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Text: Additionally, the content of the 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.
As a reminder, Annaly routinely posts important information for investors on the company's website at www.
Please note, today's event is being recorded.
Today, I'd like to highlight a number of current corporate initiatives, provide an update on the market and discuss portfolio activity across our core businesses during the quarter, and finally, provide our outlook for the balance of the year, and then I'll hand it off to Serena to discuss the financials.
Of note, while last quarter, each of our credit leaders providing an in-depth look at their respective markets and portfolios to be efficient.
I'll provide those updates today.
But as Purvi noted, each of our business heads are here as well to join in Q&A.
Now, to begin with, I wanted to touch on a few strategic and corporate actions we've taken as of late.
At quarter end, we closed our previously announced internalization transaction, which marks a significant step in the series of measures and only is implemented as an industry leader from a governance standpoint.
As an internally managed REIT, we look forward to demonstrating increased transparency and alignment with our shareholders, who will benefit from our ability to be more nimble in the way we do business in order to generate long-term value.
We also announced two leadership changes, Steve Campbell was appointed as chief operating officer, and Glenn Botek will retire from his role as senior advisor at the end of August, while remaining a director on our board.
As COO, Steve will expand on the work he has been doing as head of business operations and work closely with the executive team to help oversee Annaly's overall operations and risk management functions.
Additionally, during the second quarter, we utilized our share buyback program and have now repurchased 175 million in common stock year to date.
This underscores our belief that the stock is undervalued relative to our book value and affirms our support of the value of our stock through the various capital allocation tools we have on hand.
These initiatives are a testament to our focus on driving shareholder value ensuring that the firm as a whole, our structure, as well as our portfolio is positioned to continue outperforming as our second-quarter results demonstrate.
Following one of the most challenging and unforeseen operating environments and Annaly's history, we were pleased with our performance during the second quarter.
We delivered an economic return of nearly 15% and achieved core earnings well in excess of our rightsized dividend.
Our measured approach to weathering the crisis served us well, and we feel very good about our positioning as the recovery progresses, as I'll get into in more detail.
So the economic slowdown brought on by the pandemic has obviously created considerable uncertainty, and this is a different kind of recession than that which we have experienced in the past, given the unprecedented speed and magnitude of the downturn.
Social distancing and mandated shutdowns to damage certain sectors of the economy and the corresponding impact on the labor market has been substantial.
demonstrates the fragile nature of the recovery.
Nevertheless, financial conditions have improved considerably.
The market dysfunction that occurred amid the initial COVID outbreak in the U.S. has dissipated, and we have seen significant improvement in liquidity and asset pricing.
This is in large part due to the ongoing decisive actions taken by the Federal Reserve, which have been successful in restoring markets and easing credit strains.
Liquidity tools have sufficiently supported funding markets.
The credit facilities have opened channels to credit for businesses, households and local governments, the temporary adjustments to regulations have somewhat encouraged bank lending, and most impactful to Annaly's portfolio, the asset purchases have supported the smooth functioning of treasury and agency markets.
Now, turning specifically to the agency market.
The Fed's purchased an upwards of 850 billion MBS in just over four months has dramatically altered the supply and demand picture for the sector.
After a pace of purchases at the height of the volatility that reached nearly 50 billion per day to help stabilize the sector, the Fed has transitioned to a steady run rate of 40 billion per month, net of portfolio runoff, which on a gross basis, equates to roughly 40% current agency issuance.
Fed is largely taking delivery of the most negatively convexed MBS, which has resulted in a shift to the TBA deliverable across production coupons to more newly originated pools and as a result, nominal carry on production coupon TBAs has improved dramatically, thereby adding to returns for TBA holders.
Given this dynamic, we increased our TBA position in the quarter and gravitated further down in coupon.
The lower coupon holdings are predominantly in TBAs and higher coupons are concentrated in specified pools in light of the meaningful elevation and prepayment speeds in this environment.
While our portfolio speeds did experience an increase on the quarter, prepays on our overall portfolio were notably lower than the GSE universe, which paid roughly eight CPR faster despite the higher average coupon of our portfolio relative to universe.
And with respect to our hedges, we added to our swap portfolio, primarily in the front end, the short-term swaps with pay rates close to 0%, provide an attractive hedge to our financing.
