Annaly Capital Management's CEO Discusses Q2 2012 Results - Earnings Call Transcript

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Annaly Capital Management, Inc. ( NLY )

Q2 2012 Earnings Conference Call

August 2, 2012 9:00 AM ET

Executives

Michael Farrell - Chairman, CEO and President

Kathryn Fagan - CFO and Treasurer

Wellington Denahan-Norris - VC, CIO and COO

Analysts

Jason Arnold - RBC Capital Markets

Jade Rahmani - KBW

Steve Delaney - JMP Securities

Rick Shane - J P Morgan

Jasper Birch - Macquarie

Ken Bruce - Bank of America

Bill Carcache - Nomura Securities

Presentation

Operator

Good morning, and welcome to the Second Quarter Earnings Call for Annaly Capital Management, Inc. At this time I would like to inform you that this conference is being recorded and that all participants are in a listen-only mode (Operator Instructions).

Earnings call may contain certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements which are based on various assumptions, some of which are beyond our control, may be identified by reference to a future period or periods or by the use of forward-looking terminology, such as may, will, believe, expect, anticipate, continue, or similar terms or variations on those terms or the negative of those terms.

Actual results could differ materially from those set forth in forward-looking statements due to a variety of factors, including, but not limited to, changes in interest rates, changes in the yield curve, changes in prepayment rates, the availability of mortgage-backed securities for purchase, the availability of financing and, if available, the terms of any financing, changes in the market value of our assets, changes in business conditions and the general economy, changes in governmental regulations affecting our business, our ability to maintain our classification as a REIT for federal income tax purposes, risks associated with the broker-dealer business of our subsidiary, risks associated with the investment advisory business of our subsidiaries, including the removal by clients of assets they manage, their regulatory requirements and competition in the investment advisory business.

For a discussion of the risks and uncertainties which could cause actual results to differ from those contained in the forward-looking statements, see Risk Factors in our most recent Annual Report on Form 10-K and all subsequent Quarterly Reports on Form 10-Q. We do not undertake, and specifically disclaim any obligation, to publicly release the result of any revisions which may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

I will now turn the conference over to Michael A. J. Farrell Chairman, Chief Executive Officer and President. Please proceed Mr. Farrell.

Michael Farrell

Good morning and thank you. Good morning and welcome to the Annaly Capital Management's Earning Call for the second quarter of 2012. I am Mike Farrell and joining me on the call today are Wellington Denahan-Norris and Kathryn Fagan.

Annaly's execution and performance in the second quarter was consistent with what we've been discussing with investors for some time. We have kept leverage low, we strengthened and executed and extended the right side of our balance sheet. We have been careful on our asset selection and maintained a sizable hedge position, all while continuing to generate mid-teens returns on equity. Our portfolio positioning reflects our view that there are significant risks embedded in the financial system, some of which I will address in my prepared remarks after which we will gladly take questions about the quarter.

As usual my remarks this morning are up on our website already. The title for today's missive is Fiscal Union Civil War.

As policymakers ponder the next steps to be taken in solving the world's fiat currency issues, I thought it would be helpful to remind people of one precedent in particular for some historical lessons about the fundamental deterioration we are witnessing globally.

Much has been made about the contrast between the fiscal union in the United States and the lack of one in Europe, but recall that in 1861, eleven southern states decided to dissolve their economic and political ties with the United States of America, leaving the Union with twenty members and five border states.

The Confederate States of America had a virtual world monopoly on agricultural goods like cotton and tobacco. These eleven states together ranked as the fourth largest economy in the world. However, they were unable to agree as a group on sharing Treasury functions and responsibilities, so the Confederate Treasury issued unsecured notes. When first distributed in 1861, Confederate notes traded at a premium to gold, based on the assumption that their value was ultimately secured by the combined revenue of the South's tobacco and cotton assets. Unfortunately, for the South and for Confederate note holders, this was not the case. Since the leaders of the individual states maintained that secession was largely about state's rights, it would have been inconsistent for them to consolidate Treasury functions under a central government. Besides, South Carolina did not trust a Virginian to run their Treasury, and so the arguments went, state by state.

In late 1861, the Union Navy successfully blockaded the major Southern ports and naval trade routes, effectively killing Confederate trade and, as the graph to the left shows, the value of the Confederate dollar. As exports fell, the value of a Confederate note fell to a 10% discount to gold. This began a downward spiral so violent that by mid-1862 it was a 60% discount, by the end of 1863 a 94% discount and still lower into the last two years of the war.

