NEW YORK--(BUSINESS WIRE)--
Annaly Capital Management, Inc. (NYSE: NLY) released its first quarter
2012 market commentary providing a review of the economy and the
residential mortgage, commercial mortgage, asset-backed, corporate
credit and treasury markets. 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.
Policy
The first quarter of 2012, like the fourth quarter of 2011, was
characterized primarily by heavy central bank activity. The Federal
Reserve (Fed) continued with Operation Twist, which is currently
scheduled to end in June 2012. The ECB completed its second tranche of
Long-Term Refinancing Operations (LTRO) in February, and has provided €1
trillion ($1.3 trillion) of liquidity across both tranches. The Bank of
England added an additional £50 billion ($80 billion) in February to its
existing quantitative easing program, bringing it to a total of £325
($520 billion). The Bank of Japan recently expanded its asset purchase
program to ¥65 trillion ($784 billion) to be completed by the end of
2012, as well as upsizing its “Growth-Supporting Funding Facility” to
¥5.5 trillion ($66 billion) from ¥3.5 trillion.
All together, the four major central banks added over $300 billion of
new assets in the first quarter of 2012, and $1.6 trillion over the last
year. With financial conditions more stable, it appears that central
bank balance sheets are deploying to jumpstart employment and other
economic activity. The transmission mechanism of this lever, however, is
not so simple, as Chart 1 of our online
commentary demonstrates. Monetary policy is not
a panacea, believes Fed Chairman Ben Bernanke, and without employing a
counterfactual—“it would have been much worse without it”—a empirical
evidence would seem to agree. (Looking at Chart 1 in our online
commentary, it is easy to see the attraction of the gold standard,
or something like it, for governing monetary policy: with an objective,
apolitical delimiter on central banks, such mind-boggling credit
creation would not be possible.)
Time horizons get distorted in a crisis. When you’re staring down the
barrel of a gun, everything’s immediate. Monetary policymakers stuck at
the zero bound in the middle of a great deleveraging aren’t much
different: they try to fix the problem at hand but can’t predict the
long-term consequences of their actions. But “financial repression”—the
concept that describes the central bank’s role in a government’s
manipulation of the price, supply and demand of credit for its own
purposes—comes chock full of political connotations which become more
acute during this year of government elections/transitions in Europe,
China and the US.
People are not happy with the results: Riots in Spain and Greece, labor
agitation in China and demoralized workers dropping out of the work
force in America. Everywhere, it seems, governments are dealing with
intractable structural deficits and rising levels of debt by either
punishing their citizens for their own mismanagement (expensive social
programs help win elections but can’t go on forever) or kicking the can
down the road. Neither solution is without consequences. Either the
recession is magnified by severe austerity measures that won’t work or
demand is brought forward through government-supplied incentives, but in
both cases the market never finds its clearing price. Skeptical market
participants see this happening on a micro scale—think of “cash for
clunkers” or the many government efforts to “fix” housing finance—as
well as a macro one. Cautiously pessimistic about how this will all turn
out, we are mindful of the fact that politics will always be trumped by
economics.
The Economy
The effect of central bank-fueled liquidity on financial markets has
been obvious. The S&P 500 was up 12.6% in the first quarter, gold was up
6.7%, crude oil up 3.6%, gasoline futures were up 18.5%, and even the
Barclays Aggregate Bond Index managed to gain 0.3%.
Less obvious were the effects of central bank activism on the US
economy. Most of the incoming economic data have been mixed, but as we
look at the Fed’s headline performance as benchmarked by its dual
mandate of stable prices and maximum employment, it seems the Chairman
would have reason for satisfaction. The unemployment rate has steadily
declined to 8.2% from near 10% as recently as late 2010. Employment has
continued to grow, although the pace is slower than hoped and the trend
was lower throughout the quarter: +275,000 in January, +240,000 in
February, and +120,000 in March. Inflation as measured by the FOMC’s
preferred metric, the core PCE Index, has leveled out at around 1.9%.
This is supported by inflation expectations, as measured by 5-year TIPS
breakevens, of 2.05% at quarter end. These are about as close to 2%, the
Fed’s newly-minted inflation target, as one could ever hope to get. In
any event, there seems to be a fair amount of dissent among the ranks.
