Annaly Capital Management Announces Monthly Commentary for March

NEW YORK--(BUSINESS WIRE)-- Annaly Capital Management, Inc. (NYSE: NLY) released its monthly commentary for March. Through its monthly commentary and blog, Annaly Salvos on the Markets and the Economy (Annaly Salvos), Annaly expresses its thoughts and opinions on issues and events in the financial markets. Please visit the Resource Center of our website (www.annaly.com), to see the complete commentary with charts and graphs.

The Economy

Economic data continued to send mixed signals in February. The pace of deterioration in the jobs market has slowed, but no recovery has yet been seen. Initial jobless claims have settled into a range of approximately 450 to 500 thousand, a level higher than all but a few months in each of the last two recessions and still consistent with job losses. Non-farm payrolls dropped, though there was much confusion surrounding the weather and 2010 Census hiring. Manufacturing jobs have grown for two months in a row, confirming the slew of positive surveys (ISM, Richmond Fed, Empire Manufacturing), but only managed to add one thousand jobs in February, down from the 20 thousand added in January. Manufacturing has become a relatively small portion of the economy over the last few decades, but a cheaper dollar certainly helps make America more competitive globally and we may be surprised by a resurgence in this sector going forward. Workers on manufacturing payrolls are at low levels not seen since the very early 1940s, when the American population was less than half of what it is today. As we've mentioned before, if we are to have a faster than expected jobs recovery, it would likely come from this sector. The larger portion of our economy, personal consumption, continued its march higher despite much more tepid growth in personal income. As a result, the personal savings rate has begun to roll over and now stands at 3.3%, versus a series average since 1959 of near 7% and its recent peak of 6.4% in May 2009.

Government statisticians delivered the first revision of fourth quarter 2009 real GDP growth during the month, taking the initial reading of 5.7% up to 5.9%. It's always interesting to watch the moving parts of each revision, and GDP has a lot of moving parts. Inventories became an even larger part of the growth story than originally thought, accounting for 66% of total growth (up from the initial 59%). Personal consumption was revised down, as was residential investment, but on a positive note, investment in equipment and software was revised higher and accounted for over 1% of the total 5.9%. Perhaps obscured by all these ups and downs is the fact that nominal GDP was actually revised lower, from $14,463.4 billion to $14,461.7 billion, thanks to a downward revision of the GDP price index from 0.6% to 0.4%.

Some of the more negative news during the month came from the housing market. Construction spending and investment in residential structures continue to fall, January new home sales posted the lowest level ever recorded in the data series, and the Cash-for-Clunkers-style "surge and retreat" pattern in the chart of existing home sales suggests that the effect of government stimulus is wearing off (sales are back to roughly 5 million (seasonally adjusted annual rate) from an incentive-induced 6.5 million in November). Weather may have played a role in the sales volume decline, but according to the various home price indices available, prices have either stalled or begun to droop again. The FHFA and LoanPerformance indices are both pointing down again, while the Case-Shiller 20-city index is drifting just slightly higher.

The home price indexes all measure prices in the month of December, while the disappointing sales data are for January, so it will be interesting to see if prices track sales volumes down in the early part of 2010. We think there still may be room to the downside in home prices, as we illustrate in our online version. We have historically used the home price-to-income relationship, which put up very early red flags on the housing bubble. In the graph in our online version we use the LoanPerformance national home price index and annual median household income data from the US Census Bureau. The relationship between home prices and the income needed to support the associated mortgage debt is an easy one to understand, and should hold reasonably steady over time. A more complete analysis would control for the level of interest rates, and any devil's advocate worth his salt would suggest that the current low mortgage rates should support a higher price-to-income ratio. No argument here, but the chart still seems to suggest that further declines in home prices may be necessary (conservatively another 10% to 15% drop would put the relationship back to more "normal" historical levels). In the online version we present a chart that looks at the decision every prospective homeowner must make between owning and renting. We owe a debt to Calculated Risk for the methodology, which looks at the ratio of home prices to owners' equivalent rent (the CPI bucket that is supposed to approximate what an owner would pay to rent his house or would earn from renting it out) on a monthly basis.

If home prices become too expensive in relation to comparable rental properties, households will choose to rent until prices become more reasonable for purchasing. Of course, determining the "correct" level is impossible, but the kind of declines in home prices suggested by the price-to-income chart would not be out of the historical norms of this ratio. If our goal is to figure out the inning of this housing correction game, it's safe to say that we've already sung "Take Me Out To The Ballgame," but there's still some ball left to be played.