By 1865 the Confederate economy was in ruins. The South never fully recovered from the Civil War until the outbreak of World War II, meaning it took eighty years to rebuild what had been the fourth largest economy in the world.

As the Confederacy showed, a common currency without fiscal union is a recipe for disaster. Today we have a Europe without Federalism, as each individual country hangs on to its own sovereignty at different levels. As we witness the flight of capital from Europe and the decline of the euro towards parity with the dollar, it is clear that the assembled countries of Europe needs an Alexander Hamilton. If the Eurozone didn't have the money-printing backstop of modern central banks, I suggest the euro would be no better than the Confederate dollar.

Meanwhile, the North was united behind the dollar, but it was having its own problems struggling with a radical shift in its economy. To pay for the war and the agricultural products that the South had previously provided at cheaper levels, the Secretary of the Treasury, Salmon P. Chase, developed new revenue sources through taxes and tariffs, and authorized and funded national banks. In addition, the Legal Tender Act of 1862 created the greenback, fiat money that was not backed by gold. Federal debt quadrupled during the four years of the war. Eventually, the monetary system was so clogged and currencies held in such disdain that the bartering of gold and cotton become the main commercial tool for both the North and the South. The cost of the war for the North was staggering, and was only met through punitive reparations by the South.

Thus another lesson of the Civil War is that fiscal union alone is no solution if an economy is facing a drastic change in fiscal circumstances and steep growth in debts and deficits. Today the United States has a unique, historical opportunity to lead the world out of the current mess. But it is my concern that our political system is so polarized that we will be unable to seize the moment and capitalize on it for the benefit of all Americans. We are heading towards a fiscal cliff with the election year debate of tax reform, tax increases, new protectionist tariffs on China, economic blockades on Iran and, surprisingly, immigration issues. States are attacking Amazon for the collection of internet sales taxes.

In the mortgage market alone, we watch carefully as the federal government mandates aggressive refinance and modification programs and as individual states consider reforms that actually will negate mortgage securitizations. These "solutions" threaten consumers with significantly limited access to capital. Investors will avoid such states. I experienced a market just like this earlier in my career. I was trained in the 1970s to avoid loans in the oil bust states that were tagged as COLT-Colorado, Oklahoma, Louisiana and Texas. In the current swing of the pendulum to protect borrowers, the ultimate price could be a fractured mortgage origination market that is unable to be scaled and therefore more expensive to finance. Liquidity is the key to attracting commodity-like savings, not customized rules, state by state.

There are tough, unpopular decisions to be made across all markets, but if we don't make them, history has shown us that it will take a very long time for the system to heal itself.

Now with regards to the quarter, I'd like to put some highlights out there before we get to Q&A. Since our $2.4 billion common equity offering in July of 2011, we've raised over $1.1 billion in capital via the first ever concurrent overnight convertible offering and perpetual preferred transaction in history. These transactions represent the largest reconvertable offerings since 2007, the largest mortgage reconvert ever and the largest non rated conferred deal ever.

Annaly's weighted average cost of capital during these transactions was 5.75% versus 14.7% for almost $11 billion of equity that was raised in the mREIT sector during the past 12 months. Also in the past year, one third of the 34 offerings in the sector had been diluted to book and may have been diluted to earnings. On an average the sector's deals have been done with the weighted average rate on the 10-year treasury of 1.97 versus the 2.92 that we did our offering at last July.

As discussed on our last earnings call, we focused on liability management. We have now extended our average days to maturity on interest bearing liabilities to 216 days, 156 days longer in the next closest agency reach. Currently, we have over $12.2 billion of liabilities with the maturity greater than one year, 12.4% for the borrowings versus an estimated 4 billion across the rest of the entire agency REIT sector, 3.5% of the borrowings. With that stated I open up the call for questions.

Question-And-Answer Session

Operator

The question and answer session will begin at this time. (Operator Instructions) Our first question is from Jason Arnold of RBC Capital Markets.

Jason Arnold - RBC Capital Markets

Hi good morning guys and Mike, great commentary as usual. And also want to thank you for the added disclosures on the release, very helpful there. One question on those in particular on the 0 to 3 year maturity bucket on swaps, can you add any context around the average pay fixed rate and the weighted average year to maturity with respect to the dispersion of those averages, kind of looking specifically for whether or not you've got a lot of 4% and 5% pay fixed rates falls maturing near term balanced against some 1% to 2% rates whilst the longer end of equation there.

