Annaly Capital Management - Q2 2023

Transcript

Operator (participant)

Good morning, welcome to the Second Quarter 2023 Earnings Call for the Annaly Capital. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing star then zero on your telephone keypad. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. To withdraw your question, please press star then two. Please note this event is being recorded. I would now like to turn the conference over to Sean Kensil, Investor Relations. Please go ahead.

Sean Kensil (Director of Investor Relations)

Good morning, and welcome to the Second Quarter 2023 Earnings Call for Annaly Capital Management. Any forward-looking statements made during today's call are subject to certain risks and uncertainties, which are outlined in the Risk Factors section in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the disclaimer in our earnings release in addition to our quarterly and annual filings. Additionally, the content of this conference call may contain time-sensitive information that is accurate only as of the date hereof. We do not undertake and specifically disclaim any obligation to update or revise this information. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our earnings release.

Content referenced in today's call can be found in our second quarter 2023 investor presentation and second quarter 2023 financial supplement, both found under the Presentation section of our website. Please note this event is being recorded. Participants on this morning's call include David Finkelstein, Chief Executive Officer and Chief Investment Officer, Serena Wolfe, Chief Financial Officer, Mike Fania, Deputy Chief Investment Officer and Head of Residential Credit, V.S. Srinivasan, Head of Agency, and Ken Adler, Head of Mortgage Servicing Rights. With that, I'll turn the call over to David.

David Finkelstein (CEO and CIO)

Thank you, Sean. Good morning, everyone, thank you for joining us for our second quarter earnings call. Today, I'll begin with our performance during the quarter, review the macro landscape and housing market, followed by an overview of our portfolio activity and positioning. Serena will go over our financial results for the quarter, we're also joined by our other business leaders who can provide additional context during Q&A. Starting with our performance, we are pleased with the 3% economic return generated for the quarter, despite elevated rate and spread volatility. To note, we've achieved a 6% return year to date and kept book value largely unchanged, notwithstanding heightened uncertainty caused by the changing path of Fed rate hikes, the regional banking turbulence, and debt ceiling negotiations.

Our ability to manage through this volatility is attributable to our diversified capital allocation, prudent hedge portfolio, and responsible leverage position. Even with the reduction in leverage from 6.4x-5.8x, we again out earned our dividend this past quarter. Now, shifting to the macro environment, despite the banking stress at the onset of the quarter, the U.S. economy has remained on solid footing, with healthy gains in the labor market and economic growth consistent with recent quarters. Inflation was elevated through most of the quarter. However, data began to signal a more pronounced slowdown in June. Lower used car prices and improvement in shelter inflation and a seemingly more price-sensitive consumer have begun to put downward pressure on prices. This should slow inflation more than recent year-end FOMC forecasts of 3.9% in core PCE.

Now, beyond inflation, data during the quarter suggests the likelihood of a soft landing has increased and that the Fed will hold interest rates higher for longer, particularly if the labor market continues to demonstrate resilience. It is likely that the Fed has reached peak interest rate levels for the cycle after yesterday's hike, but upside surprises in inflation readings may lead to an additional hike this year. With respect to the housing market, home prices continue to outperform expectations, as we have now experienced five consecutive months of national home price increases, according to Zillow. Recent momentum has turned positive even in the previously hard-hit areas, as the top 50 metro areas all experienced positive month-over-month HPA in June, with the year-to-date national home prices now up 4.7%.

Market participants were projecting meaningful home price declines, given elevated mortgage rates and low affordability, with the expectation of those factors translating to reduced housing demand. Although transactional activity has declined, the market has been supported by historically low available for sale inventory, as existing borrowers with low mortgage rates are unwilling to trade up or move, given the potential increased payment. Total active inventory was down 10% from last year and currently sits at a very notable 45% below June 2019 levels. Now, before turning to the portfolio, I want to make one point on the banking sector. During last quarter's call, we stated that the main implication of the regional bank stress was that it created an overhang of assets that need to be absorbed by private market participants.

This supply came to the forefront during the second quarter, as the FDIC began selling assets from the SVB and Signature Bank receiverships. The sales weighed on the market for parts of the quarter, but money manager demand and transparency on the disposition process have helped the market digest a substantial portion of the $114 billion in assets already. When you look at the overall performance of the portfolio, the quarter once again looks more benign on the surface than that which actually occurred. As previously discussed, a confluence of market events and the resulting uncertainty led us to believe mortgage spreads would widen. Accordingly, we proactively reduced our agency exposure early in the quarter, with our portfolio declining by roughly $5 billion in notional.