The Residential Mortgage Market

In January (February release), despite low mortgage rates prepayment speeds declined 15% for 30-year Fannie Mae fixed-rate mortgages from the prior month. This trend of abnormally slow prepayment speeds should come to an abrupt end, particularly for Freddie Mac collateral, beginning with February's factor release. As noted in our last Commentary, on February 10th both Fannie Mae and Freddie Mac announced plans to buy 120+ day delinquent loans out of their pools--Freddie said they would buy "substantially all" delinquent loans by the end of the February and fully reflect them in the March 5th factor release, while Fannie was less precise, stating instead that their initial program would be completed over the course of "several months." These buyouts will be passed through as a prepayment to the MBS bondholder.

It is reasonable to assume these initial buyout programs by Fannie and Freddie will not be completed in totality any time soon. We believe it is likely that both Fannie and Freddie will have loans that will continue to transition to 120+ days delinquent. Thus both GSEs will simply repeat or continue these buyout programs until they have flushed out all, or substantially all, of their seriously delinquent loans.

What are the near-term implications for prepayment speeds? The tables in our online version, provided by Laurie Goodman's team at Amherst Securities Group, show their near term speed estimates on thirty-year fixed-rate 5.5s and 6s by vintage. Their estimates for February for Freddie Mac were on target based on recently issued factors. You will notice some differences between Fannie and Freddie prepayment estimates, expressed as Constant Prepayment Rate or CPR. This takes into account Freddie's plan for immediate buyout versus Fannie spreading theirs out over the subsequent several months. Further, Amherst assumes that Fannie stages its buyouts by coupon--higher then lower. However, the most important distinction to notice is that once the bulk of the announced buyouts work through the system, prepays subside but still remain at higher levels than before, particularly on 2005-2007 collateral which was originated during the peak of the housing boom and should therefore have the greatest percentage of delinquencies. This is due to the assumption that delinquencies continue to ramp up and that these delinquent loans are removed from the pool, and that the denominator in the CPR calculation is smaller as a result. Amherst also calculates that hybrid ARM prepayment speeds will be even faster than 30-year fixed rate speeds.

The Commercial Mortgage Market

Last month, we looked at how the losses on the $3 billion Stuy Town mortgage would create a new Directing Certificate Holder ("DCH") to control the decision making within a commercial mortgage-backed security that owns the loan. The Stuy Town loss, however, will have a more pervasive effect, as the loss will create new DCHs that will multiply throughout the CMBS universe.

During the go-go years in the commercial real estate market, the size of transactions and the leverage on properties increased, and it became problematic for these large mortgages to be deposited into a single CMBS pool. The rating agencies would require more subordination due to their diversification requirements if the loan was too large relative to other loans in the pool. Thus to optimize the use of securitizations, commercial real estate loans on a property were divided up into pari passu notes having equal rights of payment or levels of seniority. Like Tinker Bell with her pixie dust, the pari passu notes could then be sprinkled about numerous CMBS pools. In the case of Stuy Town, the $3 billion loan was divided into five pari passu senior A Notes and deposited into five separate CMBS deals. In our online version you can view the table with the distribution of the Stuy Town notes at securitization.

Each of the CMBS structures is on a different issuer's offering shelf--WBMCT is Wachovia, MLCFC is Merrill Lynch and CWCI is CW Capital. (Wachovia and Merrill originated the Stuy Town loan, and sold it into their respective CMBS trusts.) Assuming 50% loss on the Stuy Town notes, and combining those losses with credit losses from other problem loans as of February 28, we arrive at the new lowest rated class for each transaction (listed in the table available in our online version). They are all investment grade classes. So for example, the WBCMT 2007-C30 transaction had collateral losses of $750 million from the Stuy Town exposure, plus an additional $173.4 million from other poorly performing collateral in the CMBS. These losses ate through the subordination all the way up to the AJ class of note holders, which now becomes the DCH. Typically the largest holder at these more senior levels of a CMBS ownership structure are insurance companies. Thus, the pari passu nature of the Stuy Town loan has spread the loss and the confusion among several different structures, affecting many different investor bases.

In today's market, however, it doesn't stop at Stuy Town. On March 5, after the table discussed above and available on our online version was calculated, the property identified in 2007 as the most expensive office building in the country, 666 Fifth Avenue, burdened with a $929.5 million mortgage, was turned over to the special servicer after a drop in occupancy and rents. Similar to Stuy Town, its overleveraged counterpart of the apartment sector, 666 Fifth Avenue had a loan which also had to be divided into pari passu notes and sprinkled into various deals. One such note for $249 million was deposited into the WBCMT 2007-C31 deal. This brought together two very large, very leveraged transactions, Stuy Town and 666 Fifth Avenue. If we apply an estimated 60% severity to 666 Fifth Avenue, the collateral losses will total $517 million, making the new lowest rated class for WBCMT 2007-C31 Class D, not Class G any longer. It is the uncertainties caused by these intersections that create a much more unsettled condition in which the DCH is determined. Perhaps this is a green shoot of new job creation: the legal eagles and workout specialists figuring out exactly how pervasive these uncertainties will be.

