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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good morning and welcome to the Q2 2022 Annaly Capital Management earnings conference call. Today, all participants will be in a listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions]
At this time, I would like to turn the conference over to Sean Kensil, Investor Relations. Please go ahead, sir.
Good morning, and welcome to the second quarter 2022 earnings call for Annaly Capital Management.
Any forward-looking statements made during today’s call are subject to certain risks and uncertainties, including with respect to COVID-19 impacts, 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. As a reminder, Annaly routinely posts important information for investors on the company’s website, www.annaly.com. Content referenced in today’s call can be found in our second quarter 2022 investor presentation and second quarter 2022 financial supplement, both found under the Presentations section of our website. Annaly intends to use our webpage as a means of disclosing material non-public information for complying with the company’s disclosure obligations under Regulation FD, and to post and update investor presentations and similar materials on a regular basis.
Please note this event is being recorded. Participants on this morning’s call include David Finkelstein, President and Chief Executive Officer; Serena Wolfe, Chief Financial Officer; Ilker Ertas ,Chief Investment Officer, and Mike Fania, Head of Residential Credit.
With that, I’ll turn the call over to David.
Thank you, Sean. Good morning, everyone, and thanks for joining us for our second quarter earnings call. Today, I’ll review the macroeconomic and housing market backdrop, our performance during the quarter, and then provide an update on our broader strategic direction as we begin the second half of the year. Ilker will then discuss our portfolio activity in more detail, followed by Serena who will go over our financial results for the quarter.
Starting with the macro landscape, as all are aware, the first half of 2022 has been an exceptionally challenging investment environment. Very high inflation, geopolitical uncertainty, and the fastest pace of monetary policy tightening in recent history led to broad-based deterioration across asset classes. Despite forecasts for inflation to peak this spring, headline CPI climbed through the quarter, reaching 9.1% year-over-year in June. Meanwhile, tight labor markets supported healthy consumption, making it increasingly clear economic activity was too strong for inflation to slow meaningfully. In response, the Federal Reserve hiked 125 basis points in the second quarter and another 75 basis points just yesterday.
The Hawkish Fed market’s pricing an additional 100 basis points of rate hikes for 2022 in June relative to March led to the largest quarterly tightening of financial conditions since the onset of the financial crisis. Economic activity now appears to be slowing, which can best be seen by the decline in activity in interest rate sensitive sectors, such as housing. Given the importance of the housing market to our business, I want to spend a moment on the outlook for single family housing.
Home prices have continued to rise sharply, appreciating over 10% the first five months of the year, according to the Case-Shiller Index. Housing activity, however, has slowed recently as the highest mortgage rates since 2008 and 40% cumulative home price appreciation since the start of the pandemic has weighed on both consumer and builder sentiment. Affordability for prospective home owners has been significantly reduced with mortgage payments 50% higher year-over-year on a national average. This is curbing consumers’ ability to purchase homes and in turn is reducing demand for mortgages. This correction will be welcome for the agency MBS market as it reduces elevated net supply, which has been the main headwind for the sector in the recent past.
Our expectation is that housing will exhibit negative momentum in the second half of the year with the deceleration of home prices and declining month-over-month HPA becoming a realistic possibility, particularly on a regional level; however, a systematic shortage of one to four single family homes relative to future demand, low leverage as measured by outstanding mortgage debt to equity, lean builder inventories, historically tight underwriting standards, and the majority of mortgage borrowers locked into a low fixed rate mortgage suggests a moderation and slight decline in home prices is more likely than a protracted decline.
Now shifting to the broader market outlook, risk to the rates market are more balanced now as concerns over an economic downturn are on the rise. The Fed has demonstrated its commitment to curve inflation and markets are now anticipating elevated inflation to decline, particularly if we experience an economic slowdown. As a consequence, we expect investors to allocate more capital to fixed income in this environment, which should result in a welcome decline in volatility going forward.
The combination of lower volatility and reduced supply would provide a positive backdrop for agency MBS, where spread remain historically high. While our MSR residential credit businesses have benefited from rising HPA, we maintain a constructive outlook given the underlying composition of our portfolios and the support from the long-term supply-demand imbalance in the housing market.
Turning to our performance, we experienced a negative economic return of 9.6% in the second quarter in light of this difficult environment. Economic leverage increased slightly to end the quarter at 6.6 turns, and despite our decline in book value, we generated strong earnings available for distribution of $0.30 for the quarter; however, as we have signaled in prior quarters, we expect earnings to moderate going forward, as Serena will cover in more detail.
