provisions added to the rule, including a requirement for transparency
for the B-piece buyer, disclosure of the purchase price for the
securities and limitations on selling and transferring the risk.
Much like in the residential space, the purpose of these requirements is
to create a long-term alignment between the issuers and their product.
Indeed, if the proposals described herein had been in effect during
2005-2007 we believe there would have been much less speculative CMBS
created. Thanks in large part to the CDO machine, a B-piece investor
could immediately transfer its acquisition and, by extension, the risk
to the non-recourse finance vehicle. The cash proceeds from the CDO
would nearly eclipse any investment by the B-piece investor, and enable
B-piece investors to transfer the risk, thus circumventing the intent of
the proposals. Interestingly, very few commercial mortgages originated
over the past few years would qualify under the “qualifying” category,
so the B-piece investor solution was welcomed by the market.
The problem is that regulators added a new directive to the risk
retention language that caught the market by surprise. The provision
would require the funding of a “premium capture cash reserve account,”
in which an issuer who sells CMBS for more than the par value of the
transaction—essentially the profit in the transaction—pays those excess
proceeds into a reserve account that serves as a first loss piece
subordinate to the B-piece. This account would prevent issuers from
immediately monetizing the profit created through issuance of
interest-only securities (IOs). Analysts at JP Morgan put it this way:
“[T]he introduction of the premium capture cash reserve account makes
the economics of issuing CMBS infeasible using traditional structures.
Furthermore, if enacted, the likely second-order effect would be that
pricing across the capital structure would change to such a great extent
that B-piece buyers may no longer be interested in participating.”
Risk retention regulations for the securitization market are clearly
necessary. But while the intent of this regulation is to create long
term alignment, this provision could have unintended consequences. It is
still early days in the comment period on the proposed rules and this is
one provision that will likely be reviewed.
The Corporate Credit Market
Not only has QE2 helped support financial asset prices, but as the
central bank takes out Treasury bond float, corporate issuers have
stepped up to fill the void. Since QE2 commenced, supply has been robust
across the sub-sectors of investment grade, high yield and leveraged
loans at record lows in yields. Hence, the Fed’s effort to propagate the
virtuous cycle of liquidity has had a quantifiable result: improved free
cash flow of corporate America.
The low return on cash continues to support demand for fixed income
assets, and in credit demand creates supply. High yield issuers sold a
record amount of bonds in Q1-2011, a massive $107 billion, or nearly 9%
of the market size. Further up the capital structure, leveraged loan
origination also improved dramatically from 2010, thanks to deep bids
from CLO managers and funds. At $137 billion, first quarter loan new
issue volume grew a hefty 216% year-over-year. In investment grade, the
multi-tranche, multi-billion dollar industrial issuer propelled overall
index-eligible gross supply to $210 billion, up 12% year-over-year.
Investment-grade financial issuers, in contrast, reduced new issue
activity by 2% year-over-year.
The use of proceeds for the majority of speculative grade new issuers
remains debt refinancing. While the old trend of high-yield bond tenders
continues, a new trend emerged in the first quarter. Loan issuers began
to aggressively call loans and refinance them at much tighter spreads
and LIBOR floors (the market’s prepayment rate is 39% vs. 15% in 2010).
For leveraged companies, the resulting decline in interest expense can
have a meaningful impact on free cash flow. Arguably, this is the kind
of positive feedback loop on Bernanke’s wish list. “Easy money” has yet
to transmit into excessive leverage: the institutional loan market has
contracted 2% this year, while the amount of high yield and investment
grade bonds outstanding are up 3% and 4%, respectively. Low rates and
the debt recycling machine are among the biggest fundamental positive
supporting the corporate sector. Moreover, firms continue to deleverage
balance sheets, albeit at a slower pace than any point in the current
expansion. Balance sheet liquidity remains strong as evidenced by
termed-out debt capital structures and extreme cash balances. While
margins have likely peaked for the cycle, higher top line growth can
support higher levels of future EBITDA. While a couple of name-brand
companies recently filed Chapter 11 bankruptcies, the driver was
technological obsolescence. More broadly, S&P estimates a mere 1.9%
corporate default rate at year-end.
As far as corporations are concerned there is another component of the
“liquidity story” that underscores the change in the post credit-crisis
landscape. Corporate cash balances remain near record levels. One reason
is that firms have become less reliant on banks for revolving lines of
credit and commercial paper back stops. Non-financial commercial paper
outstanding is just $108 billion for U.S. companies. Casually, one might
expect a “return to normal” with such robust capital markets. However,
under Basel III, banks will be required to hold liquid assets against
unfunded commitments. One CEO avowed that as a result his bank would
ration credit and charge higher prices. So, the high “liquidity” on
corporate balance sheets may not be transitory but a more or less
permanent feature of their funding strategy.
The Treasury/Rates Market
The events of the first quarter were the main drivers of the price
action in the Treasury market. Yields on 10-year Treasurys traded in a
relatively tight trading range even though equities have continued to
march higher. Yields reached their peak in early February heading into
and shortly after the release of the January unemployment report, but
the 3.75% level brought in the buyers as tensions in the Middle East and
North Africa (MENA) became more prevalent. The rally continued into mid
March as the radiation fears out of Japan caused whatever shorts were
left in the market to capitulate around the 3.15% level.
Auction sizes were steady for the quarter. There was a total of $501
billion of new nominal issuance, but results varied across the curve.
January saw good demand for the entire curve during the auctions except
for the 30-year as the market needed a slightly higher yield to take
down $13 billion of longer term bonds. In February we saw similar
results but the one outlier was the 5-year where weak demand from end
users caused a higher than expected rate. March was an interesting month
on the auction front as results from the first round of auctions early
in the month differed greatly than the second round at the end of the
month. The 3-year, 10-year and 30-year were all well received and demand
statistics were strong. Toward month end, however, the 2-year auction
surprised many when the auction rate results came cheaper than where the
issue was trading at the auction deadline. That was the first time that
had happened in almost a year and caused the market to sell off. The
5-year and 7-year both followed suit with higher auction rate results
than expected as bidders demanded higher yields. The results helped
Treasurys extend their 9-day losing streak into month end.
Fedspeak ratcheted up in the first quarter, from both hawks and doves,
adding to the volatility around market expectations for when the Fed
will move the target rate. The best gauge for these expectations is to
look at the Fed Funds futures contract. If we look at the March 2012
contract which is cash settled a year from now using the 30-day average
of the overnight Fed Funds rate for that month, we see that on Jan 1st
of this year the market fully expected the Fed Funds rate to be at .50%
(see chart below). Rate expectations reached a high in early to mid
February after economic data started to show some promise for the
economy and the hawkish language first started, but as the MENA unrest
escalated and the Japan news first hit, the market made an about face
and priced out the majority of the tightening. The hawkish tone from
some of the Fed Governors then started to pick up more steam as we
headed into the end of March and the 25 basis point hike was priced back
into the market. This time series is notoriously volatile the further
away from the contract date. In the meantime, market participants will
cut through the headlines and the rhetoric and stay focused on what is
important—the economic data and inflation expectations (see graph in our online
version).
*Please direct media inquiries to Jeremy Diamond at (212)696-0100
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(“Annaly”), FIDAC or any other company. Such an offer can only be made
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Source: Annaly Capital Management, Inc.