This tactical shift proved beneficial as spreads reached their quarterly peak in late May, and it afforded us flexibility to opportunistically deploy capital across our businesses amidst the volatility. In June, as the debt ceiling resolved and the banking sector recovered, risk-on sentiment reemerged and MBS experienced broad-based outperformance, ultimately driving spreads modestly tighter for the quarter. With respect to portfolio positioning, we continued to rotate into higher coupons, which provide the most attractive nominal spreads. We also reduced our holdings of seasoned intermediate coupons to 15-year MBS. As a result, the average coupon on our portfolio shifted modestly higher to 4.3%, but we remained disciplined in managing our convexity profile through collateral selection. We also took advantage of softer payups to replace over $8 billion TBAs with specified pools during the quarter.

In addition to their favorable prepayment profile, specs provide incremental carry relative to TBAs in the current environment. On the hedging side, the notional value of our hedges declined in line with our assets, though we remained fully hedged. We maintained a slight flattening bias throughout the quarter, as twos, tens, and treasuries exceeded negative 100 basis points, but have shifted to a balanced curve position given the extreme inversion in the yield curve. The diversity of our assets allows us to be opportunistic in our rates exposure as the market stays highly sensitive to income data. Moving to residential credit, spreads tightened and the credit curve flattened on the quarter, driven by a supportive backdrop of limited net issuance, resiliency in the housing market, and a strong consumer.

Benchmark CRT below investment grade spreads tightened 95 basis points on the quarter, while production coupon non-QM loan spreads were 75 basis points tighter, reflecting a declining cost of funds in the securitization market. Our residential credit portfolio ended the quarter at $4.9 billion in market value, down approximately $300 million quarter-over-quarter, given our increased pace of securitization activity. Whole loan purchases remained healthy, increasing 16% relative to Q1, with approximately $750 million in loans settled. We securitized $1.5 billion in loans in the second quarter through our OBX platform, generating $162 million of retained assets. In post-quarter end, we priced our latest non-QM deal, taking advantage of the recent market rally to achieve triple A levels, 20 basis points tighter than at the end of June.

This brings our aggregate year-to-date securitization volume to 8 transactions, totaling over $3 billion. Notably, Annaly has been the largest non-bank securitizer since the beginning of 2022, and second largest overall, including bank issuers. Our securitization activity has been supported by our correspondent channel, which continues to gain momentum despite a challenging landscape for mortgage origination. Our Q2 loan lock volume of $1.5 billion was our largest since inception, and the channel accounted for 85% of our total loan settlements. We maintained a disciplined credit focus, as demonstrated by the current pipeline, exhibiting a weighted average FICO of 748 and an LTV of 68%, as well as limited layered risk. Now, finally, within MSR, we grew our portfolio by $350 million, or 19%, during the quarter through the purchase of 4 bulk packages.

Our holdings now stand at just over $2 billion in market value and $150 billion in unpaid principal balance. The portfolio exhibited another quarter of slow prepayment speeds, paying below four CPR, and delinquencies were unchanged and remained minimal. All told, our strategy of acquiring low note rate, high credit quality MSR continued to deliver predictable cash flows with attractive risk-adjusted returns. MSR trading volumes were strong in the second quarter as market participants efficiently absorbed high levels of bulk supply, a dynamic that we expect to persist for the foreseeable future. Despite elevated supply, pricing has held firm and low WAC MSR valuations improved, driven by the rise in rates, muted prepayment speeds, and modest spread tightening. Shifting to our outlook, we expect the second half of 2023 should provide a more accommodative environment for agency MBS.

While supply and demand challenges will persist, with money managers likely to be the primary buyers of mortgages, net supply from banks is likely to decline as FDIC sales are completed, the Fed nearing the end of its hiking cycle should lead to lower volatility and a potentially steeper curve, making MBS more attractive to investors on an option-adjusted spread basis. I would note that we do expect spreads will stay wider relative to historical averages, given technical considerations, though there is still room for tightening from here. That said, the benefit of agency spreads settling at wider levels is that we expect to earn a healthy yield without employing excessive leverage. As it relates to residential credit and MSR, we're optimistic about the opportunity set within these businesses, and we'll look to grow these strategies responsibly.

In resi, we anticipate further expansion of our correspondent channel as we now have approximately 160 counterparties onboarding, and we expect to benefit from our scale as we further penetrate the market. Post-quarter end lock volume has been strong, with a current expanded credit pipeline of $900 million. In MSR, we're well positioned for opportunistic growth as an established top 20 servicer, and we continue to add partnerships, including new sub-servicing, as well as bulk and flow relationships, and have ample capacity to further leverage our platform. Now, with that, I'll hand it over to Serena to discuss the financials.