Now I’d like to provide an update on our strategic initiatives. We completed the previously announced sale of our middle market lending portfolio during the quarter as planned, and to reiterate our rationale for the transaction, the sale provided an opportunity to monetize a less liquid, non-core business at an attractive valuation to redeploy capital into our core businesses. As I discussed on last quarter’s call, the sale of the MML portfolio culminates our natural evolution to becoming a dedicated housing finance REIT. With our sharpened focus, we have the capacity and flexibility to expand our operational capabilities and leadership across the residential credit and MSR landscape, and we have made significant strides over the past year, which I’ll turn to now.
Notwithstanding the broader market volatility and disruptions to the mortgage finance sector this year, our residential credit and MSR platforms have built upon their strategic capabilities and gained market share, all while maintaining an intentional focus on credit and risk management. Within residential credit, we remain a programmatic securitization issuer with Onslow Bay, representing the largest non-bank issuer of prime jumbo and expanded credit MBS in the first half of 2022. We have securitized $4.8 billion across 12 transactions year-to-date, generating $525 million of credit investments.
Our issuances benefited from increased originator partnerships and continued momentum in our residential whole loan correspondent channel. Our 2022 non-QM locked commitments are approximately 50% above our 2021 total locked volume, and Annaly’s balance sheet, commitment to the market and permanent capital are differentiated factors that reinforce our position as an industry leader and a reliable source of capital to the originator community.
Our mortgage servicing rights portfolio has grown significantly with Onslow Bay establishing itself as the fourth largest purchaser of MSR year-to-date and a top 20 owner of GSE mortgage servicing rights. We have prudently built the infrastructure necessary to scale as we continue to enhance our operations through the addition of key hires and partnerships. While the business has grown to 15% of capital in the span of a year, we’ve been disciplined with respect to our purchasing activity in order to responsibly build our MSR assets vis-à-vis our broader portfolio.
Also to note, we closed our first MSR credit facility subsequent to quarter-end. However, consistent with our prior guidance, we plan to employ only modest leverage on MSR in the facility search, primarily as a tool to manage liquidity. Over the long-term, we expect our allocation of residential credit and MSR to approach 50% of our capital based on prevailing returns and where we are in the cycle. Accordingly, agency is at the higher end where we see some long run capital allocation, which we were very comfortable with given the current relative attractiveness of the agency sector. But ultimately, we are confident that increasing our exposure to lower leverage, less liquid assets with a premium return will help improve the durability and quality of our economic returns.
While this year has been difficult throughout financial markets, we are encouraged by the robust growth within these businesses and the long term potential as we fully scale our housing finance capabilities.
Now finally before I turn it over to Ilker, I want to highlight that we published our third corporate responsibility report last month. The 2021 report demonstrates our continued focus on setting and measuring progress on our ESG goals, as well as our commitment to providing best-in-class disclosure and increased transparency. We continuously strive to advance these efforts each year.
In the latest report, for example, we included incremental disclosures that outline climate-related risks and opportunities across our business. We’re proud of the progress we have made to further integrate ESG priorities throughout our company that has undoubtedly helped to create lasting value for all of our stakeholders.
Now with that, I’ll hand it over to Ilker to provide a more detailed overview of our portfolio activity for the quarter and outlook for each sector.
Thank you David. As you had discussed, volatility in the fixed income market persisted throughout the second quarter with a continued sell-off in rates and underperformance in risk assets. Agency MBS widened 20 to 30 basis points as supply remained elevated, while on the demand side the Fed began reducing its balance sheet and banks were sellers on the quarter, leaving money managers as the primary buyer of MBS.
The largest buyers of MBS have shifted from being price agnostic and yield-based - the Fed and the banks respectively, to investors who are more focused on nominal and option-adjusted spreads. Mortgage underperformance has been closely tied to the rising interest rate volatility, which outside the short-lived spike in March 2020 is at the highest levels since 2009.
In the agency universe, a reversion of the trend in the first quarter lowered coupons underperformed as they were weighed down by fears of potential sales from the Fed and investors gravitated towards wider spreads and increased carryover in higher coupons. Specified pools outperformed TBAs, attributable to improved convexity [indiscernible] protection from the extreme levels of realized interest rate volatility, a worsening of the TBA deliverable due to higher average loan sizes, and TBA growth softening over the course of the quarter as new production replenished the float [indiscernible] coupons.
