NEW YORK--(BUSINESS WIRE)--
Annaly Capital Management, Inc. (NYSE: NLY) released its fourth quarter
2011 market commentary providing a review of the economy and the
residential mortgage, commercial mortgage, asset-backed, corporate
credit and treasury markets. Through its quarterly commentary Annaly
expresses its thoughts and opinions on issues and events it monitors in
the financial markets. Please visit our website, www.annaly.com,
to view the complete
commentary with charts and graphs.
Policy
Before the current crisis, participants in the marketplace generally
would not consider the vote on raising the U.S. debt limit to be market
moving, nor would they place much emphasis on the results of the latest
sovereign debt auction in Italy or Portugal (no offense to those
countries). The Spanish housing market and Greek tax collections were of
purely provincial concern. Meetings between European heads of state were
seen to be largely ceremonial, not transactional. Governments, whether
democratic or autocratic, generally were in control of their citizenry.
Central bankers didn’t see themselves as firemen. Regulators and
legislators took small steps to improve markets, not large actions that
threatened to not only fix what was broken but break that which was
working. America’s was the triple-A risk-free rate.
This world no longer exists. 2011 was a year in which the whims, actions
and inactions of policymakers were a dominant driver of market activity
and volatility. In 2011, some $6.3 trillion in global stock market value
was erased, with most of those losses coming in the second half of the
year. European and Asian indexes were hit particularly hard, and the
euro ended the year as the worst performing major currency.
By the end of the year, it was clear that the United States Treasury
market—large, liquid and relatively safe—was the primary beneficiary of
all of this turmoil. U.S. interest rates were driven to generational
lows. Leading the way in this effort was the Federal Reserve (the Fed).
No sooner had the American central bank completed its second round of
quantitative easing (QE2) in June 2011 (in which it bought $600 billion
of Treasurys and grew its balance sheet to $2.8 trillion) than only
three months later it announced what has come to be known as Operation
Twist (in which $400 billion of short-maturity Treasurys are sold and a
similar amount of longer-term ones are purchased in a further attempt to
suppress interest rates along the yield curve without growing the size
of the balance sheet). When the European crisis deepened, the Fed
reopened, expanded, and cheapened the dollar liquidity swap lines with
several central banks amid tightness in dollar funding markets.
In short, prior to the crisis, the future could be counted on to
generally follow the same path as the past, with governments and
institutions playing their familiar roles. The uncertainty in the
marketplace seems to reflect a perception that this belief no longer
holds. Part of the problem is policymakers’ penchant for kicking the can
down the road (what Nouriel Roubini has called the “infuriating
euphemism”). European policymakers have yet to fully confront the
possibility that at least one and maybe more of their eurozone member
nations are insolvent and that their union (and currency) lacks some
critical mechanisms such as fiscal union and joint and several
liability. The United States, no better, has let its crisis moment pass
without taking serious steps towards fixing its structural fiscal
deficits and unwieldy entitlement systems. Many suspect that China, with
its social imbalances and mercantilist policies, will have its own day
of reckoning in the future. The gloom of the market as we head into 2012
is that the can, so to speak, may not be kickable much longer. As if
this weren’t enough, policymakers have made headway in at least one
respect—regulation. The looming catalysts of the enactment of the
various pieces of the Dodd-Frank Act and Basel III are about to do
nothing less than change the way in which our financial system operates.
The new year will start off with a bang. The European struggles will
remain at the forefront of the market’s immediate concerns—the test of
more than €457 billion of eurozone government debt coming due in the
first quarter. Beyond this, the market will grapple with more regulatory
uncertainty and the spectacle of the pivotal U.S. election season. In
this environment there will be both opportunity and despair, but it is
hard to disagree with Christine Lagarde, head of the International
Monetary Fund, who said recently, “There is no economy in the world,
whether low-income countries, emerging markets, middle-income countries
or super-advanced economies, that will be immune to the crisis that we
see not only unfolding but escalating.”
Economy
At the press conference following the November 1-2 meeting of the FOMC,
Federal Reserve Chairman Bernanke stated: “In short, while we still
expect that economic activity and labor market conditions will improve
gradually over time, the pace of progress is likely to be frustratingly
slow.” If we could put words in Mr. Bernanke’s mouth, we would say he is
“cautiously neutral.”