Serena Wolfe (CFO)

Thank you, David. Today, I will provide brief financial highlights for the quarter and six-month period that ended June 30, 2023. Consistent with prior quarters, while our earnings release discloses GAAP and non-GAAP earnings metrics, my comments will focus on our non-GAAP EAD and related key performance metrics, which exclude PAA. Many of the themes we discussed in the first quarter continued to play out in Q2, we are proud of our strong earnings and economic return considering the challenging market. Our book value per share for Q2 was relatively unchanged from the prior quarter at $20.73. As David mentioned earlier, with our second quarter dividend of $0.65, we generated a positive economic return for the quarter of 2.9% and approximately 6% for the first six months of the year.

Higher rates for the quarter drove gains in our hedging portfolio of roughly $2.26, and in our MSR book of $0.19, while having a modest drag on our agency portfolio, resulting in losses of approximately $2.49 for the quarter. We generated earnings available for distribution of $0.72 per share for the second quarter. Consistent with the prior quarter, EAD was adversely impacted by the rise in repo expense, albeit our swap portfolio continues to mitigate the increase in rates. Average yields ex PAA were 26 basis points higher than the prior quarter, at 4.22%, as we continue to rotate up in coupon this quarter, with 57% of the agency portfolio and 4.5% coupons and higher.

The factors that impacted EAD are also illustrated in NIM for the quarter, with the portfolio generating 166 basis points of NIM ex PAA, a 10 basis point decrease from Q1. Net interest spread declined 17 basis points quarter-over-quarter at 1.45% versus 1.62% in Q1. The continued rise in repo rates impacted our total cost of funds for the quarter, rising by 43 basis points to 277 basis points in Q2, and our average repo rate for the quarter was 515 basis points, compared to 462 basis points in the prior quarter.

As previously mentioned, our swaps impact on the cost of funds improved by 4 basis points due to an increase in average notional, and the swaps portfolio ended the quarter with a net received rate of 255 basis points, compared to a net received rate of 274 basis points in Q1. Turning to details on financing. Funding markets remain ample and liquid. We continue to see strong demand for funding for our agency and non-agency security portfolios. Our repo strategy is consistent with prior quarters, and our Q2 reported weighted average repo days were 44, down from 59 days in Q1, mainly due to the roll down of longer-term trades we referenced during our Q1 earnings call.

The appetite for credit by lenders has also been robust on the warehouse side, and we continue to engage with new and existing counterparties as we look to enhance our dedicated warehouse facilities for our credit businesses at very competitive terms. Given the characteristics and growth of our MSR portfolio, we have significant unplaced assets available that we can utilize to further unlock liquidity. That being said, as of the end of Q2, we had $1.7 billion of unused warehouse capacity across our resi credit and MSR financing facilities, which leaves us in a very comfortable liquidity position for these businesses. Our liquidity profile improved compared to the prior quarter, with unencumbered assets of $6 billion compared to $5.7 billion in Q1, including cash and unencumbered assets of $4.4 billion for the quarter.

The approximately $328 million increase in unencumbered assets primarily came from lower on-balance sheet leverage for agency MBS securities and MSR purchases during the quarter. That concludes our prepared remarks, and we will now open the line for questions. Thank you, operator.

Operator (participant)

We will now begin the question-and-answer session. To ask a question, you may press star, then one on your telephone keypad. If you're using a speakerphone, please pick up the handset before pressing the keys. At any time your question has been addressed and you would like to withdraw your question, please press star and then two. At this time, we will pause momentarily to assemble our roster. Our first question comes from Bose George. Please go ahead.

Bose George (Managing Director and Senior Equity Research Analyst in Financial Institutions Equity Research)

Hey, everyone. Good morning. First, I just wanted to ask about returns, but, you know, for the different groups. I mean, last quarter you had that slide that just showed the blended ROEs. I didn't see that. Is the return kind of the same level as it was last quarter, that, you know, 11.5%-13.5% range?

David Finkelstein (CEO and CIO)

Sure. Good morning, Bose. I'll just run through it real quickly. It's similar. agency, you can call mid to upper teens.

... residential credit securitization through OBX, retaining the triple Bs on down with internal leverage gets you to low to mid-teens, and then MSR unlevered around 10-11%, with internal leverage gets you to 15%. Still healthy.

Bose George (Managing Director and Senior Equity Research Analyst in Financial Institutions Equity Research)

Okay, great. Thanks. Then just on the book value, can you just give us an update quarter to date?

David Finkelstein (CEO and CIO)

Sure. We were up 1% as of last night.