The Corporate Credit Market

The corporate credit market is carving out a trading range, underpinned by a confluence of macro headwinds (public sector debt burdens, policy-induced event risk) and micro tailwinds (abundant liquidity, lean cost structures). Technically speaking, investor demand for fixed income assets remains brisk and will likely be met with opportunistic issuance over the course of the next several months. Having recovered from a modest correction last month, option-adjusted spreads have narrowed 11 basis points (bps) for Investment Grade (IG) and 66 bps for High Yield (HY) off their February wides.

In previous Commentaries we have argued that the corporate sector is exhibiting a typical cyclical pattern, in contrast to that of its mortgage sector counterpart. While the recovery in corporate credit may be more short-lived or more muted than average, its foundation is becoming clear. Both defaults and other metrics that handicap expected defaults-- rating transitions and outlooks-- are evidence of improving corporate credit trends.

Last week, Moody's published its most recent default rate for bond and loan issuers. In the U.S., the twelve month trailing default rate has declined for the third consecutive month. Having peaked at 14.5%, it declined to 12.7% in February. This most recent drop in the rate is the largest decline since January of 2003. Perhaps more telling of the cyclical trend, Moody's forecast that the year-end 2010 U.S. default rate will be a mere 3.3%. Recall, this rate embeds smoothing as it reflects a twelve month average. Thus, it is also informative to look at the pattern of actual defaults. In February, only two issuers experienced credit events: Penton Media executed a pre-packaged Chapter 11 and FGIC missed an interest payment.

Rating trends are consistent with those of default rates. The chart, available in our online version, shows the rating migration behavior since 1997, adjusted for par bonds in the Bank of America Merrill Lynch (BAML) Investment Grade and High Yield Indexes. In HY there are more bonds experiencing positive rating changes than negative changes. While one could debate the prescience and relevancy of rating agency ratings at length, these ratings still provide guidelines for managers of credit risk and, thus, the improving trend in ratings is a form of relief. Furthermore, reinforcing the ratios are changes in the sample. That is, the least credit worthy IG bonds are moving from IG to HY and the riskiest HY names are falling out of the sample altogether as they default. This helps propel the "virtuous cycle" of the recovery due to survivor bias and the redistribution of risk into new portfolios suitable for the risk.

While the rating agencies have just started to upgrade more high yield bonds than they downgrade, they are still sanguine with respect to their credit outlooks, although net negative outlooks are trending lower. At present, both S&P and Moody's have a negative credit outlook on over 20% of the market value of the HY index. In contrast, positive outlooks are running just over 5%. In the table available in our online version, we show how outlooks vary across industries. The only industry where positive outlooks exceed negative outlooks for both Moody's and S&P is Healthcare. The most net negative outlooks are in Real Estate, Financial Services and Insurance, with Energy and Banking not far behind. All told, while default and ratings trends have turned, the rating agency outlooks are still biased negative. This takes us back to the macro: clearly more top line growth would augment the liquidity improvements leading to a more positive outlook picture.

March 10, 2010

Jeremy Diamond

Managing Director

Robert Calhoun

Vice President

Ryan O'Hagan

Senior Vice President

Mary Rooney

Executive Vice President

*Please direct media inquiries to Jeremy Diamond at (212)696-0100

This commentary is neither an offer to sell, nor a solicitation of an offer to buy, any securities of Annaly Capital Management, Inc. ("Annaly"), FIDAC or any other company. Such an offer can only be made by a properly authorized offering document, which enumerates the fees, expenses, and risks associated with investing in this strategy, including the loss of some or all principal. All information contained herein is obtained from sources believed to be accurate and reliable. However, such information is presented "as is" without warranty of any kind, and we make no representation or warranty, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use. While we have attempted to make the information current at the time of its release, it may well be or become outdated, stale or otherwise subject to a variety of legal qualifications by the time you actually read it. No representation is made that we will or are likely to achieve results comparable to those shown if results are shown. Results for the fund, if shown, include dividends (when appropriate) and are net of fees. (C)2009 by Annaly Capital Management, Inc./FIDAC. All rights reserved. No part of this commentary may be reproduced in any form and/or any medium, without our express written permission.

    Source: Annaly Capital Management, Inc.