Not a bad conclusion, actually. Though real GDP accelerated throughout
2011, the pace of growth was well below levels that typically mark a
robust recovery: 0.4%, 1.3% and 1.8% in Q1, Q2 and Q3, respectively.
New housing starts averaged just over 600 thousand for 2011, well below
the historical average of 1.5 million and previous troughs between 800
and 900 thousand. New home sales were just as bad, averaging around 300
thousand during the year, down over 75% from a bubble-time peak of near
1.4 million in 2005. Prices continue to drift lower. The
S&P/Case-Shiller 20 city index was down 3.4% year-over-year in October,
and has fallen in every month since April 2011 (seasonally adjusted).
The CoreLogic index turned in a slightly worse performance, falling 3.9%
year over year in October.
Inflation, one of the Fed’s two mandates, is being watched very closely
by the central bank. Headline CPI inflation accelerated throughout the
year from below 2% to near 4% on the back of higher gasoline and food
prices, and core CPI also accelerated from below 1% to 2.1% by November
2011. Inflation expectations, however, as measured by the TIPS 5-year
breakeven, are telling a different story. After rising from around 1.7%
at the start of 2011 to a high near 2.5% in May as QE2 was nearing its
completion, expectations fell to 1.4% before the Fed announced Operation
Twist. Expectations have stabilized, but have yet to move significantly
higher, ending the year at 1.55%. This is a level that the FOMC would
consider lower than its mandate, and it expressed appropriate concern in
its December 13 statement: “The Committee also anticipates that
inflation will settle, over coming quarters, at levels at or below those
consistent with the Committee’s dual mandate. However, the Committee
will continue to pay close attention to the evolution of inflation and
inflation expectations.”
The second part of the dual mandate is the job market which, depending
on your comparison year, turned in either relatively strong or
relatively disappointing results. Compared to the job creation track
record of the prior three years, 2011 was a change for the better. But
compared to any other year of economic recovery, it was anemic. The
widely-followed nonfarm payrolls averaged gains of only 137 thousand
jobs per month during 2011, ranging from a high of 235 thousand in
February to a low of 20 thousand in June. Gains in the household survey
turned in a similar 131 thousand average for the year, but was much more
volatile. The unemployment rate showed a continued downward trend,
ending the year at 8.5% from 9.4% in the year-ago period. There were a
few drivers of this decline: the number of unemployed workers fell by
1.3 million from last year, but more than 1.4 million people left the
work force entirely. This pushed the participation rate down to 64.0% by
the end of 2011, a level not seen since the recessionary period of the
early 1980s. The labor force remained effectively flat for the year, but
notably has not grown at all in the trailing four years. In fact, the
trailing four-year growth rate dipped to -0.02% in December 2011; this
is the first time since the labor force began being measured in 1948
that the 48-month growth rate has been negative. A stagnant labor force
has important implications for potential GDP growth and inflation, among
other things.
Furthermore, nominal per capita wage growth is also negative over the
trailing four-year period, another unfortunate first for this 52-year
old data series. If nominal wages have lagged this badly, real wages
must be worse. This is certainly significant, as personal consumption
expenditures (PCE) as a percentage of GDP has remained at its historic
peak of 71%. PCE has shown continued strength despite slow/negative wage
growth, but this isn’t a new trend. Since 1980, PCE has grown at around
a 6% nominal annual pace while personal income has grown at about 5.8%
annualized. This gap looks small, but 20 basis points annualized over
30+ years becomes significant when you are dealing with trillions of
dollars. Famously, falling savings rates, household debt growth, and
wealth extraction from ripping equity and housing markets allowed
consumption to outpace incomes, but these trends have stalled and
reversed course in recent years. Increased government transfer payments
have taken their place to support spending in recent years. Chart 1 in
our online
version breaks out some notable components of personal income in
search of underlying trends.
Chart 1 in our online
version excludes payments for contributions to government social
insurance, which are subtracted from personal income. The “other” bucket
consists of proprietors’ income, rental income, and supplements to wages
and salaries such as employer contributions to social security and
pensions. While this “other” bucket has stayed fairly constant as a
percentage of total personal income over the past 60+ years, several
other trends immediately stand out. From the 1940s into the mid-1970s,
wages made up roughly 65% of personal income. They now account for
roughly half. The categories that took this share are the aforementioned
transfer receipts, as well as income on assets (interest income and
dividends). The growth in government transfers seems to be secular
(population growth and aging) and due to social security payments (31%
of the total), Medicare (24%), and Medicaid (18%).