Kathryn Fagan

Jason, you could tell just from rate alone that there is older, higher pay rate swaps included in that. And obviously by virtue of the rate they are much older in time, so they are nearer to maturity today and so you would expect that a lot of that higher pay rates stuff is near to maturity than not.

Jason Arnold - RBC Capital Markets

Okay, helpful there thank you. And then I guess the other one I was interested in is on the prepayments side of the equation. Have we certainly seen the 10-year yield fall quite a bit here, but we've also got a weakening macro and still damaged mortgage and the housing market is an offset, so just kind of curious if you could update us on your thoughts on the prepayment side?

Kathryn Fagan

It seems like with every rally there's less and less response to it, I don't know if there's a borrower burnout with respect to new rates being lower but obviously a lot of the macro economic conditions continue to weigh on normal refinancing incentives. I still think that the greatest risk is policy known and unknown and as the economy continues to falter, I think there is no limit to what the administration will roll out whether it's real or not that will weigh on the market psychology with respect to prepayments. None the less, they have remained subdued from a rate perspective and we would continue to expect the worst case but certainly welcome the subdued nature of borrower's responses to the ever decreasing rate environment.

Jason Arnold - RBC Capital Markets

Okay, so its sounds like you might think that there would be a verbal expression of some additional refinance help, but that it may not come in, in actual forum or ?

Kathryn Fagan

I just think even with the eminent domain coming out of California, you just never know what to expect and I think that is your greatest risk given the fact that, as rates continue to go lower and lower, that borrowers responses to that. Maybe they have been conditioned to think that there is never going to be just a small window to re-finance, it's going to be a very long term situation so it's a more subdued response.

Michael Farrell

I think clearly from the perspective of the statements that were made by DeMarco over the past couple of days about the global re-financing. It is really directly in line with what we've been talking about for the past 4 quarters which is, we have to realize that if they decide to forgive principals and somehow override the Congress' wish is not to do that. The bottom line is that is more re-distribution of wealth, that money will come out of the tax coffers and by the way one of the biggest holders is the Federal Reserve for bonds that are premium. So, it is a self damaging and all it is doing is moving around along the balance sheet from the feds to the treasury, start to finance more losses. And I think that what DeMarco said is true and I think what the message that Bernanke has been delivering for the past few testimonies, the Congress is true which is hey, it is not about low interest rates, right, affordability is at an all time high when you want to measure against that. The rest of this is policy and also tax issues. Just because your house dropped by a third in value, doesn't mean that your property taxes drop by a third in value. So, what you are seeing is a bifurcation here, in the markets between properties that are say $700,000 and lower and anything above a $1 million. It is the government guaranteed stuff that's why there is 95% of that stuff clearing. It is not clearing how much higher prices from my analysis than it was several years back. So, it is like you've almost lost money by holding a house even if you have to move up. So, I think you are stuck in the mud exactly as Bernanke said, and this is going to be churning for a while and I think that people have their heels tugged in on the policy side of that debt forgiveness. It is enough of that, we have done enough. If you haven't been able to re-finance your house at 3.5% the only thing that is going to really start this thing over again is the real job creation and real income creation.

Jason Arnold - RBC Capital Markets

Makes sense, excellent. Thanks for the color. I appreciate it.

Michael Farrell

Thank you Jason.

Operator

And the next question is from Bose George of KBW.

Jade Rahmani - KBW

Hi, thanks for taking my question. This is Jade Rahmani from Bose's team. I wanted to ask the issue of eminent domain has garnered much attention lately, do you have a view on how this issue plays out and what you think the impact on the mortgage market could be.

Michael Farrell

Yeah, we first saw the outline or the sketch of this plan last fall. We don't feel like there is any true legal backing behind this. We cautioned the people who are going around trying to raise capital like this would be an issue that would threaten the securitization market, but ultimately would cause a lot of noise and have to go away. If you think about it, you have a bankrupt city that will be in the middle of the credit transaction between a mortgage holder and the new borrower. So, it is not like you are moving in the middle or you don't use transfer and capitals from an existing holder that under contractual law under underwriting standards owns those cash flows. Now, to break that under eminent domain that is an extremely tough hurdle to hit, but I will tell you that the concept of a national mortgage market is a relatively new concept in America's history. It really only started in the late 1970s and has continued up to today and one of the reasons for that was because the loans became homogenous in their underwriting standards and Fannie and Freddie and FHAs, loan standards became the underwriting standards for the market.