During the quarter, we kept the size of our agency portfolio relatively stable while we continued to rotate up in coupon, reducing our holdings of 2s through 3s by nearly $16 billion in favor of 3.5s, 4 and 5s. The technical decision of rotating up in coupon reduced our spread duration and improved the earnings in the portfolio. In lower coupons, we maintain a significant portion in specified pools, notably lower loan balance, credit impaired and faster services stories, which have historically prepaid rapidly in these kinds of environments.
Turning to our hedge portfolio, we maintain a defensive posture given the volatile interest rate environment. We replaced the roll-down in front-end swaps with longer dated hedges across swaps and treasury futures, which extended our hedges to match the extension of our assets as rates continue to rise.
Moving to our residential credit business, spreads widened materially across both non-agency and structured finance markets, notably underperforming corporate credit in light of the risk of environment and market volatility. Pure play non-current spreads were 35 basis points wider on the quarter while benchmark investment grade credit risk transfer was 100 basis points wider. Supply technicals and a deceleration in housing momentum have weighed on sentiment within the non-agency market, although consumer fundamentals have yet to show any deterioration.
Mortgage delinquencies are at the lowest point over the last 20 years and current delinquency roll rates remain stable. We took advantage of the spread dislocation and negative risk sentiment by increasing our allocation to short duration NPL-LPL securities and GSE credit risk transfer in addition to retaining our OVX securitizations as we [indiscernible] our whole loan portfolio. The economic [indiscernible] of the residential credit portfolio ended Q2 at $4.8 billion, a $430 million increase quarter-over-quarter. Also to note, as Serena will elaborate on, we chose to technically increase our leverage in the residential credit portfolio given attractive financing terms with dedicated capital declining from 19% in Q1 to 14% at the end of Q2.
In residential whole loans, we settled $1.1 billion of expanded credit home loans in Q2 and we issued five securitizations, generating $275 million market [indiscernible]. Our loan portfolio is well positioned for the volatility in the securitization market as we ended the quarter with less than $800 million of unsecuritized loans on the balance sheet with significant warehouse capacity.
In our MSR business, we continued to take advantage of the record origination volumes and the need for non-bank originators to monetize them as such, growing the portfolio by nearly $500 million in Q2 inclusive of the unsettled purchases. As of the quarter end, our MSR portfolio had sub-3% weighted average coupon and we continue to favor low note rate, high credit quality collateral. With our MSR portfolio over 200 basis points out of the money, it’s now fully extended and has minimal duration; however, the position provides strategic benefit to our overall portfolio. It generates high single digit, stable, unlevered returns with low correlation with the agency portfolio and provides a hedge to our lower coupons should the elevated discount speeds begin to subside. Our portfolio is now over $1.7 billion market value and represents approximately 15% of the firm’s capital.
Now expanding on David’s comments regarding our outlook, the latter part of Q2 brought about a shift in the market narrative from struggling to price the impact of inflation to preparing for a possible recessionary environment, which has led bond yields to retrace from the highs and regain some of their typical negative correlation with other risk assets. This shift has important implications which specifically benefit agency MBS from the perspective that market pricing and Fed costs in early 2023 to potential for Fed sales of the MBS is now less likely, and a slowdown in housing activity will result in reduced MBS supply. Furthermore, given the favorable liquidity and risk profile of agency, we anticipate that fixed income investors will prefer mortgages over corporate credit in a recessionary environment.
Fundamentally, we believe that the outlook for agency MBS looks very attractive with the sector trading near historically wide spread levels. Asset convexity is at record lows as cash flow certainty has improved, given over 90% of borrowers lack incentive to refinance their homes.
Overall, the investment opportunities across our three businesses are as compelling as we have seen in recent years and we believe that we are well positioned to benefit in what we expect to be a less volatile environment, which improves risk sentiment across the fixed income landscape.
With that, I will hand it over to Serena to discuss the financials.
Thank you, Ilker. Today I will provide brief financial highlights of the quarter ended June 30, 2022. 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.
To set the stage with some summary information, our book value per share was $5.90 for Q2 and we generated earnings available for distribution per share of $0.30, ample coverage of our dividend. Book value decreased by $0.87 per share for the quarter primarily due to a continuation of themes referenced in Q1; that is, higher rates and spread widening and the related declining valuations on our agency position. Agency and TBA valuations were down $2.18 per share on the prior quarter.