The importance of income from assets rose through the early 1980s and
has been in decline ever since. Why? Lower interest rates and lower
dividend yields, compounded most recently by a general decline in net
worth. The owners of financial assets are clearly starved for income,
and the Fed has promised that it will stay this way for some time to
come, all along the yield curve. Chart 1 in our online
version represents a worrisome headwind for the economy, as is the
fact that the “growth” segment of personal income is dependent on
government social programs (and our continued ability to fund them).
Hopefully consumers have learned their lesson and won’t resort to
excessive borrowing to keep their consumption levels up.
Residential Mortgages
Even amid the volatility induced by European solvency and contagion
fears, on a spread basis agency mortgaged-backed securities ended the
quarter roughly where they began as investors sought the relative safety
of high-quality, liquid fixed income assets. In addition, the fourth
quarter of 2011 brought with it details of the re-vamped Homeowner
Affordable Refinance Program, or “HARP 2.0.” “HARP 1.0” was initiated to
help homeowners avoid foreclosure, stabilize the country’s housing
market, and ultimately improve the economy by providing a competitive
refinancing solution to borrowers who were experiencing hardship. While
in theory the program was a feasible solution to the nation’s housing
problem, it failed to deliver: Amid lender representation and warranty
concerns, inability to subordinate second liens, and loan-to-value (LTV)
and mortgage origination capacity constraints, only slightly over 800
thousand borrowers were officially refinanced, far fewer than the
hoped-for millions.
HARP 2.0, announced on October 24, 2011, sought to ease the frictions
associated with the original program. There were five key revisions to
the original program: 1) eliminate mandatory Fannie/Freddie borrower
risk-based fees for borrowers who refinanced into a shorter-term
mortgage, 2) remove the 125% LTV cap, 3) waive certain lender
representations and warranties, 4) eliminate the need for a new
appraisal, and 5) extend the end date for HARP until December 31, 2013
for loans originated on or before May 31, 2009. While these revisions
should certainly marginally help refinancing activity, it is important
to note that these revisions are far from any kind of “blanket”
government refinance program. In fact, the Federal Housing Finance
Authority (FHFA) estimated that roughly 800,000 borrowers per year
through 2013 may potentially refinance as a result of the changes, a far
cry from the 14.7 million homeowners estimated to be underwater on their
mortgages.
Despite the above mentioned revisions, there continue to be major
frictions to refinance even the official target amount. First, as
illustrated by Chart 2 in our online
version, provided by Nomura Securities, employment in the mortgage
origination industry is off about 20% from January 2010, which in and of
itself creates capacity constraints.
Second, as Nomura analysts pointed out in their “2012 Prepayment
Outlook”, HARP 2.0 did not “indicate any significant changes to
underwriting standards or reps and warrants”, two components believed to
be the main drivers of HARP 2.0 speeds.
Commercial Mortgages
After two years of virtually no investment activity, commercial real
estate participants entered 2011 more confident and poised to
participate in a market revival. Their outlook was bolstered by the fact
that CMBS spreads had grinded tighter since the summer of 2010. The
favorable spread environment fostered a proliferation of conduit lending
platforms. Lower financing costs coupled with pent up investor demand
facilitated more transaction activity. And owners of properties sought
to lock in historically attractive low long term rates provided the
underlying property credit supported the financing. All signs pointed to
a property recovery, albeit modest. All of this market momentum reversed
during the summer of 2011 amidst increased volatility, and as “risk-off”
became the mantra. Spreads widened and transaction quotes were pulled.
As we enter 2012, macro themes—European debts, economic growth, job
creation, etc.—overlap with the realization by investors that this
incipient recovery may be limited to certain properties and markets.
The one constant in the lending arena has been the life insurance
companies. Bolstered by portfolios that emerged in relatively good shape
following the Great Recession, an under-investment of commercial
mortgages in the portfolios because of aggressive originations by
conduit lenders, and value that is attractive relative to other fixed
income instruments, life companies issued $60 billion of commitments.
This trend should continue in 2012. We also expect to see renewed
conduit lending activity, but enthusiasm for large loans and long
warehouse holding periods are likely to be tempered by recent memory.