This reduced our pay rate, as well as shortened the maturity of our swap portfolio.
We further reduced the LIBOR footprint of our hedge portfolio with our swap book now 80% in OIS and we reinitiated our treasury future short position that was unwound in the first quarter.
We also continue to take advantage of the attractive low levels of volatility to answer the tail risk of a sharp rise in rates in the long end of the yield curve, and as such, we replaced much of our legacy swaption position with additional out of the money payer swaptions.
Shifting to residential credit, the sector saw significantly more activity as market dynamics began to improve following the crisis.
The housing market remains strong given long-term positive fundamentals, which we believe will help the ultimate recovery.
We're experiencing a meaningful imbalance between supply and demand as the cyclically low number of housing units meets continued strong household formations.
An anecdotal evidence suggests that pandemic disruptions have had limited impact on the home buying and refinancing processes.
Non-agency securities across legacy, CRT, Jumbo 2.0 and non-QM have seen substantial recovery.
Improvement signals that the market currently believes that the majority of forbearance cases, which have stabilized over the past couple of months, will ultimately be resolved.
However, non-agency lending has been somewhat slow to redevelop as credit standards have tightened relative to pre-pandemic underwriting and mortgage originators tend to be focused more on agency originations in light of fewer frictions in a wide primary secondary spread.
Our residential portfolio was roughly unchanged quarter over quarter at 2.6 billion as modest purchases and mark-to-market increases largely offset sales and portfolio runoff.
Securitization market started to show signs of life in mid-May, and we issued nearly 500 million of expanded prime securities earlier this month, subsequent to quarter end.
Aggregate issuance under our OBX shelf has now reached 4.5 billion across 11 transactions since 2018.
As I mentioned last quarter, we expect to see more growth in this segment as markets continue to normalize, and we are encouraged by the steady pace of securitization activity to support our asset generation strategy.
In the commercial sector, we are slowly beginning to see activity pick up, but volumes do remain somewhat muted.
June, however, did bring about an increase in new refinancing requests with some new acquisition activity at post-COVID purchase prices.
And simultaneously, we have seen a significant number of warehouse providers begin to close new loans, although pricing levels have been reset higher.
Cross sectors within commercial, the operating fundamentals remain challenged in hospitality as the average national occupancy rate hovers around 40%.
And in retail, the prolonged shutdown and increasing number of retailer bankruptcies is continuing to weigh on that sector.
On a more positive note, multifamily remains strong throughout the quarter as the latest data indicates over 90% of renters made a full or partial rent payment as of June.
And in the office sector, although new leasing has slowed significantly, office REITs have reported strong rent collections above 90% throughout the back end of the second quarter.
With respect to our CRE portfolio, specifically, total assets at quarter end of 2.5 billion represented a slight decrease, while economic interest remained essentially flat.
The decline in portfolio size was driven by approximately 53 million in loan payoffs, as well as securities sales.
On the financing side, our weighted average cost of borrowing decreased by roughly 60 basis points to 2.7%, driven largely by a reduction in LIBOR given Fed cuts.
Overall, we feel good about the conservative positioning of the portfolio across sectors and the strength of our relationships with best-in-class sponsors and operating partners to mitigate any further disruption.
Shifting to middle market lending, activity has also picked up as of late as spreads have tightened and sponsors have refinanced transactions that have exhibited improving underlying leverage profiles.
New deal activity is primarily relegated to more broadly syndicated loans.
However, for context, first lien executions on larger transactions have tightened 75 to 100 basis points over the past quarter.
While traditional middle market has shown less movement in pricing.
Unit tranches and second lien loans within middle market are experiencing more notable price discovery than its larger market brethren, and we expect these gaps to remain as traditional middle market participants grapple with their portfolios.
Consistent with our communication last quarter, we continue to speak actively with sponsors, borrowers and agents to closely monitor performance.
Despite the challenging environment, we are pleased with how the portfolio has performed during the period, ending the quarter essentially unchanged at 2.2 billion in assets.
As we gain further clarity around the long-term implications of COVID, we are reassured by the stable and defensive nature of our portfolio and remain confident in its ability to withstand prolonged bounce and market volatility.
We believe our focused industry-specific positioning within nondiscretionary defensive and mission-critical names will generate the outperformance versus peers that will further differentiate our brand in the sector.