If you begin to carve out that you are going to be subjected to eminent domain well as an investor I am not buying the California loan. As I said earlier it has happened before in the market where we were told don't buy Colorado, Oklahoma, Louisiana or Texas loans during the oil bust because the duration on those loans was much longer because people weren't worded on their properties. It's happened before and if they continue to try to get down this road I think they are really beating their heads against a very solid wall.

Jade Rahmani - KBW

Great again thanks for that. Could you comment on where you are seeing incremental spreads and what part of the market you view as most attractive? Last quarter you mentioned prepayment protected bonds are expensive, do you have that same view today and also, yeah go ahead.

Kathryn Fagan

There is no question, everything is expensive. The weighted average dollar price of the fixed rate mortgage market is around 108.5 and 109 depending on the day. By any historical perspective that is rich.

Michael Farrell

Let me just go back to my openings comments if I may, my point in these comments is that the fundamental strategy behind investing is to buy low and sell high. If you've been raising equity to buy assets aggressively over the past year then what you've been doing is buying high in the hope that you can sell it higher. That is not an investment strategy, right. The place where you need to be working right now is the place where we've told people we have been working for the past year and it is demonstrated in the statistics I said.

We are working on the low side of the balance sheet, we can buy liabilities at low and this - they are not going go much lower, right. We issued a 3-year bond at 5%, that's an incredible transaction for an underrated company. So, my view is you have to be very careful what you are going to buy. There is value in the market, but you have to be careful.

Jade Rahmani - KBW

But with that in mind, is it safe to say we could see your hedges ratio increase and your leverage remain at these levels or even potentially decline?

Michael Farrell

Well, if you go back to the opening comments again, if Europe becomes the Confederate States of America which apparently they are willing to become and you can bet that there are a lot of hedges that has to be put in place, going forward for everybody which are going to be more expensive than the second. It is going to change the course of the capital on the front and the backend. We think more on the borrowing side. The assets are going to get cheaper.

Jade Rahmani - KBW

Thanks a lot.

Operator

And our next question is from Bill Carcache of Nomura Securities.

Bill Carcache - Nomura Securities

Good morning and thank you for taking my questions. I just wanted to delve a bit more into the though process that you've laid out and near the view point that everything is expensive that certainly consistent with your relatively lower leverage levels compared to others in the industry, but I was wondering how you reconcile that with - to the extent that there is a QE3, or prices going to bid up even higher and…

Michael Farrell

--Hang on. I just said it, if you're a hedge fund go do it, get in front of the fed and run in their face, does not read business. And it is not a sustainable investment plan. What happens when they unwind QE3 or QE2 or QE1 right? That is the point, is that buying these assets in the hope that a government program is going to bail them out, the fed has done everything it can do, it has run out of bullets. The next moves will be extremely difficult to implement. It'll be like going to negative rates as they have in some countries and in some states. You are going to start to see that kind of implementation on the liabilities side of the balance sheet. So, if the QE3 comes in I can tell you if I am Ben Bernanke I have to use that by treasuries because I don't have tax receipts coming in and there are no normal buyers for the thirty year. I would like anybody on this call has ever bought a 30-year government security outright for a buy-and-hold ever in history except for maybe 1983 and tell me how that trade worked out for them. The only people who used to buy that were life insurance companies and that is why the far end of the curve is out there.

Bill Carcache - Nomura Securities

Thanks Michael. That is a really helpful perspective. Can we talk a little bit about the swap book to portion of your swap book, it looks like about 18% of the notional value of your swap book goes out over 6 years. Is there a competitive advantage that Annaly has relative to others, it just seems to me like being able to get swaps that go out longer than 5 years is not something that I've really seen and so, is that -- do you guys have an advantage there. Can you talk a little bit about how difficult it is for other market participants to be able to get protection that far out?