GAAP net income of $0.55 per share and our multi-faceted hedging strategy continued to support book value, providing a partial offset to the agency declines mentioned above with swaps, future and MSR valuations contributing $1.25 per share to the book value during the quarter. MSR valuations moderated in comparison to Q1 but were valued $0.06 per share higher at the quarter end that in the prior quarter. After combining our book value performance with our first quarter dividend of $0.22, our quarterly economic return was negative 9.6%.
As noted earlier, the portfolio generated EAD per share of $0.30. Earnings continued to be strong, resulting from high dollar roll income, increasing MSR net servicing income, reduced amortization due to lower CPRs, and a benefit from our swaps portfolio as it turned to a net receipt position during the quarter on higher short term rates. However, EAD was meaningfully aided this quarter by an increase in specialness and dollar rolls, primarily driven by a scarcity of TBA-type collateral and newer higher rate production coupons. We don’t expect this temporary phenomenon to persist in subsequent quarters as production is catching up with TBA demand and rolls are trading close to carry thus far in Q3.
We believe that the anticipated reduction in the specialness of dollar roll combined with the expected rise in the cost of funds due to rising rates should moderate future earnings; however, we expect to out-earn our $0.22 dividend in the third quarter all things equal.
Average yields ex-PAA were higher than the prior quarter at 2.87%, up 25 basis points compared to the preceding quarter due to lower CPRs and, to a lesser extent, from the overall composition of the portfolio shifting to higher yielding assets during the quarter. Additionally, the portfolio generated 220 basis points of NIM ex-PAA, up 16 basis points from Q1 driven by the higher TBA dollar roll income that surpassed higher economic interest expense, which included the beneficial net interest component of swaps. Net interest spread does not have dollar roll income and the increase was more muted, up three basis points at 1.76% compared to 3/31/22 as lower amortization and reduced swap interest modestly outpaced higher repo rates during the quarter.
Now turning to our financing, funding markets continue to function well with lender repo capacity for agency MBS remaining robust; however, uncertainty about the pace of future rate hikes has led to a shift in liquidity within the repo market towards the front end of the term curve as providers have priced longer dated repo contracts more conservatively in light of Fed uncertainty. Consequently, we have reduced our weighted average repo maturity to 47 days from 68 days in the prior quarter.
We expect to maintain a shorter dated book over the near term which we are comfortable with given ample reserves remaining in the system. Further to note, as Ilker discussed, early in the quarter we increased the repo leverage on our resi credit assets, taking advantage of attractive prevailing haircuts in financing levels. Given the volatility experienced through the first half of 2022, this strategy added to the company’s liquidity while taking advantage of beneficial economics in credit funding markets.
In warehouse financing, after adding $500 million of credit facility capacity to our resi credit business, our warehouse capacity for resi is now approximately $2 billion with significant unused capacity, and we continue to explore other financing alternatives for the business. Additionally as David alluded to, to further enhance the firm’s overall liquidity profile, we added a $500 million facility for our MSR business after quarter end.
The upward trend interest rates impacted our overall cost of funds for the quarter, rising by 22 basis points to 111 basis points in Q2, and our average repo rate for the quarter was 81 basis points compared to 20 basis points in the prior quarter.
Our activity in the securitization market also impacted funding costs, increasing the weighting of securitization on the composition of cost of funds along with higher effective rates of 2.73% compared to 2.30%, resulting in an increase of 11 basis points to cost of funds. Finally, swaps positively impacted cost of funds during the quarter, as previously mentioned, by 41 basis points.
Moving now to our operating expenses, our efficiency ratios improved during the quarter from decreased compensation expenses in the second quarter related to the sale of our MML portfolio, offset by the impact of the degradation in equity on the computation of the ratio.
In closing, Annaly maintained an abundant liquidity profile with $6.3 billion of unencumbered assets, down from the prior quarter at $7.2 billion, including cash and unencumbered agency MBS of approximately $4.5 billion. Much of the reduction in unencumbered assets was due to the sale of our MML assets and increased leverage on credit, which was partially offset by increased unencumbered MSR.
That concludes our prepared remarks, and Operator, we can now open it up to Q&A.
[Operator instructions]
Today’s first question comes from Bose George with KBW. Please proceed.
Hey everyone, good morning. Can I get your book value quarter-to-date? I don’t think you mentioned that in the prepared remarks.