Given the low yields available in many fixed income products, investor
appetite for real estate that exhibits relatively stable cash flows has
remained strong. Investor preferences have and will remain focused on
gateway cities subject to appropriate pricing. While opportunities for
higher yields exist outside coastal and 24-hour cities, the risk-off
mindset will likely keep capital flows choppy for these assets.
With interest rates remaining low for the foreseeable future and new
product supply likely muted for almost all sectors, investors will
continue to look for commercial real estate as an investment option to
generate stable income with relatively high current rates of return.
Asset-backed Securities
Total volume of issuance increased sharply for asset-backed securities
in the fourth quarter, particularly in October and November. In fact,
November issuance ($18.7 billion) outpaced all other months of the year.
According to J.P. Morgan, total public and private asset-backed issuance
for the year ending 2011 was approximately $139 billion, which
represents a 29% increase over total issuance in 2010.
Collateral performance remains strong in the benchmark credit cards,
autos and utilities sectors of the market. Defaults in the credit card
sector fell to pre-crisis levels while the average monthly payment rate
(another measure of credit performance) rose well above 2010 levels.
Excess spreads remained at near-record highs, providing investors with
robust protection against credit losses. The auto and equipment sectors
continued to see rating upgrades in subordinated tranches during the
quarter in response to solid collateral performance and increases in
credit enhancement/support.
Owing to sovereign credit concerns, during the quarter there was a
pronounced bifurcation between the benchmark sectors and the off-the-run
sectors such as retail cards, student loans and UK and Aussie mortgages.
These latter sectors traded at a discount to the more liquid benchmark
sectors. There was also strong demand in the primary/new issue market
for these sectors, as many deals were upsized and/or driven by reverse
inquiry.
In general, the asset-backed sector delivered robust total returns in
2011, with the manufactured housing sector providing the best total
return performance (10.82%), followed by the utility (5.36%), credit
card (4.90%), home equity (3.63%), equipment (2.15%), and auto sectors
(1.69%). Additionally, according to Merrill Lynch research, the only
sectors that generated excess returns over the comparable Tresury
benchmarks for the year were the asset-backed and commercial
mortgage-backed sectors, with asset-backeds exhibiting less volatility
than most other spread sectors.
In 2012, we expect to see a modest increase in issuance in the auto,
equipment and some of the esoteric segments (timeshare, franchise,
structured settlements, container leases, and aircraft) of the asset
backed sector. Technicals are likely to remain favorable in the sector
due to continued strong investor demand. The implementation of proposed
securitization rules under the Dodd-Frank Act and other regulatory
proposals remain the big wild cards; while these rules are unlikely to
shut down the securitization markets they may ultimately increase the
costs of issuance and slow new issue volume.
Corporate Credit
The same themes that underpinned the credit market as 2011 began were
still in place as it came to an end. Fear of “Euro shock”, coupled with
forthcoming watershed changes in financial regulation and the 2012 U.S.
elections, is likely to continue to contribute to choppy trading
patterns, low conviction and heavy discounting of improving domestic
conditions.
Last year is illustrative of the challenge of extrapolating too far into
the future, and the resulting tendency to shorten investment time
horizons. Risky assets posted very strong total returns in the first
half notwithstanding tremors from the Japanese earthquake and Middle
East unrest. Investors had cash to put to work and asset prices rose
accordingly. The second half was unhinged by the re-emergence of Euro
woes and the U.S. budget/debt limit debacle. These events were a boon to
the Treasury market: The 10-year Treasury posted a spectacular 26.9%
return in the second half, while financial bonds, high yield (HY),
leveraged loans, the S&P 500 and Euro sovereign bonds posed negative
returns (see table 1 in our online
version).
The pricing of U.S. financial credit provides some insight into the
direction of market risk and liquidity premiums. If the “tail event”
stemming from Europe is financial institution failure, it makes sense
that U.S. bank credit default swaps (CDS) would be correlated to changes
in perceptions about Euro stresses. Chart 3 in our online
version shows how the correlation has increased starting last
summer. Moreover, the U.S. government faces its own fiscal imbalances
and the rating agencies have recently lowered the rating of a number of
U.S. banks based on lower levels of perceived government support. A
final factor to consider is relative pricing: if the marginal buyer of
fixed income is indeed a global asset allocator, it is important to look
across markets as to the pricing of risk. As chart 3 in our online
version shows, the single-B rated HY CDX index is trading at roughly
the same level as the average CDS spread of Portugal (Ba2/BBB- ), Spain
(A1/AA-), and Italy (A2/A+).