Bose George (Managing Director and Senior Equity Research Analyst in Financial Institutions Equity Research)

Okay, great. Thank you.

David Finkelstein (CEO and CIO)

Thanks, Bose.

Operator (participant)

Our next question comes from Crispin Love. Please go ahead.

Crispin Love (Equity Research Analyst in Consumer and Retail Equity Research)

Thanks. Good morning. Can you just talk about leverage and just how you're positioned in the third quarter? You brought down leverage in the second quarter to levels I don't think we've seen since 2021. Based on your comments, you're optimistic on the environment. Curious if you've begun to bring leverage higher and add agency MBS after decreasing agency early in the second quarter.

David Finkelstein (CEO and CIO)

Sure, sure. Yeah, we troughed at leverage levels, I think, the beginning of 2022. I want to say at 5.7, we ended at 5.8. A fair amount of that is capital allocation. We did add MSR, as I mentioned, $350 million. We committed this quarter to a little bit more. Given the leverage profile of MSR, that does account for about a quarter of a turn of the decrease. We have an active pipeline in resi, which is also less levered. As we sit today, we did add a little bit of mortgages to begin the quarter, we're right at around six turns of leverage, and we really like where we're at. We have ample liquidity.

If there is an opportunity to add mortgages, if they widen, our leverage will organically go up, but we do have capacity to add. We're able to generate the returns we need, with current leverage, with ample liquidity. If you look at our, our spread shocks, you know, our, our improvement in book value isn't materially different, with lower leverage. You know, I think we, for a 25 basis point, spread tightening, we're around 10.4% appreciation versus 10.9% last quarter. We're able to do a lot more, given longer spread duration, with less, and we really like where we sit right here.

Crispin Love (Equity Research Analyst in Consumer and Retail Equity Research)

Thanks, David. That's helpful. Just one other question from me. Just money managers have been vocal and fixed income flows have been positive, kind of in the last quarter or so about the attractiveness of agency MBS. How are you thinking about banks potentially entering the agency market again? Is there a scenario where you'd expect them to become buyers of agency later in the year or early next, or too soon to tell? Do you think banks need to reenter for spreads to tighten meaningfully?

David Finkelstein (CEO and CIO)

To answer the question, will banks be involved this year? Our guess is not. We don't expect to see active selling, but we do think they'll still be run off from bank portfolios. We estimate about another $50 billion in decline in bank MBS holdings by the end of the year. You know, beginning in 2024, we'll see what the outlook looks like and the Fed's posture, but you could see them reemerging at that point. It's just too early to tell. In terms of do we need banks for mortgages to really tighten? Look, it really depends on how money managers are postured. You know, we are at or near the end of the Fed hiking cycle. That does bring about optimism with respect to fixed income.

Yields are elevated and real rates are certainly attractive. Our expectation is that you will see more money coming into money managers, which will provide support. Agency MBS are amongst the cheapest assets in fixed income. Even in addition to new money coming in, we hope to see overweights in agency on the part of money managers, which will certainly support the basis. Another point to note is that, you know, vol is still relatively elevated. The end of the Fed hiking cycle, the passage of significant risk events should lead to a decline in vol, and that'll be very beneficial for the agency basis.

Crispin Love (Equity Research Analyst in Consumer and Retail Equity Research)

Thanks, David. I appreciate the comments.

David Finkelstein (CEO and CIO)

Our pleasure, Crispin.

Operator (participant)

Our next question comes from Eric Hagen from BTIG. Please go ahead.

Eric Hagen (Managing Director and Mortgage Specialty Finance Analyst)

Hey, thanks. Good morning. Maybe a follow-up on the spread environment. I mean, at this point, do you feel like spreads are more likely to widen or tighten into an interest rate rally? Maybe somewhat separately, I mean, how much sensitivity do you see between MBS spreads and bank deposit rates right now? Thank you, guys.

David Finkelstein (CEO and CIO)

In terms of the, in terms of the symmetry, widen versus tighten, we do think spreads should tighten. Not materially, but we definitely feel like given where we're at in the cycle, you know, spreads should come in. We're above fair value. You know, we do look at today's market and compare it to past, past cycles. If you look pre-COVID, where agency spreads were roughly around 75 bps, we're materially wider than that. A lot of that is explained. Factors like volatility is likely to remain more elevated, option cost is higher, given loan balances are higher, mortgage refinancing is more efficient and factors like that.

Lastly, the supply picture is a little bit more negative for mortgages, this environment relative to the last time even the Fed was engaged in QT, just given banks and other factors. Spreads should tighten. We think there's about 15 basis points in spread tightening to get them to fair value. You know, what will be the determining factors I mentioned to Crispin, is where volatility goes. If we get a decline in vol, that's gonna be very beneficial. Should there be some unforeseen event on the horizon and vol spikes, then we would expect some widening. Our view is that they should tighten somewhat. In terms of bank deposits versus mortgages. Look, here's the way I'd characterize it.

