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Text: Additionally, the content of this conference call may contain time-sensitive information that is only accurate as of the date hereof.
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Today, I'll provide an overview of the current macro environment, briefly discuss our performance during the quarter and full year 2021 and close with our outlook for the year ahead.
Ilker will then provide more detailed commentary on our investment portfolio, while Serena will discuss our financial results.
And as noted, our other business heads are also here to provide additional color during Q&A.
Now, beginning with the macro landscape, we saw increasingly challenging market conditions in the fourth quarter and into 2022 as the robust performance of the U.S. economy has made it evident that a withdrawal of pandemic era stimulus is imminent.
economy grow 5.7% in real terms in 2021, marking the best annual growth in nearly 40 years.
Meanwhile, the labor market has seen a rapid recovery as employers added 6.4 million jobs last year and the unemployment rate fell to 3.9%.
Both measures suggest that the labor market has recovered significantly since the onset of the pandemic.
Stimulus measures fueled this rapid recovery, which has also spurred inflation to generational highs as seen in December when the consumer price index reached 7% year over year.
Although much of this increase in prices was initially seen as temporary, ongoing elevated price gains across various categories of goods and services raise the risk that inflation could persist for some time.
Accordingly, current macroeconomic conditions have led to a meaningful shift by the Fed, which now views less accommodative monetary policy is the primary way to ensure parts of its mandate, full employment and stable prices are being met.
In addition to an accelerated taper, Fed has begun to signal a larger number of hikes than previously expected.
Front-end rate markets are pricing roughly 25 basis point rate hikes this year beginning in March, up from just two -- one quarter ago.
Given the uncertainties around the economy, the Fed is likely to direct market pricing and hike in line with it rather than provide forward guidance well ahead of time.
The Fed has also begun to discuss shrinking its balance sheet, and we expect the Fed will let assets run off at a pace faster than the prior taper of $50 billion per month.
Now, this notable shift in policy expectations and higher volatility have led to a tightening of financial conditions and an underperformance of assets most closely tied to monetary policy, best seen through the spread widening in agency MBS in recent weeks.
Turning to Annaly's portfolio, agency MBS underperformed given weaker demand following the initiation of Fed taper and a flattening of the yield curve.
In anticipation of wider spreads, we managed the portfolio to decrease leverage and optimize our asset allocation with total assets decreasing by approximately $5 billion to $89 billion in the quarter.
As a result, economic leverage declined slightly from 5.8 times to 5.7 times.
Now, we were certainly not immune to the spread volatility as we experienced an economic return of negative 2.4% however, we generated earnings available for distribution of $0.28, unchanged from the prior quarter and exceeding our dividend by $0.06 per share.
With respect to capital allocation, in line with recent quarters, we increased the allocation to our credit businesses by approximately 200 basis points to 32% in the fourth quarter as prospective returns continued to favor credit.
Looking back on the full year, our credit allocation increased approximately 10 percentage points from December 2020, even with the successful sale of our commercial real estate business, which underscores the favorable fundamentals and strong execution from our resi credit and middle market lending businesses.
Now, I'll touch more on our outlook shortly, but notably, both market and business-specific tailwinds remain favorable for our credit businesses.
Now, 2021 was a transformative year for Annaly, marked by the sale of our CRE business, the launch of our mortgage servicing rights platform and the expansion of our residential credit business.
The collective impact of these initiatives has increased our presence throughout residential housing finance and allow us to allocate capital effectively where returns are most attractive, a key differentiator for Annaly.
Now, I'd like to briefly touch on notable milestones in our businesses and how they have better equipped Annaly to be nimble in the midst of volatility.
First, our MSR business had a solid year with assets increasing over $500 million throughout 2021 to $645 million.
We successfully established our MSR platform last year through the addition of key hires, procurement of strategic partnerships and build out of the operations and infrastructure necessary to scale the business efficiently.
As a result of these efforts, we have proven to be a key player in the market ending the year as the fifth largest bulk buyer of MSR.
And with over $200 million of MSR commitments already through the end of January, we're continuing to see progress toward fully scaling the platform and we expect to see increased market activity given diminished originator profitability.