Treasury/Rates
There were three main influences in the Treasury market that have worked
to counteract each other. First, the somewhat better-than-expected
economic numbers, which should have led to higher yields; second and
third, the continued problems coming out of Europe and the commencement
of Operation Twist, which helped drive down rates. These factors are
responsible for the trendless market we have been experiencing since the
fall, with the 10-year Treasury trading in a tight 35 basis point range
for the last two months.
Auction sizes were steady during the quarter with a total of $501
billion in notes and bonds. The auction statistics were mixed, but
overall demand for Treasurys remained strong. The 2-year, 3-year and
5-year Treasury notes continue to auction well and have seen the
steadiest results. The 7-year saw solid demand in November but
lackluster interest for both the October and December auctions. The
10-year saw mixed results as well with weaker than expected results for
October and November but then very good demand in December. The 30-year
auctions saw the widest swings in demand, with the December auction
finishing with the highest bid-to-cover ratio since August 2000. (The
bid-to-cover ratio is the number of bids received divided by the number
of bids accepted and with December’s reading at 3.05 it means the
auction was more than 3 times oversubscribed.)
The Federal Reserve officially announced Operation Twist after its
September 20-21 FOMC meeting. “To support a stronger economic recovery
and to help ensure that inflation, over time, is at levels consistent
with the dual mandate,” the FOMC announced that it was going to extend
the average maturity of its holdings of securities. “This program should
put downward pressure on longer-term interest rates and help make
broader financial conditions more accommodative.” The idea of Operation
Twist started to get priced into the market right around the time the
debt ceiling issue was temporarily resolved in early August. As Chart 4
in our online
version shows, the yield spread between the 3-year and the 30-year,
the curve flattened significantly (~90 basis points) from early August
up to the announcement on September 21st. But from when the
first operation began on October 3rd through the end of the month, the
curve actually steepened moderately.
Chart 4 in our online
version, as well as similar price action observed in the rally of
the spring and summer of 2010 as the Fed hinted at QE2, illustrates that
Fed transparency can result in market moves ahead of a Fed operation.
This is worth watching in 2012. The minutes to the December 13, 2011,
FOMC meeting, released January 3, 2012, described the Fed’s intentions
with regards to increasing the transparency and clarity of its public
communications, including publishing the interest rate forecast built
into each participant’s economic forecast. As the Fed prepares to alter
its communication policies, the market will continue to try to stay a
step ahead.
The Markets
The equity market ended the year essentially flat, rallying for the
first half and fading in the second, with plenty of large daily swings.
Commodities were down as a whole (-8% as measured by the CRB index),
with precious metals and energy up for the year and industrial metals
and grains mostly down. This was a year of historic lows in interest
rates, with Treasurys one of the best performing asset classes of 2011.
The 30-year moved from 4.33% to 2.89%, while the 10-year declined from
3.29% to 1.88%. Even the 2-year note, which started the year at a
seemingly miniscule 60 basis points managed to shrink down to 24 basis
points. The rally can be pinned partially on a relative scarcity of
“safe” assets, particularly as the European sovereign debt crisis
intensified.
*Please direct media inquiries to Jeremy Diamond at (212)696-0100
This material is not intended to be relied upon as a forecast,
research or investment advice, and is not a recommendation, offer or
solicitation to buy or sell any securities, including securities of
Annaly Capital Management, Inc. or any other company, or to adopt any
investment strategy. All information and opinions contained
herein are derived from proprietary and nonproprietary 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, and we do not undertake to advise you of any
changes in the views expressed herein. While we have attempted to make
the information current at the time of its release, it may be or become
outdated, stale or otherwise subject to a variety of legal
qualifications as conditions change. No representation is made that we
will or are likely to achieve results comparable to those shown if
results are shown. Reliance upon information in this material is at the
sole discretion of the reader. ©2012 by Annaly Capital Management,
Inc./FIDAC/Merganser. All rights reserved. No part of this commentary
may be reproduced in any form and/or any medium, without our express
written permission.
Annaly Capital Management, Inc.
Investor Relations
1-888-8Annaly
www.annaly.com
Source: Annaly Capital Management, Inc.