Michael Farrell

Yeah, I think what we've broken the ice in a lot of different markets and one of them was in the swap markets back in the early part of this decade. Wellington and the team here have devised a method that we were finally satisfied with that allowed us not to concentrate on floating rate assets as much as the ability to swap them out versus collateral. And we paid a price for that, our earnings over the past 10 years as we developed that market with the dealers and of course the dealers began to spread that out to others, but the reward for that and having that higher price of swap if your will is that today since you got a history with those guys and they know how you perform and they understand your operations, they were willing to expand the growth rather with you and I think that is a great advantage. Having been through 3 times of tightening, flattening, steepening high prepayments, low prepayments that gives all the credit departments a great deal of confidence in the way that we run the book. And as a result they are willing to expand with us. A lot of guys who were born over the past few years have not been through the reversal yet. And I can tell you when it comes it will be ugly.

Bill Carcache - Nomura Securities

So, many of the counter parties that are going out that far 6 to 10 years or beyond, are they generally the same kind of parties that you have shorter duration swaps with.

Kathryn Fagan

Well, they would generally be the to-bid-to-sale counter parties.

Michael Farrell

We call them nationalized banks.

Bill Carcache - Nomura Securities

Okay, and one finally if I may, can you kind of incorporate your thought process and everything that you said in maybe at the beginning in the missive about how kind of all that fits in with your view on and how concerned you are about the extension risk at the end of the day. Is that - and certainly something that by extending the duration of your swap book you would be protected against, but can you just talk about that and also maybe incorporate whether there is a role for swaptions in your strategy and that's it, thanks.

Kathryn Fagan

We constantly weigh all of the available options to try and reconcile the fact that once borrowers get in to a 30-year 2.5 the likelihood of them ever re-financing is very slim and that you are at the low end rates and so you do need to prepare for a reversal. Maybe, we are here for 20 years maybe we're not, but as a levered player you need to be able to handle the twist and turns and if you use Japan as a guide you can see there were periods where rates doubled at the low end, yet nonetheless there can be a lot of volatility associated with that and so even if the 2-year doubles still a very low rate, but there can be significant market movement associated with that especially as a levered player, which I don't tell anybody how it magnifies it. So, we continue to weigh all the options, one of the things that we have obviously found to be most effective given our years of going through these markets and this market is very different than all the others.

I don't think any of us have ever experienced anything like this, but what we've found is running at lower leverage it may seem simplistic but it is really one of your most effective navigational tools through turbulent times. So, combine that with swaps IOs, all kinds of other things that you try and bake into the portfolio to allow it to perform the best through market moves. I will say once again nothing is perfect and there is no magic hedging tool out there that the market has mis-priced. Everything is relative, if something is cheaper, it is expensive in the long run if it is more expensive today, it may be cheaper in the long run. So, it is all a relative value analysis that we put into it.

Michael Farrell

I think also if you just step back and do an autopsy on two of the biggest government agencies that ever existed with portfolios Fannie Mae and Freddie Mac and had government guarantees behind them and were issuing debentures as opposed to re-purchase transactions. If you take a look at what destroyed them, take a look at the swaptions market. That is what a real autopsy will show you. So, be careful in that market because of the counterparty risk and because of the inability to execute at levels. It is like having flood insurance that says at the bottom, "invalid in the event of flood."

Bill Carcache - Nomura Securities

Okay, that is extremely helpful color, I really appreciate it. Thank you.

Operator

And the next question is from Steve Delaney of JMP Securities.

Steve Delaney - JMP Securities

Thank you, good morning everyone.

Michael Farrell

Hi Steve, great to hear from you.

Steve Delaney - JMP Securities

Likewise Mike, it is great to be on the call with you. So look, thanks, I want to add this thanks for the expanded swap disclosure really is helpful to us and now help us to do a better job, keeping track a book and also I think it is clear this morning from your comments, I just want to say thanks for stepping up and giving us the differentiated view of the MBS market. We are - Ben Bernanke is kind of leading us all down the road and I think it is easy to stay on the bandwagon, but we have to step back sometimes and look at the market maybe in a little more historical fashion and so I wanted to- while you have covered a lot of this, the wording in your quote in the press release was, I thought was pretty strong and I highlighted it to be my primary question and that is. The long term risk related to the general direction of monetary policy and when I'm assuming you're talking about our Fed, as far as domestic monetary policy and when I read in the that quote and what I've have heard you say today is that we need to be focused. The QE3 does not come without a price. And then you're trying to focus on the other side of the coin, so to speak, we get this short term feel good but there will be a price to pay. Am I reading you right in terms of the risk you see there and how that affects your portfolio management?

