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Back on our first-quarter 2020 earnings call, I discussed the conceptual three-phase process for how our portfolio strategy would evolve coming out of COVID.
To review briefly, the first phase was about preserving capital and shoring up liquidity, which we did successfully as the crisis unfolded, positioning us with the healthiest liquidity and capital position this company has exhibited in years.
Phase two characterized the majority of last year, was about deploying capital in the agency sector, which I referred to as the shelter in the storm, while making opportunistic investments within credit, while the Fed and fiscal intervention provided strong support for both our assets and liabilities.
We then outlined phase three, which involves more transformative and strategic reallocation of capital to best position the company in a new environment.
We were prepared to utilize our liquidity, benefit from the dislocations across markets and sharpen our strategic focus.
Today, I will provide an update on our progress on this third phase which reflects our macro views and the vision for the company going forward.
Following changes to the senior leadership team, including my appointment as CEO last March, was an opportune time to reevaluate certain businesses and revisit our expense structure, while also actively building out the necessary infrastructure and personnel to broaden our operational capabilities within residential housing finance.
Now before I go too far down that path, I'll begin with the commentary on the rates market, the price action this past quarter was notable.
First quarter was marked by a meaningful sell-off in interest rates as the 10-year note rose over 80 basis points, signifying one of the largest quarterly sell-offs in the past 5 years.
The sharp repricing was driven by a meaningful boost in economic growth expectations, best seen in the Federal Reserve's economic forecast for 2021 GDP growth.
While FOMC members had forecasted a strong 0.2% growth this year at the December meeting, they revised their projections up to 6.5% by the March meeting.
annual growth would be the strongest in nearly 40 years as the significant progress made on vaccinations appears to be paving the path out of the pandemic.
And at the same time, substantial government stimulus, a very healthy consumer balance sheets are also boosting the U.S. economy.
Longer-dated rates also reflect the anticipation of higher inflation base effects and consumers' willingness to pay elevated prices given the receipt of stimulus checks are noticeably lifting prices.
Inflation is likely to temporarily rise above the Fed's 2% target in the near term, but it remains uncertain as to whether persist and higher inflation will take hold until we see meaningfully higher wages for consumers.
In addition, all the factors that have been associated with lower inflation over the past three decades, changing demographics, automation, and increased globalization to name a few remain in place, which does reduce the risk of a continued sharp sell-off.
That being said, volatility in rate markets suggests that investors are not yet efficient in pricing the economic response to consumer enthusiasm.
However, any turbulence should be dampened by a Federal Reserve that continues to signal patients when it comes to its monetary policy decisions despite the strong improvement in the outlook in recent months.
Further down the road, the Fed will face difficulties extricating its sizable policy footprint for markets, necessitating any withdrawal to be gradual and well communicated.
While we still see strong tailwinds for Agency MBS, which Joe will expand upon following my commentary, the forecasted strong economy and the interest rate landscape tilts the relative value equation modestly in favor of certain pockets of credit.
Our capital allocation to credit rose from 22% to 27% this past quarter primarily driven by $1.4 billion of gross residential credit investments.
I'll also note that the nominal increase in the percentage was in part due to capital optimization decisions for certain credit products made possible by our excess liquidity cushion.
Now turning to our strategic activity in the quarter.
We announced the sale of our commercial real estate business to Slate Asset Management for a purchase price of $2.33 billion.
And we feel the transaction achieves great execution for our shareholders and is a validation of the quality of the portfolio that has been on balance sheet since 2013 and the experience of our team.
The rationale for the transaction is best illustrated by briefly revisiting history.
Turning back to the environment when we acquired CreXus, bringing commercial assets onto our balance sheet, the Fed was a few months into QE3, and Agency MBS looked rich on a risk-adjusted basis relative to credit given the first-order impacts of the MBS bond-buying program.
Moreover, we were still in the somewhat early stages of the economic cycle and could therefore pick up 200, 300 basis points of excess spread and senior transitional light loans with strong visibility of business plan in top markets.
That relationship has sharply reversed over time as the commercial market has seen strong investor interest and record levels of capital raised, which subsequently eroded the compatibility of the commercial platform with our core Agency strategy.
We had embarked upon an evaluation of the optimal size and structure of the commercial business pre-COVID, but the pandemic required CRE participants to confront the fundamental structural changes in the industry that we expect to occur over time.