Our residential credit platform, which grew nearly 90% last year, remains diversified with the ability to deploy capital efficiently in either whole loans or securitized markets.
The generation of assets for Annaly's balance sheet, while controlling strategy, diligence and servicing outcomes remains paramount to our investment approach.
Business activity was enhanced by the launch of our whole loan correspondent channel which expanded our sourcing capabilities through the addition of new strategic partners and product offerings.
We've also benefited from new bulk partnerships established outside of our correspondent channel and altogether, these efforts helped drive the group's record $4.5 billion in whole loan purchases last year, which exceeded the amount of originations in both the prior two years combined.
Further, Onslow Bay remains a programmatic issuer of securitizations, pricing 13 whole loan transactions totaling $5.3 billion since the beginning of 2021 with OBX being the fourth largest nonbank issuer of prime jumbo and expanded prime MBS over the past two years.
And with housing fundamentals expected to stay strong, residential credit should remain a key driver of our overall portfolio growth in the year ahead as we build on our origination and securitization momentum.
Now, shifting to our 2022 outlook.
Our portfolio is well prepared for volatility, which we anticipated would materialize as the Fed normalizes monetary policy.
First, we have thoughtfully reduced our economic leverage to one and a half turns since the onset of COVID to 5.7 times, the lowest it's been since 2014.
Our defensive leverage profile is further supported by our low capital structure leverage with 88% of our equity in common stock and minimal asset level structural leverage as highly liquid agency MBS make up the vast majority of our portfolio.
Second, we have substantial liquidity with $9.3 billion of unencumbered assets up $500 million year over year.
And this liquidity is complemented by a wide array of financing options, including our own broker-dealer.
And finally, we are conservatively hedged to mitigate interest rate risk with a year-end hedge ratio of 95%, and we expect to remain close to fully hedged over the near term.
Now, with ample liquidity and historically low leverage, we are well positioned to take a more offensive posture if and when the opportunity presents itself.
While agency returns are increasingly attractive as Ilker will elaborate on, we believe there will be better tactical opportunities out the horizon, and we'll be patient given uncertainty around the market and the Fed.
But should assets continue to widen past current levels, which we deem close to fair value, we stand ready to add fundamentally desirable assets.
Now, Finally, before handing it off to Ilker to discuss our portfolio in greater detail, I wanted to congratulate him on recently being named our Chief Investment Officer.
I've worked with Ilker at three different institutions for the better part of the past 20 years, and I cannot think of an individual more knowledgeable about mortgages and prepayments or better suited to help us drive success for Annaly into the future.
As you discussed, the fourth quarter was challenging for Agency MBS due to a combination of factors.
The Fed initiated and then accelerated the taper, which in conjunction with risk of sentiment caused by the virus variant and geopolitical risks led to significant curve flattening and an uptick in interest rate volatility.
Mortgage investors, notably banks turned their attention to 2022 without Fed support and decreased the pace of their purchases.
MBS underperformance was broad-based across the coupons stack with supply weighing on to upside threes, while higher coupons struggled into the curve flattening.
Although our portfolio was not immune to these sectors, we had been proactively reducing our MBS based exposure throughout 2021.
In fourth quarter, we reduced our agency holdings by roughly $5 billion, primarily through TBA sales, bringing the total 2021 portfolio reduction to $10 billion.
Through this resizing, our portfolio construct remains well positioned across the coupon stack.
In lower coupons, we continue to favor TBAs, which maximize our liquidity profile and despite the initiation of the taper, dollar roll financing remains special in the context of 30 to 40 basis points.
Meanwhile, our specified portfolio is based up in coupon, up in quality and is roughly four years season, which should provide resilient cash flows as we shift out of the financing environment and into on debt favors for extension protection.
In terms of our interest rate exposure, we adjusted hedges toward the front end of the yield curve by selling additional short-term treasury futures, which increased our hedge ratio to 95% of our liabilities.
We have also added short-term software swaps, which are an efficient hedge to our repo-funding levels.
Our conservative hedge portfolio is integral to managing high volatility market environments like the one we experienced recently.