Sure Bose, good morning. Book is up 4% as of yesterday, and this morning, post-Fed follow-through as well as GDP, it seems as though there’s very positive momentum.
Okay, great. Thanks. And then in your hedges, your treasury future position continues to increase relative to swaps. Can you just discuss the benefits of futures versus swaps? And then just from an accounting standpoint, is there anything we should think about in terms of how they flow through the P&L?
Yes, that’s a good question, Bose. So with respect to an outsized position in futures relative to historical, it’s about liquidity and better fit with the agency portfolio. And to your point with respect to accounting considerations, and Serena mentioned that our swap position turned to a net receive where we generated income in Q2, and we expect that to grow given higher short rates, and as a consequence, the futures position does not flow through EAD. There is an economic benefit much like there is with swaps, but it doesn’t flow through EAD. And so as a consequence, EAD may temporarily underestimate the economic earnings of the portfolio.
Okay, great. But I guess is there any way to sort of quantify that, or just -- yes, because I guess there was a period where -- or, I guess maybe to could rephrase that, when you think about your total return and what drives the dividend, I guess there could be a period where EAD is being depressed by the use of futures, but your economic return still is higher than that, right?
That’s correct. And the way we think about the dividend is based on the economic earnings of the portfolio.
Okay, great. Thanks.
You bet, Bose.
The next question comes from Rick Shane with JP Morgan. Please proceed.
Thanks guys for taking my question, and I apologize - we’ve been bouncing around, so some of this was covered, I apologize.
So when we look at book value and we look at the ROE hurdle you need to sustain the dividend, which is about 15% right now, given the opportunities that are in front of you, do you think that the market is presenting you with a 15%-plus ROE opportunity that makes sense within your risk parameters?
Sure. So look, I would say when we look at levered returns on agency and residential credit, we can get into the details within each of the sectors, but you can earn 15% in both sectors. MSR on an unlevered basis is lower than that, but given the fit in the portfolio, we’re perfectly comfortable with that.
So to answer your question, the dividend yield on book value at quarter-end, 15%, it’s actually a little bit lower than that given higher book value, but current levered returns are reasonably consistent with the yield.
Got it. And then, Ilker, just curious, when you think about the trajectory of the forward curve, how does that impact your both tactics and strategy in terms of where you want to play in the coupon stack?
Forward? Obviously, as you know – as everyone knows, the curve is extremely flat and inverted in some parts of the curve, big chunk of the curve, and forwards are also inverted. So that basically tells us that we can hedge down the stack like a lot better than what we used to, so basically we are arranging that in our hedges and then we are using coupons to also take advantage of that. But it doesn’t provide that much challenges; if anything, it makes hedging relatively easier.
Got it, okay. Thank you very much.
Thanks, Rick.
Our next question comes from Doug Harter with Credit Suisse.
Thanks. You guys talked about the return opportunities across your asset classes as being incredibly attractive. Can you talk about your appetite to continue to grow the portfolio, whether that’s through increased leverage or additional capital?
Sure. Well, let me talk about leverage first, Doug. So leverage is a function of three factors: first, capital allocation, and obviously higher allocation to agency, you’re going to have more leverage; and then second, liquidity of the portfolio and asset valuation. Now, if you look at our portfolio over the past six months, for example, we actually have increased leverage and we feel good about it.
The way we evaluate leverage is we have a baseline level of leverage, and if we think that there will be capital appreciation associated with the assets, then we’ll increase leverage and vice versa. We are above our baseline level of leverage, thus expecting capital appreciation which, to start the quarter, that’s materialized.
Now, another important point to note is where we are versus historical. Our leverage currently is the highest it’s been since March of 2020, and we feel good about it. That being said, we have ample liquidity and we can increase it more. One of the things we’re waiting on, and you’ve heard a lot about this, is just a decline in macro volatility. We’ve taken steps in the direction of increasing leverage, but should we see a more definitive decline, we can increase it.
Now with respect to capital raises, we obviously did raise capital in the second quarter. A number of conditions have to be met. It needs to be accretive to book value, and assets have to be attractively priced such that there could be accretion to earnings. Another factor is governance-related issues, and the three of those considerations all have to line up, and they did in the second quarter. And as a consequence, we were able to raise capital.
Great. Appreciate that. Thank you.
Thank you, Doug.
The next question comes from Trevor Cranston with JMP Securities.
Hi, thanks. Good morning.