With the unprecedented support injected in the economy, we had certainty the recovery would prevail when the data began to turn, we were well prepared and confident that the sale of our commercial platform would provide the strongest outcome for the company and our shareholders.
After a comprehensive exploration and a process to find firms that represent strong fits for the business going forward, we identified a potential buyer to acquire the platform, including its assets in the majority of the people.
In addition to the economics to the buyer, we will maintain a favorable carry profile on the assets until close, mitigating our reinvestment risk.
With respect to use of proceeds, while Agency may serve as a placeholder for capital return, considerate of spreads, over time, we will rotate the capital across our other investment strategies as opportunities arise.
Given the customary closing conditions and regulatory approvals, we're still multiple months away from receiving the capital back from the sale, which will be approximately $650 million.
The transaction will give us additional capacity to further expand our leadership and operational capabilities across all aspects of the residential mortgage finance market, which has been the cornerstone of Annaly's strategy since our founding.
The current environment reaffirms the strength of the housing sector, and we continue to be excited about the growing synergies between our agency and residential credit businesses.
Now the first area in which we're expanding our capabilities is the MSR sector.
Previously, we owned MSR via a servicer that we acquired in connection with our Hatteras acquisition and later sold.
But our portfolio has been in runoff mode for the past year, and therefore, we've employed a multifaceted approach to investing in the asset class today.
We have committed third-party partnerships that we've developed as part of our build-out to own and overseas servicing of MSR in-house, and we have made several key hires with decades of industry experience, lead this effort.
Additionally, we've witnessed significant progress with licensing our base subsidiary, established a satellite office, and have begun to grow our portfolio again.
We are a complementary strategic partner to originators because of the breadth of products we can acquire from them and the certainty of our capital as a takeout.
This has become particularly useful as the primary-secondary spread has contracted, reducing originator profitability, leading to increased secondary MSR volumes.
MSR is highly additive to our prospective returns as a positive yielding hedge to our core agency strategy, while also modestly reducing our agency basis exposure.
However, as we have said in the past, in the absence of a severe pricing dislocation, we do not see capital allocated to the sector much above 10% on a run-rate basis given the implied structural leverage and liquidity of the asset.
Our view is that MSR is a very attractive ingredient in the portfolio, but the measurements and the recipe require precision in light of potential volatility and risks.
Now additionally, we continue to add to our third-party and in-house sourcing capabilities on the residential credit front, which drove the over $450 million of whole loan purchases we saw in the quarter, and our pipeline continues to grow.
We also continue to believe that a diversified platform beyond residential is a key differentiator for us, including the optionality embedded in our alternative strategies like our middle-market lending platform.
Through that business, which has been on balance sheet since 2010, we generate leading returns with cycle agnostic investments.
And we'll also retain a $500 million commercial mortgage-backed securities portfolio, which we expect to grow over time depending on pricing and our outlook.
The portfolio delivered another solid quarter despite a very volatile interest rate environment, characterized by sharp sell-off in the intermediate and long end of the curve.
MBS performance was mixed with lower coupon price performance lagging higher coupons due to extension of the cash flows and resulting delta hedging costs.
However, spreads generally continued their trend tighter as investor demand outpaced issuance, which remains near-record levels.
Most notably, the bank demand we discussed last quarter remained robust, as expansionary and fiscal policies continue to drive the level of deposits higher, while commercial and industrial loan growth has been muted.
The size of our agency portfolio remained stable as we reinvested runoff primarily into TBAs, which benefited from negative implied financing rates over the quarter.
Within our TBA position, we shifted exposure into two and a halfs and threes, while we reduced lower coupons as we expect Fed and bank purchases to migrate hiring coupons following the rise in rates.
In specified pools, our average portfolio payout declined by approximately three-quarters at a point due to higher rates.
However, their good prepayment and resulting profile contributed to specified pools outperforming both TBA and duration hedges over the quarter.
While the sell-off brought mortgage rates above 3%, we remain in high prepayment environment due to technological latencies and increased capacity in the originator community.
And therefore, we expect protection to continue to prove valuable part in higher coupon specified pools.
Now shifting to our hedges.
We were well-positioned for the steepening of the yield.
As we mentioned on our Q4 call, we added additional treasury futures and swaption positions during Q3 and Q4 of last year.