At the current rate levels, to converge the profile of the Agency MBS market has improved meaningfully, but we continue to pursue a conservative approach to managing interest rate risk.
Since the year-end, we have seen a higher in rates and repricing in MBS as the market digests technical impact of Fed monetary policy tightening.
Following the move, wider MBS spreads are within a few basis points of their average 2018 levels, which was the last time the Fed was reducing balance sheet.
When drawing historical comparisons, we believe mortgage cash flows are currently more attractive compared to 2018 for multiple reasons.
Other fixed income alternatives are relatively tight from a historical perspective.
More of the mortgage universe is locked away in Fed and bank held-to-maturity portfolios and the prepayment outlook is much better for the mortgage universe.
In higher coupons, remaining borrowers did not refinance after months with historically low mortgage rates.
So we anticipate they would be less reactive to changes in rates going forward.
Meanwhile, due to very high realized home price appreciation, cash-out refinancings should alleviate extension risk in lower coupon mortgages.
All these factors should materially improve the profile and predictability of mortgage cash flows.
Consistent with these trends, our portfolio paid 21.4 CPR in Q4, 7% slower than in Q3, and we expect a further deterioration of approximately 15% in Q1 of 2022.
With respect to our MSR platform, our fourth quarter purchases brought the portfolio to nearly $650 million in market value net of runoff.
Additionally, as David mentioned, with over $200 million in bulk MSR commitments in January and the recent price appreciation due to the sell-off in rates, our current MSR portfolio has reached nearly $1 billion in market value.
The sector remains very active due to consistent disposition of MSR by the originator community.
Coupled with wider spreads, we see this as an attractive growth opportunity for our MSR business which is complementary to our core agency strategy.
Turning to residential credit.
We continue to execute our primary strategy of acquiring expanded residential whole loans through Onslow Bay.
The economic value of residential credit portfolio grew by approximately $330 million quarter over quarter, primarily through the addition of $1.7 billion of whole loans, the retention of assets manufactured through our OBX securitization platform and the deployment of capital into short spread duration securities.
Return on our securitization strategy remains in the low double digits with minimal recourse leverage.
The residential credit portfolio ended Q4 with $4.6 billion of assets representing $3.1 billion of the firm's capital.
Our view on housing fundamental strength remains intact despite mortgage rates increasing as the shortage of one to four units single-family housing in the United States continues to be a long-term structural issue that has no near-term resolution.
The supply demand imbalance of housing stock, combined with the strength of the consumer's balance sheet has continued to play out in outsize on price appreciation, positive resolution out of forbearance agreements and stable delinquency roll rates, all benefiting our existing portfolio.
Lastly, our middle market lending portfolio had an active quarter closing nine deals totaling over $325 million in commitments, while five borrowers repaid.
Middle market lending ended the fourth quarter with nearly $2 billion in assets, up 4% from the prior quarter.
The portfolio's strong credit profile is demonstrated through a 10% increase in underlying borrowers' average EBITDA since closing and a nearly 30% reduction in system reserves throughout the year with no loans on non-accruals.
And as discussed last quarter, the close of our private closed-end fund allows for increased capital allocation flexibility and provides recurring fee revenue to the REIT.
As David discussed, the current environment is marked by challenging conditions as the Fed begins to remove with accumulative policy that has supported asset prices and financial conditions since the onset of the pandemic nearly two years ago.
We remain focused on protecting the portfolio through defensive positioning and proactive hedging.
In addition, a key focus will be to opportunistically grow our MSR and residential credit businesses which should provide strong returns and diversification benefit to our broader portfolio.
Although we remain patient in light of recent spread widening in Agency MBS, the improving cash flow fundamentals and increased prospective returns on the sector should provide attractive reinvestment opportunities and even potentially bring leverage back to levels more consistent with our historical leverage considerate of our overall capital allocation framework.
With this, I will hand it over to Serena to discuss our financials.
Today, I'll provide brief financial highlights for the quarter and as of December 31, 2021 and discuss select year-to-date metrics.
As discussed earlier, the last quarter of the year exhibited challenging market conditions resulting from a risk off sentiment over the Omicron variant and anticipation around the initiation of the Fed tapering.