Can you talk a little bit about what you guys are seeing in the residential credit whole loan markets, particularly, I guess on the non-QM side, there were some companies that seemed to have difficulty managing through all the rate volatility to start off this year. So I was curious what you guys are seeing in terms of origination volume in the non-agency loan space and kind of where you think returns would be on newly acquired loan securitization as the market stands today. Thanks.
Sure Trevor, I’ll start and then hand it over to Mike. I actually alluded to the turbulence in the origination channel in my prepared comments. And the fact of the matter is yes, there has been disruption amongst firms, and I think it as primarily related to capital markets, given the volatility in the market.
And the way we look at it is we are a partner to originators. We’re a liquidity provider. And as the market has evolved over the past six months, the world has turned from scarcity of assets to a scarcity of capital, and that puts capital providers like us in a better position, and we’re absolutely taking advantage of it, but responsibly.
And with that, I’ll hand it over to Mike to go into more details.
Yes, thanks David. Trevor, I think that when you look at the market, some of the originators that have entered bankruptcy or have closed their doors, it’s a misallocation of capital markets distribution, nothing to do with the actual loans being originated or the ability for the market to digest those loans. We do think it’s an isolated incident regarding un-sophistication around hedging both rates, credit, and the ability to distribute that risk.
In terms of the non-QM market, we still believe that volumes are healthy. I would say Q2 through our correspondent channel, we have $1.2 billion in lots, virtually all non-QM. In the month of June, it’s been $440 million of lots - that’s the highest lot volume that we’ve seen to date, and really what you’re seeing is large non-bank originators are entering the space given declining margins, declining volumes, and you’re also seeing small thinly capitalized originators that were bulking and selling it by the bulk market to come to the correspondent market.
With that being said, our volumes are at the healthiest levels that we’ve seen. Right now, we see current coupon non-QM, call it a one or two dollar price, you know, 7.75% gross WAC. We think it’s a low, mid 7% unlevered yield, mid-teens levered ROE on warehouse, and then through securitization without any recourse leverage, we’ll call it the bottom 8%, we think is a low, mid double digit return.
Got it. Okay, that’s helpful. I think last quarter, you mentioned that there weren’t any specific company acquisitions that you were looking at, at the time. As market volatility has continued throughout the second quarter, could you maybe provide an update on whether or not there are any companies out there that might make sense for Annaly as a sort of add-on to the businesses you guys are growing in? Thanks.
Sure Trevor. Look - we’re always looking at the market and evaluating opportunities in the M&A landscape, but the fact of the matter is if you look at the evolution of the company over the past couple of years, our organic build strategy has been very effective in both residential credit through the correspondent channel, as well as the MSR build, so we feel very good about our ability to acquire assets. Really, a transaction in the mortgage origination space would be based on the ability to secure flow, and as I mentioned, the world has shifted from asset scarcity to capital scarcity, and we’re not in a position to where we can acquire the assets we want, so the organic build has been very effective. It’s got a lot of momentum associated with it, but we’re always looking at opportunities in the M&A landscape, whether it’s a peripheral product or something that could enhance our own platform, but there’s nothing to report right now.
Thank you.
You bet, good talking to you, Trevor.
Thanks.
The next question comes from Kenneth Lee with RBC Capital Markets.
Hi, good morning. Thanks for taking my question.
Just one on the credit portfolio, specifically what characteristics are driving you to increase the allocation versus agency? You talked about increasing the durability of earnings, but just wanted to see if you could further expand upon that point and perhaps any other key points there. Thanks.
Sure Ken, and good morning. Look, expanding residential credit, and MSR for that matter, is a longer-term objective. From a capital allocation standpoint, agency is always going to the anchor of the company - the liquidity benefits are just so demonstrable that that’s going to be the mother ship for the company. That being said, we do know that adding incremental credit will be beneficial to the risk-adjusted returns of the portfolio over the long term.
Now when we look at where we’re at now with respect to the cycle, as I talked about in my prepared comments, we do expect housing to soften certainly, so we’re certainly a little bit more cautious; but to the extent that Mike has opportunities that are very healthy from a credit standpoint, we’re going to add. But we feel good about the allocation now, it’s just that over the longer term, we expect it to be higher.
Got you, very helpful. Just one follow-up, if I may. Wanted to get your thoughts around any of the key potential risks for any further negative impact to the book value when you look over the near term there. Thanks.