Chairman Bernanke was seen as dovish in his recent television interview,
but this clashed with the March 13 FOMC meeting minutes which were
viewed as hawkish by comparison. Several regional reserve bank
presidents (including Williams, Lacker and Lockhart to name a few with
voting power) recently gave speeches indicating that the bar for further
easing is now higher. The debate comes down to the sustainability of
recent growth in jobs and the economy, and the ability of monetary
policy to fix problems like long-term unemployment.
In general, the momentum of economic outperformance that started 2012
has faded, at least as measured by the Citigroup Economic Surprise
Index, which stood above 90 in early January before closing the quarter
at 18.9. Notably weak was personal income, specifically real disposable
personal income (RDPI), the kind that’s available to spend after Uncle
Sam takes his cut and inflation deducts its invisible tax. Through
February 2012, RDPI is up only 0.32% year-over-year. This is well below
the already weak 1.8% pace in 2010 and the still weaker 1.3% 2011 gain.
What is worse is that RDPI per capita has turned negative
(down 0.4% year-over-year) and is stuck at 2006 levels. Call it a lost
decade for household income growth. As Chart 2 in our online
commentary shows, the only time the 5-year growth rate has been
lower is 2009, but that was due to a spike in personal income in
December 2004 driven
by a one-time Microsoft dividend. On an organic basis, the trailing
5-year growth rate has never been lower. This suggests that total real
disposable personal income growth will be driven by population growth,
which is itself slowing versus historical trends (currently 0.73% versus
an average north of 1% since 1970).
Real personal consumption expenditures nevertheless plow ahead at the
expense of the savings rate, which now stands at 3.7%. This is down from
crisis-induced highs north of 6%. While this rate is above the 2.2%
average of the debt binge years of 2005-2007, it is about half the
historical average of 7% since 1959. Low interest rates drive a
preference for current period consumption over future consumption, which
is exactly what we are seeing in the monthly income and spending data.
Perhaps this is what the Fed is aiming for with a 0% interest rate on
savings?
Residential Mortgage Market
Mortgage spreads, as measured by the 30-year Fannie Mae current coupon
minus the 10-year US Treasury, finished the quarter 8 basis points (bps)
tighter than where it began. There was, however, volatility, as spreads
ranged between 65 bps and 92 bps, primarily driven by the uncertainty in
Europe and news on domestic mortgage issues.
On March 12, the United States along with multiple state attorneys
general filed servicer settlements with Bank of America, JP Morgan
Chase, Wells Fargo, Citibank, and Ally for approval in Federal Court.
The total settlement was for $25 billion and will be allocated four
ways: 1) $17 billion for credits towards principal reductions,
forbearance, and costs to facilitate short sales, 2) $3 billion to
refinance underwater borrowers current on their payments, 3) $1.5
billion to provide cash payments to borrowers who were foreclosed on
between January 1, 2008 and December 31, 2011, and 4) $3.5 billion to
pay states to fund consumer protection efforts. In addition the
settlement cleared what has been a major impediment to refinancing over
the past several years, the treatment of existing second-liens. Prior to
the settlement, second lien holders (which were also in many cases the
servicers themselves) were unwilling to subordinate their encumbrance,
thus preventing a refinance of the first lien. Under the settlement,
banks will be able to share losses on their second liens with first lien
bondholders and receive credit toward the cash they pledge to spend in
settlement. This change incentivizes banks to subordinate second liens
and refinance first liens, as well as assists in the processing of
foreclosures.
The dollar amounts of the settlement, in general, are small, but even so
the impact needs to be put in context. From a historical perspective
prepayments are tame relative to prevailing interest rates. Chart 3 of
our online
commentary illustrates historical prepayment speeds on mortgages
with 100 basis points of rate incentive. The time series adds 100 bps to
the 30-year Fannie Mae Current Coupon (which represents where current
mortgages are being originated) and looks at the prepayment rate for
mortgages at that rate level. For example, in March 2012 the current
coupon was approximately 3%, and the prepayment speed on 4% mortgages
was 22.1%. In contrast, in July 2003 the current coupon was
approximately 6% and the prepayment speed on 7% coupons was 67.1%. What
should be obvious from Chart 3 in our online
version is that interest rates have never been lower and speeds on
collateral with substantial rate incentive have rarely been slower,
certainly prior to the credit crisis.