In fact, some of our industry concentrations have materially benefited from the current environment.
For example, government mandates at all levels have created an even greater dependency on technology while also driving demand and behavior in ways that is made once boring annuity businesses into growth sectors.
Portfolio construct has been protected against broader sectors that have witnessed demand destruction and we maintain meaningful exposure where pockets of spend remain resilient.
Now, additional note with respect to our direct lending portfolios, we have taken what we believe to be a very conservative approach regarding reserves and CECL adjustments, which Serena will discuss in further detail.
And finally, shifting to our outlook.
As we think about our capital allocation out of the horizon, we've been focused on preserving flexibility, given uncertainty in the greater economy related to the COVID shutdown.
We maintain the view that the agency sector represents the most attractive investment opportunity currently, while also providing strong liquidity.
We have entered a more normalized environment with Fed action serving as a key driver.
MBS spreads have retraced much of the widening experienced in March.
We do remain positive on the sector, given ample funding availability at low rates, subdued rate volatility and a complete reversal of an inferior technical backdrop that characterized the sector at the outset of this year.
While our allocation agency may increase modestly, we do continue to evaluate opportunities to deploy capital across our three credit businesses.
And we are beginning to develop a better lens into how each credit sector is evolving, and we expect to shift to a more offensive posture in the coming months as we gain more clarity on the economic and real estate landscape.
We were certainly careful to take prudent steps during the early phase of the market recovery to ensure we are well positioned to capitalize on the opportunities that are sure to arise.
And as part of our preparation, we have chosen to be conservative with our leverage, as well as our dividend.
Our goal has been to maintain optimal liquidity thresholds and to manage the portfolio within conservative risk parameters to produce the highest level of quality earnings in this smart environment.
Consequently, we reduced leverage during the quarter from 6.8 to 6.4 times and made the prudent decision to set our quarterly dividend at $0.22.
The dividend represents a 10.5% yield on our book value, which is in line with our historical average, while being competitive relative to our peers and various fixed income benchmarks.
As I mentioned, we outearned the dividend by $0.05 this quarter, and absent another market dislocation or other unforeseen developments, we expect Q3 core earnings to also exceed the dividend.
Overall, we maintain a more constructive view of the operating environment and our ability to deliver compelling returns as each of our businesses, respective sectors begins to emerge from the initial volatility and disruption caused by the pandemic.
And now with that, I'll hand it over to Serena to discuss the financials.
As David mentioned earlier, the stabilizing actions of the Fed, coupled with our active portfolio management, resulted in improved fair value of our agency assets and significant improvement in financial performance.
Our book value per share was $8.39 for Q2, a 12% increase from Q1, and we generated core earnings per share, excluding PAA, of $0.27, a 30% increase from the prior quarter.
Book value increased on GAAP net income of 856 million or $0.58 per share, which includes $0.05 related to CECL and specific reserves, and higher other comprehensive income of 721 million or $0.51 per share on improved valuations on agency MBS, resulting from lower market rates.
GAAP net income improved this quarter as a result of higher GAAP net interest income of 399 million, primarily due to lower interest expense from reduced repo rates and balances, and we also experienced lower losses on our swap portfolio of $92 million.
Last quarter, I noted that most of our assets and liabilities are at fair value.
And that our book value decline was not a function of fourth asset sales, but rather unrealized mark-to-market losses with potential full recruitment.
This point was evidenced this quarter with the improvement in fair value measures and resulting improved book value.
While financial conditions have stabilized, there is still significant uncertainty around the long-term economic picture.
This makes analysis regarding CECL reserves particularly challenging.
As a result, we ran numerous scenarios in excess of 20 to determine the appropriate amount of CECL reserves for the quarter and ultimately booked reserves that were considerably more conservative than our base case scenario.
In comparison, our base case scenario resulted in a modest release of reserves, which we felt inappropriate given the continued economic uncertainty centered around the evolving pandemic.
We recorded reserves associated with our credit businesses of 68.8 million on funded commitments during the second quarter, consisting of 22 million of additional reserves during the quarter, primarily resulting from the impact of COVID-19 on our borrowers.
And more general reserves related to forecasts for a deterioration in economic conditions and market values of 46.8 million.