Sure. It’s volatility - that’s plagued, I think, the market over the last number of months, and that’s certainly something that we think about continuously. That being said, it appears to have declined when you look at implied volatility in the market, and so we feel good about the direction we’re going, but we have a lot of data coming up and we’re always going to be cautious about an increase in volatility, but that’s the main risk.
Got you, very helpful there. Thanks again.
Good talking to you, Ken.
As a reminder, if you do have a question, please press star then one.
Our next question comes from Eric Hagen with BTIG. Please proceed.
Hey, thanks. Good morning.
Going back to the liquidity for just a second, right now you have $4.5 billion of excess agency liquidity. How much liquidity do you think you’d use in levering up another turn? In your answer, if you could talk about any differences in margin between pools and TBAs, maybe revisiting the hedging tail.
Maybe just as one follow-up to that, is there a threshold for excess margin which you aim to run the portfolio, regardless of how much debt to equity you’re using?
Yes, so first of all, let me answer your second question first in terms of margin. Our business is liquidity management, and we’re incredibly conservative with respect to liquidity. For the past 25 years, we’ve always led with making sure that we maintain ample liquidity, and $4.5 billion is probably excess liquidity but nonetheless, volatility is elevated, and so we’re going to run in a conservative fashion but there is capacity to utilize that liquidity.
To your question about a turn of leverage and what that would do to liquidity, if you think about if you buy 10 billion mortgages with a 5% haircut, you’re talking about half a billion in liquidity, so it’d be a 10%, a little over 10% reduction in liquidity.
Okay, I figured there might be some margin associated with hedges also included in there.
Yes, there will be, but nevertheless that’s a rough estimate.
Another point to note is that when you increase your overall portfolio, your value at risk increases, and that informs our model and our minimum liquidity that we carry as well, so it’s an iterative process.
Right, that’s helpful. On the MSR, oftentimes when MSRs get sold, as you guys know, there is recapture provisions or non-solicitation agreements for the seller or the sub-servicer to abide by. Can you talk about how you structure those provisions into the MSR that you’re buying and how it drives who you buy from and where you subservice?
Sure. Actually these non-solicit provisions in the old days used to be, like, the seller used to give it to buyers, so basically sellers used to tell buyers that, look, I’m not going to solicit your borrowers, so you are buying [indiscernible], I’m not going to sell you to [indiscernible] and then go [indiscernible] those guys. But the last four or five years due to the wholesale channel, a lot of non-bank originators making broken promises to brokers that they will not solicit their borrowers, and that’s why now in this case, sometimes buyers end up giving sellers non-solicit provisions.
Obviously that reduces the value of the MSR that you are buying, especially for the operating entity, but the ones that we are buying, as you know, they are deep discount ones, sub-3% gross rate [indiscernible] portfolio, and for that the recapture, the value of recapture is much less, so that’s why at least [indiscernible] from time to time prefer those reverse non-solicit deals because the value of the recapture is a lot less.
Then another thing about that one is a lot of bank buyers are not involved in that reverse solicit MSRs, and that makes that buyer base a lot lower and that enables us to extract extra value from them. But that was a very good question.
Yes, that’s helpful. That’s really interesting. Do you mind if I sneak in one more here? You mentioned some of the different types of buyers that could step in to buy MBS as the Fed rolls off its balance sheet. What do you think are some of the things that will drive more levered buyers to step in, like what do you guys think is holding back that demand right now with spreads at 1.30, 1.40?
Obviously levered buyers, the most important thing for the levered buyers - I’m assuming you mean hedge funds in this case and obviously REITs, but mostly hedge funds, for them it’s [indiscernible] risk and they will be looking at the volatility, implied volatility as David has been alluding. As implied volatility has been subsiding and then you are seeing, like last couple days even before the Fed, the implied volatility was declining, you see levered money coming in. But most of the time, though, supply-demand imbalance cannot be met with the levered money buying, you need money managers, and we will expect more money managers buying in these instances because like fixed income, as we said in our prepared remarks, there’s the negative correlation in rates and the risk assets finally starts appearing, fixed income money managers will be getting subscriptions, and that will be the marginal demand on the MBS until banks clear their RW issues.
Got you. Thanks for the perspective this morning.
You bet, thanks Eric.
At this time, there are no further questions in the queue, and I would like to turn the conference back over to David Finkelstein for any closing remarks.
Thank you Chris. Everybody have a good rest of summer, and we’ll talk to you in the fall.
The conference has now concluded. Thank you for attending today’s presentation, and you may now disconnect.