Notwithstanding this more difficult economic return environment, we have again delivered solid earnings and ample coverage, approximately 125% of our dividend.
To set the stage with some summary information.
Our book value per share was $7.97 for Q4, and we generated earnings available for distribution per share of $0.28.
Book value decreased $0.42 for the quarter primarily due to lower other comprehensive income of $680 million or $0.47 per share on higher rates and spread widening and the related declining valuations on our agency positions, as well as the common and preferred dividend declarations of $349 million or $0.24 per share, partially offset by GAAP net income of $418 million or $0.29 per share.
Our multifaceted hedging strategy continued to support the book value, albeit in a more muted fashion this quarter due to the aforementioned spread widening with swaps, futures and MSR valuations contributing $0.16 per share to the book value during the quarter.
Combining our book value performance with our fourth quarter dividend of $0.22, our quarterly and tangible economic returns were negative 2.4%.
Subsequent to quarter end, as Ilker and David both mentioned earlier, we continue to see significant spread widening impacting the valuation of our assets, which is partially offset by the benefit of our MSR investments and rate hedging strategy through January with our book value ending the month down 3% compared to December 31, 2021.
Diving deeper into the GAAP results, we generated GAAP net income for Q4 of $418 million or $0.27 per common share, net of preferred dividends, down from GAAP net income of $522 million or $0.34 per common share in the prior quarter.
The most significant drivers of lower GAAP income for the quarter is the unrealized losses on investments measured at fair value through earnings of $15 million in comparison to unrealized gains of $91 million in Q3 and realized losses on disposal of investments in the quarter of $25 million as compared to gains of $12 million in Q3 along with the previously referenced lower net gains on the swaps portfolio by $42 million.
As I mentioned earlier, the portfolio continued to generate strong income with EAD per share of $0.28, consistent with Q3 earnings, and we continue to generate strong earnings while prudently managing lower leverage resulting in an EAD ROE per unit of leverage of 2.3%.
We have previously communicated that we anticipate earnings to moderate.
Notwithstanding this, we expect earnings to sufficiently cover the dividend for the near term, all things equal.
Average yields remained flat at 2.63% compared to the prior quarter.
However, dollar roll income contributed to EAD in Q4 reaching another record level at $118.5 million.
EAD also benefited from higher MSR net servicing income associated with the growth of the MSR portfolio and lower G&A expenses, which I will cover further later.
The portfolio generated 203 basis points of NIM ex PAA, down one basis point from Q3 driven by the improved TBA dollar roll income, offset by higher swap expense on a lower average receive rate.
Now, turning to our financing.
As I noted in the prior quarter, we have benefited from our ample liquidity position and the robust financing market during 2021 with the previous quarter marking nine consecutive quarters of reduced economic cost of funds for the company and our year-to-date economic cost of funds being 79 basis points, down 55 basis points in comparison to the prior year.
During Q4, the market pricing a more aggressive Fed tightening cycle, resulting in repo rates increasing across the curve.
This upward trend along with higher swap rates impacted our overall cost of funds for the quarter rising by nine basis points to 75 basis points in Q4, and our average REPO rate for the quarter was 16 basis points compared to 15 basis points in the prior quarter.
Moving now to our operating expenses.
Efficiency ratios improved by seven basis points in the fourth quarter with opex to equity of 1.21%.
And for the entire year, the opex to equity ratio was 1.35% compared to full year 2020 of 1.55% as we realize the benefits we projected from the reduction in compensation and other expenses following the disposition of our acreage business and the internalization of our management.
As a result of our continued build-out of our MSR and residential credit businesses, which are more labor-intensive and additional vesting of stock compensation issued in prior years, we anticipate that the range of opex to equity for 2022 and long range will be 1.4% to 1.55%.
And to wrap things up, Annaly maintained an abundant liquidity profile with $9.3 billion of unencumbered assets down modestly from the prior quarter at $9.8 billion, including cash and unencumbered Agency MBS of $5.2 billion.
Much of the reduction in unencumbered agency securities was due to pressure on valuation, which is partially offset by increased unencumbered CRT, CMBS and non-agency securities.
Operator, we can now open it up to Q&A.

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