These lower-cost duration hedges, especially on the longer end of the curve, proved instrumental to our portfolio performance as yields rose sharply on the back of fiscally induced inflation fears.
In particular, the options that we bought throughout 2020 at lower levels of implied volatility and lower float rates proved to be an excellent convection duration hedge against the extended duration in Agency MBS assets.
Although we actively rebalanced our portfolio through the rising yields this quarter, due to our prior positioning, delta hedging needs were minimal compared to the size and momentum of the sell-off.
These hedges were primarily in treasury and interest rate swaps and all swaps were executed with floating retails benchmark as we continue to decrease our LIBOR footprint.
Finally, as yields stabilize at the of the quarter, we took the opportunity to add protection against a rally as we were able to purchase receiver options at attractive levels with the market commanding higher price protection against the sell-off.
We expect to grow this position in coming quarters as it complements our planned growth in our MSR portfolio.
After the performance in Q1, spread tightening potential for MBS looks somewhat limited.
But the framework we have been operating still holds.
tailwinds such as Fed and bank demand are likely to persist, financing rates remain extremely attractive and nearly all other asset classes are trading to tight valuations.
So looking ahead, we anticipate maintaining our conservative leverage posture, while our existing core portfolio provides a solid income and enables us to grow our higher-margin businesses that David talked about.
Turning to our residential credit business.
We continue to remain bullish on both consumer and housing fundamentals given considerable government stimulus monetary policy in addition to a systemic undersupply of one to four single-family homes.
consumers have been able to successfully navigate the COVID pandemic with household net worth at all-time highs personal savings rates in excess of 10%, household debt to income at historical lows, and year-over-year declines in credit card and auto delinquencies.
The health and resurgence of the consumer has also benefited the residential credit market with outstanding forbearance plans declining to 4.4% of the total market as of mid-April, down from 5.2% as of year end and first-lien delinquencies down over a hundred basis points on the quarter coming in at five spot zero two percent.
The housing market continues to exhibit strong momentum regarding both construction and home price appreciation as a result of low mortgage rates, limited available inventory for sale, strong household formation, and changing homeowner preferences regarding both location and the desire for space.
National home prices were up 12% on a year-over-year basis in most recent release, and will most likely continue to see outsized depreciation as the supply/demand imbalance is a long-term structural issue that will not be resolved at the current pace of housing completions.
Regarding our rental credit portfolio, consistent with our comments on our last earnings call surrounding attractive residential credit spreads and net interest margin, we were active in deploying capital by purchasing approximately $910 million of residential credit securities and settling $467 million of predominantly expanded credit residential whole loans.
The residential credit portfolio ended the quarter at $3.4 billion of economic risk, excluding our committed loan pipeline.
Leverage across the residential credit portfolio has remained conservative with financial recourse leverage at one spot zero debt equity, with resi ending the quarter comprising $1.8 billion of the firm's capital.
Within securities, greater than 95% of our purchases were concentrated in the unrated MPL, RPL, and seasoned CRT subsectors.
In the beginning of the year, both of these products displayed attractive ROEs per unit of spread duration and have benefited from continued improvement in the financing market.
The shorter duration par priced assets should yield high single digits to low double-digit lifetime ROEs and serve as an excellent accretive hedge to our longer-dated CMBS portfolio.
Moving to residential whole loans.
We continue to be proactive in sourcing accretive assets and had a robust pipeline of $410 million that we anticipate will settle over the next few months.
We continue to see opportunities in the non-QM market and have started to capitalize on opportunities in the agency investor market given recent changes to the GSE's preferred stock purchase agreements.
Turning to our resi securitization platform.
In March, we securitized $257 million of expanded credit hold loans in a non-QM transaction, generating $15 million of term-funded subordinate securities with an expected low mid-double-digit ROE with minimal recourse leverage.
We also priced our inaugural prime jumbo securitization earlier this week, a $354 million transaction where we retained all of the subordinate securities, approximately $14 million in market value.
The organic creation of nonrecourse term funded assets through our whole loan strategy, allowing us to control asset acquisitions, overseas diligence, and the selection of our preferred subservicers with the ability to control loss mitigation remains our team's primary focus.
With the reopening of the economy on the horizon, a healthy consumer, and the housing market poised for strength in 2021, the residential credit market should see continued positive performance.