Michael Farrell

Yes, I would like to just broaden that if I can for a second.

Steve Delaney - JMP Securities

Please.

Michael Farrell

This is in regards to really global monetary policy right. If you look at the perch that I'm trying to create here, you can see that the largest economy in the world and I have said this on other calls, few quick recap is, our policies and all the stuff that's going on in Washington in my mind is trying to save what is an anomaly in historical economic features, which is a economy that was run by 70% of gross domestic product coming from consumers. The mortgage market, the retail markets, all this stuff was all built around the baby boomers. And if you go back and look at all the other countries, there's never been an economy that's had that waiting, right. So, it's all that most of the policy makers note today. And it's all they think of is this is what I can do, I need to get consumers out in spending. Like you have this huge demographic bubble that would have been naturally deleveraging anyway because of age, and the factors of retirement, etc, or just family is moving with their lives, etc. But at the same time, the income cannot grow underneath it because the wage pool is stagnant, right. We have got all of this new productivity that's come in, especially in the United States and makes it really, now you're even questioning why people go to college to pay $200,000, alright. So, the direction that they are taking the economy is based off I think trying to save the wrong economy. I call that we're swimming back to the titanic, right.

We are now looking at an economy that's remerging and it is going to look like I think, at the end of the day a lot of what other economies have been. Every other economy is based off a lot of business-to-business and then distributions around the side of it, and then you're moving the way you've through. I was very interested watching the Olympic opening games in London's history where they saw what the industrial revolution and led up to Google at the end, or whatever it was, but the steps here are all over the place. And at the same time, the second largest economy in the world, the Japanese, let's just go back a year not the Chinese. The Japanese demographically stuck, we said in some of our calls they sell more adult diapers now than they do children's diapers, that economy is affected by everything from tsunami's, to earthquakes, to old age and demographics. The third largest economy, the European economy, one of our biggest trading partners, you know as I said in the opening comments to me it looks like the Confederate States of America, North versus South and the South doesn't want to act as one, it want to act as 17 different states. And I think the Germans are eventually going to get tired of that. You know the French growth plan is for Germany to write up a larger check, and if I am a German, I'm not too happy with that. So, all this is going to lead to inflation at some point and a much steeper yield curve, and a much more normalized yield curve. But right now, you have to assume the markets are being manipulated by the government across the globe. The CDS market, basically got castrated by the Europeans when they changed the rules so that you couldn't collect only insurance, right. The U.S. market basically they tried to do that in the mortgage market by refinancing in HARP I and [ph]Hamsu, etc, all of which will they be big failures in the capital market structures here, because the assets are still falling in price. You have to allow failure, you have to allow clearance, what is the next biggest economy, well if you look at India, last I looked more than twice the population of the United States did not have electricity for four days there because their grid went out. They haven't invested in the grid. So, there's a lot of infrastructure investment that has to be done here and it's going to be a painful long way to do it and individually countries are going to have to make a decision between the long term liabilities of the baby boomers passing on passing their wealth over to the new generations. And frankly that's the war that's going on in Washington whether it's the AARP or if it is occupy Wall Street, it doesn't matter, right. This is a war about resources.

Steve Delaney - JMP Securities

Thanks Mike, I appreciate these additional comments.

Michael Farrell

I hope they are helpful.

Steve Delaney - JMP Securities

Yes.

Operator

The next question is from Rick Shane of J P Morgan.

Rick Shane - J P Morgan

Hi guys, thanks for taking my question this morning. It seems that the monetary in the markets has been getting coupon down and coupon and everybody has been chasing that, and I think in some ways we see that within your numbers this quarter, where you sold off lot of stuff but you grew the book and coupon clearly went down. You guys are willing to be contrarians. At what point do you start looking at the other side of that trade, is it pricing driven or do you think that higher coupon stuff is just so structurally at risk that there is no reason that you would be looking at it.

Kathryn Fagan

I mean we will constantly weigh the relative value propositions among the coupons staff. What I would say though is the longer you're here, the coupon's act becomes more and more compressed. So, it doesn't matter who you are, you're going to have limited choices that you can make. And then your real choices are leveraging how you hedge that risk. So, the market is a very like I said, you are looking at 108.5, 109 kind of dollar prices and you know weighted average coupon of the market in the fixed arena is about 4.5 unless there is, I am hopeful that we have a change in administration and that we have a change in our policy focus and that maybe the market can become a more normalized place. And maybe you do start to see more choices become available on the risks spectrum for investors. But right now, everybody is kind of forced into risk at the wrong price in my mind.

