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