Q1 of the middle market lending group was influenced by a combination of our portfolio success through the pandemic as exhibited by the year-end watch list decreasing by 41% versus the prior year, followed by a very intense refi driven market in the absence of any meaningful new issue M&A throughout Q1.
This resulted in the portfolio modestly declining from $2.39 billion at year end to $2.07 billion at quarter end $331 million.
Returns, both economic and core increased meaningfully in the quarter versus year end as the team remains disciplined about new investment activity and we'll protect the existing portfolio selectively.
As in 2020, we are very pleased with underlying portfolio performance with continuation of zero nonaccrual credits versus the Water Direct Lending index average of 2.9% and and a watch list presenting less than 4% of the Annaly middle market total portfolio size.
In addition, the portfolio continues to migrate toward a first lien -- moving three full percentage points from 66% at year end to 69% at 331.
As we have reiterated over the past 10 years, Annaly middle-market significant outputs during periods of intense turbulence is a function of staying true to the industries in which we want to invest, the forecastability of underlying credits to survive tumult, and partnering with private equity owners that exhibit like-mindedness and track records consistent with our own inside the very industries in which we want to be active.
Consistent with our behavior since joining in 2010 we have historically countered market periods dominated by refinancing with pipelines weighted alongside sponsors that acquire businesses differently.
We anticipate 2021 will be no different in that respect.
and investing in concert with freshly contributed equity from sponsors, will continue to dominate our thinking when putting money to work.
Reignited convergence in the fixed income market and more specifically the loan markets makes us wary of leverage multiples more so than pricing.
With refi-driven markets coming out of the pandemic, the broad array of issuers capturing contracting spreads for last year's performance seems to be an acute contradiction, but nonetheless, our reality.
Inside of Annaly, middle-market lending is very aware of the current credit risk versus interest rate risk equation.
And with today's yield curve, we are comfortable with middle markets current allocation.
As always, middle markets growth or contraction for the balance of the year will remain subject to the underlying credit and our perception of adequate unlevered compensation for the risk, both absolute and relative.
We continue to generate strong core results from the portfolio for the first quarter of 2021, benefiting from the continued low interest rates in the funding market and sustained specialness in dollar to set the stage with some summary information, our book value per share was $8.95 for Q1, a slight increase from Q4 2020.
Book value increased on GAAP net income of $1.75 billion or $1.25 per share, partially offset by the common and preferred dividends of $335 million or $0.24 per share and lower other comprehensive income of $1.7 billion or $0.98 per share.
A significant impact to GAAP net income and therefore, book value for the quarter was the held-for-sale accounting entries recorded in association with the announcement of the sale of our commercial real estate platform, particularly the impairment of goodwill of $71.8 million or $0.05 per share.
We generated core earnings per share, excluding PAA, of $0.29, a decrease of 3% or $0.01 per share from the prior quarter.
Combining our book value performance with the $0.22 common dividend we declared during Q1, our quarterly economic return was 2.8%.
As I noted earlier, our book value increase reflected a $0.05 impairment of goodwill.
Excluding this impairment, our tangible economic return for the quarter was 3.6%.
Economic return and tangible economic return for Q4 were 5.1% and 5.2%, respectively.
Taking a closer look at the GAAP we generated GAAP net income of $1.8 billion or $1.23 per common share, up from $879 million or $0.60 per common share in the quarter.
GAAP net income increased primarily on higher unrealized gains on our interest rate swaps and derivatives portfolio.
Specifically, GAAP net income benefited from rising interest rates reflected in unrealized gains on interest rate swaps of $772 million, which was $258 million in the prior quarter; other derivatives led by futures of $517 million, which was $12 million of unrealized losses in the prior quarter, and swaptions of $306 million, which was $4 million of unrealized losses in the prior quarter.
GAAP net income also benefited from lower interest expense on lower average repo rates and slightly lower average repo balances at roughly $65 billion.
I will cover more details on interest expense later on.
Now to provide more color on the impact to book of the commercial real estate divestiture.
The transaction is expected to close in the second or third quarter, following receipt of customary consents and approvals from regulators and joint venture partners.
As a result, as of March 31, 2021, we met the criteria for held-for-sale accounting, including the small number of commercial real estate assets excluded from the transaction, given our intent to exit those positions.
The held-for-sale criteria require all assets in the disposal group to be recorded at the lower of cost or fair value.