A lot of focus has been on money market funds and just the elevated balances in money market funds. That money is potentially dry powder for fixed income investments or other investments. We're looking for money to come out of money market funds and more into longer-term fixed income vehicles to ultimately support mortgages. In terms of bank deposits, you're going to see bank deposits and reserves go down as the Fed withdraws liquidity. Right now, reserves are sitting around three and a quarter trillion. We expect that to decline. It's currently 12% of GDP. By the end of the year, it'll probably be around 10%, 11%, and that's what's going to drive bank deposits.

Again, as I mentioned, previously, we don't expect banks to be buyers of mortgages.

Eric Hagen (Managing Director and Mortgage Specialty Finance Analyst)

Right. Yeah, that's helpful commentary. I appreciate that. Maybe on the MSR, I mean, how big do you think you can get there in light of, you know, the MSR supply hitting the market? What's the tolerance for leverage in the MSR portfolio? I mean, would you ever look to encumber the agency portfolio to basically support leverage for the MSR? Or is the idea to, you know, borrow against the MSR and encumber that, you know, directly?

David Finkelstein (CEO and CIO)

Well, we have a lot of optionality given our liquidity and our and our capital allocation. you know, currently, the MSR portfolio is levered at about 0.3 turns. The way we look at it is a steady state for low WAC MSR, with benign cash flow variability, is it should be about a turn levered. Theoretically, then, the agency portfolio is doing some of the heavy lifting in funding that portfolio, but we have ample capacity for warehouse financing, we continue to grow that. In terms of the trajectory of supply and how the year might play out, let me turn it over to Ken.

Ken Adler (Head of Mortgage Servicing Rights)

Yeah, I mean, the supply has been very steady at roughly, you know, $200 billion of GSE MSR each quarter, with the exception of, you know, the fourth quarter of each year, when, you know, the transaction volume slows down due to GSE constraints at that time of year. When we look at the balance sheets of the sellers, we don't see that supply stopping for the next few quarters. Our relationships are very encouraging that there'll be more coming of the exact sorts of assets we like to buy.

Eric Hagen (Managing Director and Mortgage Specialty Finance Analyst)

Yep.

Ken Adler (Head of Mortgage Servicing Rights)

That.

Eric Hagen (Managing Director and Mortgage Specialty Finance Analyst)

Thank you. Yeah, thank you guys for the commentary. Appreciate it.

Ken Adler (Head of Mortgage Servicing Rights)

Thanks, Eric.

Operator (participant)

Our next question comes from Trevor Cranston from JMP Securities. Please go ahead.

Trevor Cranston (Managing Director and Senior Equity Research Analyst in Industrials)

Thanks. Good morning. David, I think I heard you say you maintained a curve flattening bias sort of throughout the quarter and had moved now to a more balanced curve positioning. Can you elaborate a little bit on how you guys are thinking about the, you know, evolving shape of the yield curve going forward, given that we may be sort of at the end of the Fed rate hike cycle at this point, and it seems like, you know, we could also have a soft landing with the economy? Thanks.

David Finkelstein (CEO and CIO)

Sure, Trevor, and good morning. That is correct. We did have a flattener on for much of the quarter, and we balanced it out towards the end of the quarter here when the curve got extremely inverted. In terms of our expectations, we do expect some steepening in the curve, but it's really important to note that the way the market is priced right now has the two-year note rallying over the next year by roughly 80 basis points. There's a lot priced into the curve. If you put a steepener on in rates, for example, and it doesn't meet those lower rates, then it's not an advantageous trade. Given the fact that we do like a steepening bias, the best way to play a steepener, normalizing for volatility, is long mortgages.

You know, historically, in the absence of a risk on spike in vol type event, agency MBS do very well when the curve steepens, so we feel like we have that trade on through levered agency. In terms of our outlook for rates, you know, given the likelihood of a soft landing, we feel reasonably good about where the rates market is priced. If you look two years out, for example, at the forwards, you know, the entire curve is priced between 3.5% and 4% in Treasury. Rates will come down according to market, and we think that's the likely scenario. We do expect it to be driven more by normalization of rates from a disinflationary standpoint.