Total reserves now comprise 5.32% of our ACREG and MML loan portfolios as of June 30, 2020.
As a reminder, the impairment model introduced by the new CECL standard is based on expected losses rather than incurred losses, which was the previous measurement for reserve historically.
Under the standard, an entity recognizes its estimate of lifetime expected credit losses as an allowance, which the FASB believes will result in more timely recognition of such losses.
And while changes in economic scenarios and asset performance in the future will impact CECL reserves in subsequent quarters.
Current reserve levels should not be considered as a pervasive credit issue within the portfolio or an indication of what reserves may be recorded in the future.
We have previously discussed our methodology and our thorough and thoughtful approach to CECL reserves.
As always, we spent time analyzing the results of the reserve calculations and ensuring our expectations align with the quality of the portfolio and the performance of the borrowers.
We continue to think it critical in the current environment to consider the adverse economic scenarios available in this process and to err on the side of conservatism, given the significant uncertainty in the economic and market value scenarios.
We remain comfortable with our existing credit portfolios and the associated CECL reserves, and we'll continue to monitor specific asset performance and economic projections as we determine future reserves.
The largest factor quarter over quarter to core earnings ex PAA, were lower interest expense of 186 million versus 503 million in the prior quarter.
Due to lower average repo rates and balances, as well as higher TBA dollar roll over income of 96 million versus 44 million in the prior quarter.
Due to higher average balances, partially offset by higher expense from the net interest component of interest rate swaps of 65 million versus 14 million in the prior quarter on higher average notional balances.
As David touched on, our economic leverage declined to 6.4 times from 6.8 times quarter over quarter, which was mainly due to a decrease in repo balances of 5.4 billion and an increase in our equity base of 1.1 billion.
That was partially offset by an increase in TBA contracts of 5.8 billion and an increase in net payables for investments purchased of 1.5 billion.
Our treasury function is the best in the business, and their expertise and exemplary market timing was a key component that helped us weather the market dislocation last quarter and our ability to deliver strong core earnings this quarter -- additionally, as noted above, core did benefit from a reduction in financing costs with lower average repo rates down to 79 basis points from 1.77%, combined with lower average repo balances, down to 68.5 billion from $96.8 billion.
And we achieved these results while opportunistically extending our repo book term, increasing our weighted average days to maturity by 50% from 48 to 74 days.
Signaling from the Fed on continued low rates, combined with considerable injection of additional reserves in the financial system through repo operations and asset purchases have led to very stable funding conditions with repo markets experiencing no signs of stress through the quarter, even on pivotal month end and quarter end reporting dates.
And access to repo financing remains ample.
With the improved stability in the financial market, we have been an improvement in lenders appetite to finance credit assets, particularly in the residential space.
In anticipation of the expiration of our FHLB membership in February of 2021, we are executing an alternate financing strategy involving committed funding facilities for our residential credit business.
And as David mentioned, we maintain a strong presence in residential securitization market.
Consistent with that strategy, since the beginning of the second quarter, we added 1.125 billion of capacity across two new credit facilities for our residential credit group for permanent nonrecourse financing.
The portfolio generated 188 basis points of NIM, up from Q1 of 118 basis points, driven primarily by the decrease in cost of funds that I mentioned a moment ago.
Annualized core return on average equity, excluding PAA, was 12.82% for the quarter in comparison to 9.27% for Q1.
Our efficiency metrics changed modestly relative to Q1 being 2.01% of equity for the second quarter in comparison to 1.98%.
Also, as David mentioned, our internalization transaction closed at the end of the quarter, and we anticipate generating cost savings over the long-term as we embark on being an internally managed company.
Annaly ended the quarter with excellent liquidity profile with 7.9 billion of unencumbered assets, an increase of 1 billion from prior quarter, including cash and unencumbered agency MBS of 5.3 billion.
And finally, the company has performed exceptionally well given the challenges faced from remote work and market uncertainty.
We continue to be impressed by the resiliency of our workforce and the exemplary service that our IT infrastructure team has provided to every one of us during this time of remote work.
Everyone at Annaly contributes to our success, and we are proud of the results that we have reported for the second quarter and expect to continue providing best-in-class results for our shareholders.

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q2 gaap earnings per share $0.58.
core earnings (excluding paa) of $0.27 per average common share for the quarter.

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