Michael Farrell

Including the banks, if you look at the banks, whatever loans are generating they are keeping because there is no securitization model, right. So, it is a very interesting time that could change very quickly. In my experience these things do not have any graduation. They go through big giant leaps of change. And then the markets will subtle out and guys like Louis Bacon instead of giving back money will be taking money in, because he wants to be able to take advantage of the new values that have been created. But instead what we're witnessing is this controlled burn spiraled down by the global central banks trying to hold the social safety net together.

Rick Shane - J P Morgan

Okay and that actually leads to a little bit of a philosophical question and I think you guys have a tendency to be willing to talk philosophically given all of that, what is your balance right now in focus between capital preservation and protecting spread. When you come in everyday, which are you focused on?

Kathryn Fagan

You have to be focused on all. You know, to see where you - we have to deal with every market that we're in and how we do it will vary. But again, these things as Mike said, these things can change quickly. We obviously have been in control of the -- government has been controlling the market, not only domestically but internationally. And whether a new administration starts to change the tone of that, we as a company want to be in a position to capitalize on the fact that maybe there is a change in the way that we're going to deal with housing.

Michael Farrell

It is very interesting to me as a long time observer of this that this is one of the few times in my career where I can actually say that American companies are in much better shape generally than the American government is, in terms of its balance sheet. Now there's two ways to get that fixed from the government. One is rearrange and restructure the liabilities, so that you get these multi trillion dollar baby boomer entitlements out of the way or you continue to let the capital markets do its job and clean up. And there's been no appetite. All you had to do is be a holder of General Motors bonds, or Chrysler bonds in 2008 to understand that contractual rights in the United States are under threat here. And anything could happen from that perspective. So, I think when we come in, in the morning what do we look at, our rule number one is don't lose money, right. You try to preserve capital that's how we think about the business. Sometimes, look a lot of people criticized me for the past year for not raising equity. I just summarized in about 10 minutes at the beginning of the call why we didn't do that. As everyone knows from the mountainous articles that have been written about it, if we were to raise a lot more equity I would be paid a lot more money. But we chose not to do that. That is a focus on shareholder value over the long run. And what do we do, we focus on where we thought the real value was, which well everybody was out running and buying assets and trying to get in front of QE1 and QE2 and QE3. We were quietly building out and strengthening up our liabilities so that we have the fire power to buy that stuff when it's being puked out on short duration liabilities or when haircuts change because clearing houses now demand more of higher haircuts, or interest rates change because Unites Sates gets downgraded and instead of rallying, you actually see spreads wide now. Those things could occur and might occur within the next 120 days. Regarding the aircraft carrier, we're plotting this course very carefully.

Rick Shane - J P Morgan

Guys thank you very much.

Michael Farrell

Thank you.

Operator

And the next question is from Jasper Birch of Macquarie.

Jasper Birch - Macquarie

Hey, good morning everyone. Thank you for taking my question. Just starting off with, I want to dig a little bit into how you view taking on longer term debt and if you look at your three year bonds, if you're looking at just in terms of leveraging up taking MBS, that would obviously be sort of a negative spread unless you have sort of aggressive interest rate assumptions going forward and if you look at it in sort of in terms of leveraging up the already levered equity, is that how you look at it and then sort of what risks are you protecting against by taking on the longer term debt, is it just the risk of haircuts going up or so how you view it?

Kathryn Fagan

It's one of the many steps you take to - if you look we did it - we also concurrent with those transactions did a preferred, a non- rated preferred which the way that we tend to look at that is relative to our common dividend. And sometimes it is necessary in the debt as an unsecured position where its repo is secured financing. There is always the cost adjustment relative to those two. We understand that the coupon on our debt is more than the coupon we can get on the mortgage position. And so for certain periods, you weigh it in the capital sect, so that it's accretive to shareholders knowing yes, you are going to mature that at some point. But it's as a non-rated company it's a necessary step in the process to continue to migrate the capital structure of the company into this lower rate environment in a more permanent fashion and what we would like to see is a continued migration into the preferred market and have those coupon rates continue to come down relative to the comment. So it's just one of the many stuff.