You know, the way we look at the market right now, the range of outcomes has narrowed considerably, given where we're at in the cycle. You know, runaway inflation is just far less likely now, given the data we've seen. There are fewer known risks out the horizon, and yields are still quite attractive, particularly real yields at 1.5% on 10 years. The market feels pretty good, but also yields should stay elevated. You know, we did just experience this inflation bout, and we're not just going to go back to where we were in 2018, 2019, or the post-crisis period. Monetary policy is not going to be as active of a benefit for rates, and, you know, real rates should stay positive. And we think they're fairly priced right here.

Trevor Cranston (Managing Director and Senior Equity Research Analyst in Industrials)

Got it. Okay. Very helpful. Thank you.

David Finkelstein (CEO and CIO)

You bet, Trevor.

Operator (participant)

Our next question comes from Douglas Harter from Credit Suisse. Please go ahead.

Douglas Harter (Director and Senior Equity Research Analyst)

Thanks. Can you talk about, you know, how you're viewing the residential credit market? You know, while you mentioned that spreads and securitizations have improved, you know, spreads still remain volatile, and kind of how you're viewing the market and willingness to kind of balance sheet loans, you know, while waiting for securitizations.

David Finkelstein (CEO and CIO)

Sure, Doug. Look, as I mentioned in my prepared comments, resi has had a very good, set of performance quarters here. It stands to reason. Housing's done reasonably well, far better than our expectations. There's also a scarcity of supply in residential credit, unlike the agency market. We understand why spreads have tightened. To elaborate, Mike can jump in here.

Mike Fania (Deputy CIO and and Head of Residential Credit)

Yeah. Thanks, Doug. I think in, in terms of securitization, we expect to continue to be programmatic. We just priced a deal that's actually closing today. The economics on that deal is it's a 91% advance to our market value at a blended cost of funds at 178 over the curve. You know, call it a 650 cost of funds to an IRR. When we look at that relative to warehouse or warehouse financing is called mid-high 100s, high 100s. The ability to term out that debt inside of warehouse is certainly something that we think makes sense. As you've seen, you know, issuance this year has lagged. We'll say, you know, $36 billion-$37 billion of total gross issuance within the non-agency market.

We do think that the positive technical should be a tailwind for issuers like ourselves in the second half, in terms of spreads continuing to tighten, absent any sort of macro weakness or risk off. We were 20 basis points tighter quarter-over-quarter, and I think if we came out with a deal today, we would be inside the levels that we just transacted about a week ago.

Douglas Harter (Director and Senior Equity Research Analyst)

Great. Thanks, Mike. Ken, when you're looking at counterparties to kind of buy MSR from, you know, you know, in the past, you know, refinance ability and, you know, the, you know, the counterparties, you know, refinance ability kind of greatly impacted performance. You know, I guess, how are you thinking about that in terms of, you know, of who you're buying from today?

David Finkelstein (CEO and CIO)

Doug, thanks for the question. Yeah, counterparties are really important to us from a few perspectives. You know, on the prepayment speeds, you know, being not a competitor with our counterparties, we can often engage in very specific relationships where we share in recapture performance with counterparties. You know, we're able to kind of price in the value of recapture in a way other participants are not as willing to because of, you know, our positioning in the market. We're extremely unique participant for the mortgage industry, in that, again, we're not competing with them, we're partnering with them. We either price in the value of the recapture or share in the recapture. I think it's very different from our peers. Yeah, one more point.

Credit's also a big consideration on that front. You know, we, we limit the set of counterparties that we transact with. We want durable counterparties, just in the event that out the horizon, there's buybacks and things like that.

Douglas Harter (Director and Senior Equity Research Analyst)

Makes sense. Thank you.

David Finkelstein (CEO and CIO)

Thanks, Doug.

Operator (participant)

Our next question comes from Rick Shane from JPM. Please go ahead.

Rick Shane (Managing Director and Senior Consumer and Specialty Finance Analyst)

Thanks, guys, for taking my question. First of all, this is sort of a more big picture question. You make the observation about spreads eventually tightening, but at this point, do you really care? I mean, it's priced into the book value, and ultimately, is this a secular change that allows you to generate higher returns with less leverage or manage risk in different ways?

David Finkelstein (CEO and CIO)

Yeah, you're exactly right, Rick. It's not our preference for spreads to tighten. We think they will because of the attractiveness of the asset, but to the extent they don't, that's perfectly fine for us. We, you know, we own the assets, we'll continue to generate yields, when we have runoff, we'll reinvest at wider yields. It's not necessarily our preference for spreads to tighten. In a perfect world, we do sit at wider spreads and continue to generate the return that we're generating with low leverage. That's how we look at it.