Commercial Mortgage Market
The first quarter of 2012 saw a continuation of the global rally for
many credit-sensitive asset classes. The legacy CMBS market has been no
different, although there has been some differentiation up and down the
credit stack and across vintages. For example, more seasoned vintages
from 2005 and 2006 are anywhere from 5 to 12 bps tighter than bonds with
less seasoning.
Moving down the capital stack requires more dexterity, as the key issue
is which holder owns the fulcrum bond for the overall transaction, that
is, the position that would enable the holder to either retain the
Special Servicer designation for the entire transaction or gain the
special servicing designation in the event they become the controlling
class representative. A premium is embedded in the securities’ pricing
to account for the special servicing fees that could be realized.
However, the buyer must determine the amount of time loans will remain
specially serviced and generate fees versus when ultimate resolution of
the loan will occur and its recoverability. Interestingly, many holders
of these classes were insurance companies. While these firms, if they
are still the holder, have little interest in being the controlling
class representative, the premium does offer potential resale value
beyond the potential credit performance of the underlying collateral.
Previously, we speculated that the rally in credit spreads, which in
turn drives down the cost of financing, spurs transaction activity. In
Chart 4 in our online
version, we note that transaction activity has increased by over
327% since 2010 as mortgage coupons have dropped by approximately 168
bps. Reviewing data back to 2001, we can see that as mortgage coupons
dropped following the recessions, transaction volume increased. Clearly,
the benefits of cheap debt cannot be underestimated. However, the spike
in transaction volumes during 2005-2007 is a reminder of how weakening
underwriting standards can distort this relationship. The memory of the
market is such that underwriting discipline has returned and remains in
place, at least for now.
Asset-Backed Market
The asset-backed securities (ABS) market was extremely active during the
first quarter as issuance ramped up sharply. According to J.P Morgan,
total new supply for the first quarter was $49.5 billion, an 89%
increase over the first quarter of 2011. The increased supply came
primarily from the auto segment but also included credit cards, global
RMBS, equipment and “esoterics”. The esoteric segment was particularly
active this quarter, consisting of deals ranging from structured
settlements and drug royalties to Domino’s Pizza and servicer advances
with no shortage of demand from yield-hungry investors. The only segment
with a reduction in issuance was the student loan segment. It’s not just
issuers who have done well in ABS, but investors have as well. Demand
was very strong: 26 deals were upsized by a total of $9.7 billion
between announcement and pricing, and spreads in the consumer ABS
segment rallied sharply during the quarter.
From a fundamental perspective, ABS is also performing well. Collateral
backing the credit card, equipment and auto segments continues to
improve. Fitch reported that cumulative net losses in the prime auto
space hit a new low in February, but the same can’t be said for subprime
auto paper. While default rates for recent vintage (2010-2011) prime
deals are at record lows, default rates in the subprime auto segment are
worsening. S&P reported strong performance in the credit card sector,
with improvement in most of the performance metrics (payment rate,
delinquencies and charge-offs).
Overall, the ABS sector generated strong excess returns over the
Barclays Aggregate for the quarter. Barclays reported that the excess
returns for the ABS index was 1.20% for the first three months of 2012,
with the AAA-rated credit card, auto and utility sectors earning excess
returns of 1.23%, 1.18% and 1.16%, respectively. The home equity sector
had an excess return of 3.95% for the quarter which eclipsed all other
segments, while the manufactured housing segment had an equally
impressive excess return of 1.70%.
Corporate Credit Market
Financials were the star performer of the U.S. credit market last
quarter. There are many reasons why this sector is so important, as its
future direction will help set the stage for the overall corporate
market’s performance for the balance of the year. First, the sector is
large, accounting for a third of market value and 41% of trading volume.