Michael Farrell

I kind of look at it as when we put on the swaps early on, we knew we were early actors in that position. We paid a price for that but it gave us the history to go out and do things like what we just did. That bond position is same with that GE put a bond out there and I think, it damaged its investing grade, I think we were only like maybe 50 or 60 basis points behind them in yield. What's there to tell you in the market? Well no one trusts us except Moody's or the rating agencies. They are looking at the performance and behavior of the actors that are borrowing the money.

Jasper Birch - Macquarie

Yeah, that is all really helpful. I appreciate the commentary on QE3 and found that really interesting. And then just going back in the prepared remarks Mike, you mentioned that you think Europe needs an Alexander Hamilton. I was just wondering Alexander Hamilton was famous for having the Central Bank pay off the state tax, was that what you are referring to?

Michael Ferrell

Yeah while he was just two, in our office there's two highlights to Alexander Hamilton. There is a bust and there's a portrait, is the only stuff that we have but, I would consider art work right, and the reason for that was is Alexander Hamilton did figure out how to put all the script together into one currency. He made the exchange rates work but the price of those exchange rates was to put yourself under one federal treasury. You could still run an independent state finance but you still had to be underneath one federal treasury and one currency and you were subject to the moves of that currency, your independent credit underneath it, just like the difference between California to New York and Texas and North Dakota. But that is what Europe needs and I don't see Angela Merkel as being that person and nor do I think that its achievable to have this big catch up where there are no real resources that come out of Italy or Spain that are say global brands. Let me just say that. Maybe you got fashion coming out of Italy, but it's made in China or it's made wherever. It's made in Indonesia. Germans are making cars, well now they are making them in South Carolina and Georgia, you buy a BMW which is probably made in the United States. The United States - that's what I meant by the United Stated has a unique opportunity here right, while all of this distress is going on globally, we have an opportunity to do it, they are bit two huge economies built out of exports. Actually three huge economies built out of exports in the past 70 years. The first one and the most important one is the oil exporting business from the Middle East. And look what that's gotten us, right. If you look at what we owe them in terms of coupons and everything, it works what we pay China. We built up Japan by letting them control their currency at a cheap level for a lot of time in the 60's and the 70's and the next thing we know we were losing our manufacturing arms in the 80's and the 90's. And then the Chinese the same thing, Chinese have three times the world's capacity to build cell phones. Who's going to go out and build a cell phone factory when you can turn those things on, on a dime, if I have to go back and look at what's going on in China today, they had this huge build out of infrastructure for the 2008 Olympics. And I ask anybody on the call to take a look at this chart on Bloomberg, putting CRY index and go back and look at 2005 till today, and you will see basically the day that the torch got lit in China on August 8, in 2008 the commodities chart fell apart. Today, the birds nest is where they hold flee market sales in China. They are not using the facilities for anything, they have cities that are amphi, etc. There is a price to pay for this, that's over capacity and it has to be dealt with. And the only way to deal with it is to let it fail. That's an ugly scenario but that's the reality.

Jasper Birch - Macquarie

Thank you, as always quite interesting.

Michael Ferrell

Thank you.

Operator

And our next questions is from Ken Bruce of Bank of America Merrill Lynch

Ken Bruce - Bank of America

Hi thanks good morning.

Michael Ferrell

Good morning Ken

Ken Bruce - Bank of America

Most any question I could have asked at this point has been answered so I will pass, but I would like to thank you for the additional transparency into financials have been very helpful. Thank you.

Michael Ferrell

Thank you Ken

Kathryn Fagan

Thanks Ken.

Operator

This concludes our question and answer session. I would like to turn the conference back over to Mr. Ferrell for closing remarks.

Michael Ferrell

Well thank you everybody for joining us today. We think we're going to live in interesting times, the next time I would be talking to you will be on the third quarter's remarks but by which time would have had some decision made politically we hope or we'll have a lot of new walls being built and in Washington between different the parties and the different interest groups. But we think that that's going to be very interesting between now and the end of the year. And you know we look forward to speaking to you and updating you with our remarks and our portfolio actions during that period, thank you.

Operator

Ladies and gentlemen if you wish to access the replay for this call you may do so by dialing 877-344-7529 or 412-317-0088 with an ID number of 10016746. This concludes our conference for today. Thank you for attending today's presentation. All parties may now disconnect.

See also Citigroup: An Entry Of $26 Or Earn 11% In 6 Months on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Economy

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