Rick Shane (Managing Director and Senior Consumer and Specialty Finance Analyst)

Got it. You know, the, the other question is this: Srini had made the comment about moving up in coupon. You know, we're seeing right now 6s with slight premiums, 5.5s with slight discounts. Given the ultimate asymmetry to interest rates, how sensitive to premium are you? Does it make sense to play a little bit lower in the stack, just so you don't take that risk, if rates start to move more quickly than expected?

David Finkelstein (CEO and CIO)

Yeah. We'll have Srini jump in here on that one.

V.S. Srinivasan (Head of Agency)

Hi, Rick. You're absolutely right. Right, we like premium coupons, particularly 6s and 6.5s, is when we can find high-quality specs. There are a lot of production, so we are building that portfolio out slowly, and it's mostly high-quality specs. Where we like the bases and where we like PBH paper, slightly below that in 4.5s and 5s, that's where we can add or take off bases very quickly. That's where I think if you look along the forwards, 4.5s and 5s are closer to par, and 5.5s and 6s are above par along the forwards, given that the forwards are pricing in a rally in Fed.... The lower coupons we've generally shied away from.

We think they will still have very good demand because money managers, when they see flows in, try to match the index, and the index has a lot of lower coupons. The technicals for them are pretty strong, but the cash flows themselves don't look particularly attractive on the stack. The value coupons is where we buy PBH paper, and higher coupons, when we can, we buy specified pools, high-quality specified pools.

Rick Shane (Managing Director and Senior Consumer and Specialty Finance Analyst)

Great, that's very helpful. Thank you, everybody.

David Finkelstein (CEO and CIO)

Thanks, Rick.

Operator (participant)

Our next question comes from Matthew Erdner from Jones Trading. Please go ahead.

Matthew Erdner (Director and Senior Equity Research Analyst in Financial Services and Real Estate)

Hey, good morning, guys. Thanks for taking the question. You mentioned mortgage spreads tightened pretty significantly during the quarter after the debt ceiling resolution. Could you provide an explanation and kind of expand why book value's down quarter-over-quarter, if the dividend is reflective of the core earnings? Thanks.

David Finkelstein (CEO and CIO)

Sure. Mortgages did tighten pretty considerably after the debt ceiling episode, but they did widen very materially for the first two months of the quarter. On balance, we were marginally tighter, I think on a nominal basis, you know, 5-7 basis points tighter maybe, and then OAS not quite as tight. There's a little bit of hedging costs that go along with it. Also, we do carry a positive duration gap. So the market obviously sold off somewhat and duration, as is often the case, can cost money. The fact that, you know, I'll say, given the volatility we experienced, you know, Fed Funds Futures went from four and 3/8 at year-end, at the beginning of the quarter, to five and 3/8. That's a significant move.

The yield curve flattened 50 basis points on the quarter, twos to ten. There was a lot more volatility that actually occurred, I think, than, you know, you see from quarter end one to quarter end two. you know, I think we managed it quite well. I'll make another observation about the sector as a whole. you know, we're much of the way through the reporting cycle here, particularly with agency REITs. you know, in light of the volatility that I just mentioned on the quarter, the sector did very well, I think. The fact of the matter is, leverage has been quite responsible and folks have managed interest rate risk reasonably well.

Now we're actually most likely at the very end of the Fed hiking cycle. The outlook looks a lot more positive. I think the investor and analyst community should be quite optimistic about where the sector sits right now and the ability to generate strong returns for shareholders.

Matthew Erdner (Director and Senior Equity Research Analyst in Financial Services and Real Estate)

Awesome. That's helpful color there. Kind of shifting gears. Previously, you guys have mentioned capital allocation, want to get to 50% on the agency side, MSR to 20%, and the resi credit to 30%. Is that still the expectation? What is the timing surrounding that?

David Finkelstein (CEO and CIO)

That is still the expectation over the longer term, and, and the timing is, you know, dependent on, on, you know, the valuation of assets. Right now, agency certainly looks attractive, and we, we expect the sector to do well, so we're going to remain overweight. Over the next, you know, number of years, that's the objective. When, when things are fairly valued, we'll continue to gravitate further into both resi as well as MSR. In this past quarter in MSR, you know, you'll see an increase in capital allocation, given the amount of commitments we've made that are, that are forward settling. You'll see that go up, and again, you know, the residential pipeline is very healthy, and so we're hopeful that we'll grow that, you know, responsibly and, and deliberately.

Matthew Erdner (Director and Senior Equity Research Analyst in Financial Services and Real Estate)

Awesome. Thank you, guys.

David Finkelstein (CEO and CIO)

You bet, Matt.

Operator (participant)

Our next question comes from Vilas Abraham from UBS. Please go ahead.