Second, it is extremely high beta; for example, the three-year financial
intermediate bond total return beta is a hefty 1.3x. Third, inasmuch as
financial credit pricing is a proxy for the overall vigor of the
financial system, it is arguably a driver of economy activity.
The markets have been on a fatigue-inducing round trip over the past
several months. In Table 1 of our online
version, we show returns, yields, and option-adjusted-spreads (OAS)
across several fixed income sectors. On an annualized basis, investment
grade financial bonds posted a spectacular annualized return of 19.4% in
the first quarter, a reversal from a massive underperformance to
investment grade non-financials in the second half of 2011. As the table
in our online
version shows, financial bond returns have been as volatile as high
yield, despite respective credit ratings of A2 and B1. The favorable
interest rate backdrop supported all credit sectors; notice that while
spreads are still wider than June of 2011, yields are not.
Several catalysts drove the outperformance of financials. Foremost, the
success of the ECB’s LTRO in alleviating refinancing risk and funding
pressures in the EU removed a significant near-term tail event. As noted
above, banks reached a $25 billion foreclosure-gate settlement, thereby
removing the uncertainty as to the size of the costs. The Fed’s stress
test generally went smoothly; those shown deficiently capitalized under
a recession scenario were found so mainly because of premature plans to
return capital to shareholders. Finally, the macroeconomic data have
shown some improvement, particularly on the all-important jobs front.
Given this year’s break-neck speed of spread and credit default swaps
(CDS) tightening, financial credit’s risk/reward proposition is a lot
less compelling than it was back in December. A popularly held belief is
a more regulated and de-risked banking sector would propel financials to
converge towards their tighter industrial counterparts. This thesis has
yet to play out in a consistent manner. Credit ratings remain on a
downward trend. Next month, Moody’s is expected to complete its review
of banks with global capital market operations. It’s quite likely that a
number of U.S. bank holding company ratings will migrate down to
triple-B.
Treasury/Rates Market
In Treasuries, the first quarter was mostly range-bound. Shown in Chart
5 of our online
version are 10-year yields over the past year, and it is clear that
they have oscillated in a tight 30 bps window for most of the first
quarter, which is where they were for much of the third and fourth
quarters of 2011. Economic data showed reasonable health highlighted by
the non-farm payrolls and a further drop in unemployment. Contagion from
Europe simmered down as progress was made with the Greek sovereign debt
resolution, although investors have certainly kept their guard up. The
range ultimately broke with a move to higher yields in mid-March.
Auction sizes remained steady with $501 billion in issuance of nominal
notes and bonds. The auctions proceeded without too much excitement,
with reasonable demand. Broadly speaking 2-, 3-, and 10-year auctions
were well supported while 5s, 7s, and 30s were more mixed.
The focus of the quarter can be boiled down to the market’s evolving
expectations for Federal Reserve policy with the coming expiry of
Operation Twist. Despite some overall economic improvement and some less
dovish Fed rhetoric, the market traded with reasonable confidence that
the Fed would engineer a new phase of easing, either more Operation
Twist or more balance sheet expansion. The game changed after the March
13 FOMC meeting where the Fed made clear that the onus is on the data
(and arguably systemic risk from Europe) to justify additional policy
action. Further, the Fed clarified that its commitment to near-zero
rates is not iron clad, but is rather an expectation. While the Fed will
maintain its enhanced balance sheet for the foreseeable future as well
as its near-zero interest rate policy, the training wheels are off for
the time being as it relates to continued easy policy action from the
Fed. The Fed is certainly mindful of the rise in rates but mostly in the
context of broader financial conditions which are otherwise still
healthy (stocks, credit spreads, etc). For now, other central banks have
taking the baton to some extent, notably the ECB. As the quarter drew to
a close and April brought some new data, the market was reminded that it
is still too early to get too confident on any forecast for the future.
Stay tuned.
*Please direct media inquiries to Jeremy Diamond at (212)696-0100
This material is not intended to be relied upon as a forecast,
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sole discretion of the reader. ©2012 by Annaly Capital Management,
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Annaly Capital Management, Inc.
Investor Relations
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www.annaly.com
Source: Annaly Capital Management, Inc.