Therefore, under held for sale accounting, assets are written down, but not up with gains recognized at closing.
This evaluation resulted in recognition of valuation allowances and impairments of approximately $157.4 million on loans, real estate, and securities offset by annualized gains on CMBS available for sale of $16.8 million.
As the various closings of the traction occur, we will realize gains that more than offset the net valuation allowances and impairments recorded on the portfolio.
As the portfolio is now held for sale, it is no longer in the scope of CECL.
And in Q1, we reversed the previously recorded reserves of $135 million through earnings.
In aggregate, the divestitures of our commercial real estate platform through the sale to Slate Asset Management and our opportunistic sale of a portion of our skilled nursing facilities in the fourth quarter of 2020 will result in a $0.02 portfolio benefit to tangible book value at closing, which will be fully recognized over time due to GAAP accounting.
In conjunction with the acquisition of CreXus in 2013, we recognized an intangible asset of Given our intention to exit the commercial real estate business, we have impaired the carrying value of the goodwill, again, $71.8 million or $0.05 per share in Q1.
Moving on now to CECL reserves.
Consistent with the prior quarter, we continue to see a general improvement in market sentiment and the economic models we use in this process.
And given the commercial real estate disposition, The CECL reserve now relate solely to our middle-market lending assets.
We recorded a decrease in reserves of $6.2 million on funded commitments during Q1, driven by a reduction in the portfolio and improved macroeconomic assumptions.
Total reserves net of charge-offs comprised 1.58% of our MML loan portfolio as of March 31, 2021.
We expect that CECL reserves will be an immaterial part of our financial statements in the future.
Turning back to earnings.
I wanted to provide more detail surrounding the most significant factors that impacted core earnings quarter over quarter.
First, consistent with my commentary around GAAP drivers, interest expense of $76 million was lower than $94 million in the prior quarter due to lower average repo rates and balances.
We had increased expenses related to the net interest component of interest rate swaps of $80 million relative to $67 million in the prior quarter as the swap portfolio position increased by $5.5 billion.
Finally, We had lower interest income primarily driven by lower average agency balances and a reduction in average agency yield.
And while the amount is consistent with Q4 at $97 million, dollar roll income contributed meaningfully to core for the quarter, given continued record levels.
Our treasury group's view on the funding markets came to fruition in Q1, with continued tightening of rates and flattening in term curves.
Today, we see overnight rates in the low single digits and term market north of six months at 12 to 14 basis points in the bilateral market.
As a result, we successfully executed our strategy to add duration to our repo book, with our weighted average days to maturity up compared to prior quarter at 88 days versus 64.
Providing further color regarding our reduced interest expense for the quarter, while overall cost of funds is consistent with the prior quarter at 87 basis points, the composition differs from Q4, with repo interest expense lower, the cost of funds associated with hedges increasing due to the increase in added.
Our average REPO rate for the quarter was 26 basis points compared to 35 basis points in the prior quarter.
And we ended March with a repo rate of 20 basis points, down from 32 basis points at the end of December 2020.
We continue to actively manage our repo book and look for further opportunities to reduce our cost of funds and improve liquidity.
For instance, we experienced lower haircuts across the board for our agency book.
And considering our liquidity profile, we selected to fund the most liquid credit assets and utilize capital to The portfolio generated 191 bps of NIM, down from 198 bps as of Q4, driven primarily by the decrease in asset yields.
Moving now to our efficiency ratios.
Previously, we've provided a range of OPEX targets associated with potential cost savings from our internalization of 1.6% to 1.75%.
And in the prior year, we incurred G&A costs for an annual OPEX ratio in this range of 1.62%.
We expect to realize cost savings due to the disposition of our commercial real estate business, and began to see these in Q1 with an OPEX to equity ratio of 1.4%.
Giving consideration to the pivot in our strategy in commercial real estate to resi credit MSR and our MML business, we believe that a revised estimated range For OPEX to equity for 2021 would be 1.45% to 1.6%.
And to wrap things up, Annaly ended the quarter with an excellent liquidity profile with $8.9 billion of unencumbered assets, slightly up from prior quarters of $8.7 billion, including cash and unencumbered Agency MBS of $6.2 billion.
And, operator, we can now open it up to Q&A.

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q1 gaap earnings per share $1.23.
qtrly book value per common share of $8.95, up $0.03 quarter-over-quarter.

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