Vilas Abraham (Equity Analyst in Financials)

Hey, everybody, thanks for the question. Just on the, you know, hedging, on the hedge ratio, flat quarter-over-quarter. Just, you know, how do you think that trends over the, you know, over the coming quarters? Do you see yourself being particularly active in implementing anything new there?

David Finkelstein (CEO and CIO)

Yeah, good question, Vilas. There's the active component and the passive component. I'll start with the passive component first, actually. If you just look at the runoff of the portfolio by year-end, 15% of our swaps will run off, about only 6% of theirabouts over the next four months. There's going to be some passive runoff. The determination we'll make is that, given where we're sitting with respect to monetary policy, do we want to let those hedges run off and be a little bit longer in the front end of the yield curve? That is quite likely. Also, if there is, you know, a meaningful change in either the rates market or the yield curve, we will absolutely intervene and reflect our views.

You know, whether it be steeper, flatten or, adding duration or taking off duration, we'll absolutely do it. Right now we're sitting right at a half a year duration with a hedge ratio of a little bit above 100%. All else equal, that hedge ratio will go down. And, and we think we're, we're fairly balanced as it relates to interest rate risk, both in actual duration exposure as well as our curve exposure.

Vilas Abraham (Equity Analyst in Financials)

Okay, guys, that's helpful. Just, you know, maybe a bigger picture question on, you know, on Fed policy at the, the press conference yesterday. Chair Powell suggested that there could be a scenario where you see rate cuts, but, you know, run off on the balance sheet still occurring. Just kind of what are your thoughts around that? You know, how would the, you know, the market react? Is that priced in to, you know, to spreads or any other parts of the market right now? Just curious to hear your thoughts there.

David Finkelstein (CEO and CIO)

Sure. The scenario where that would occur, they're cutting rates while the balance sheet is still running off, is likely a disinflationary scenario as opposed to something like a hard landing. They can actually achieve that objective. I know it's counterintuitive, but they're normalizing both policy tools, getting rates back to what they consider to be neutral. If inflation does come down below their expectations, that will likely start next year. They still need to get the balance sheet down to levels that they want to operate at. Right now, you know, the balance sheet is still quite elevated. You know, $5 trillion treasuries, $2.5 trillion mortgages.

If you look at what we think to be their timing of runoff, or when they think that they need to stop runoff and start growing again, it could be the middle of next year or later, and they may need to ease, or it may be warranted to ease in advance of that. You can do both things at once, so long as it's not driven by recessionary cuts, in which case you'd want to stop the balance sheet runoff to help the economy and add liquidity to the system. Now, in terms of the chair making that statement yesterday, it's actually relatively good for MBS. The reason being is that we did not expect agency MBS to stop running off when they end QT.

Much like the last iteration of QT, we expect agency MBS to run off and then be reinvested into treasuries after the end of QT. If they are cutting rates and still letting the balance sheet run off, they're also letting treasuries run off as well beyond the time that they stop or they start reducing rates. That basis trade that could have occurred when disinflationary cuts occur is postponed effectively. Generally it's at the margin better for the basis. Does that help?

Vilas Abraham (Equity Analyst in Financials)

Yep, that helps. Thanks, David.

David Finkelstein (CEO and CIO)

You bet, Vilas.

Operator (participant)

If you have a question, please press star then one. Our next question comes from Bose George. Please go ahead.

Bose George (Managing Director and Senior Equity Research Analyst in Financial Institutions Equity Research)

Hey, guys. Had a quick question just about you know, you have that small CMBS portfolio. Can you just remind me what the exposure is there, and is that just an opportunistic portfolio?

Mike Fania (Deputy CIO and and Head of Residential Credit)

Hey, Bose. Yeah, I think that's the correct characterization of it. We did have a CMBX position that was closed on the quarter, so we no longer have any exposure to CMBX. We don't actually think it's a core asset on a go-forward. In terms of, you know, where we're at now, we own triple A, CRE, CLO. We own around, I'd say, $340 million, and we expect that to be opportunistic, dependent upon spreads. It's an asset that you can efficiently lever.

David Finkelstein (CEO and CIO)

Yes, like 96% multifamily, I believe.

Bose George (Managing Director and Senior Equity Research Analyst in Financial Institutions Equity Research)

Okay, great. Thanks a lot for explaining.

David Finkelstein (CEO and CIO)

Sure, Bose.

Operator (participant)

This concludes our question and answer session. I would like to turn the conference back over to David Finkelstein for closing remarks.

David Finkelstein (CEO and CIO)

Thank you, Scott, and thank you everybody for joining us today. We appreciate your participation, and I hope everybody has a very good end of summer.

Operator (participant)

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.