Annaly Capital Management Inc

NYSE:NLY

Earnings Call Transcript 2023-Q2

[Operator]

Good morning, and welcome to the Second Quarter 2023 Earnings Call for Annaly Capital. All participants who may listen only mode -- should you need assistance, please see a conference specialist by pressing star 0 on your telephone keypad. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press starter than 1 on your telone keypad. Please note this event is being recorded. I would now like to turn the call -- the conference over to Sean Kensil, Investor Relations. Please go ahead.

[Sean Kensil, VP, Annaly Capital Management]

Good morning, and welcome to the Second Quarter 2023 Earnings Call for Annaly Capital Management. Any forward-looking statements made during today's call are subject to certain risks and uncertainties, which are outlined in the Risk Factors section in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the disclaimer in our earnings release in addition to our quarterly and annual filings. Additionally, the content of this conference call may contain time-sensitive information that is accurate only as of the date hereof. We do not undertake and specifically disclaim any obligation to update or revise this information.

During this call, we may present both, GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our earnings release. Content referenced in today's call can be found in our second quarter 2023 investor presentation and second quarter 2023 financial supplement, both found under the Presentation section of our website.

Please note this event is being recorded. Participants on this morning's call include David Finkelstein, Chief Executive Officer and Chief Investment Officer; Serena Wolfe, Chief Financial Officer; Mike Fania, Deputy Chief Investment Officer and Head of Residential Credit; , Head of Agency; and Ken Adler, Head of Mortgage Servicing Rights. And with that, I'll turn the call over to David.

[David Finkelstein, CEO, CIO & Director]

Thank you, Sean. Good morning, everyone, and thank you for joining us for our second quarter earnings call. Today, I'll begin with our performance during the quarter, review the macro landscape and housing market, followed by an overview of our portfolio activity and positioning. Serena will then go over our financial results for the quarter, and we're also joined by our other business leaders who can provide additional context during Q&A.

Starting with our performance. We are pleased with the 3% economic return generated for the quarter despite elevated rate and spread volatility. And to note, we've achieved a 6% return year-to-date and kept book value largely unchanged, notwithstanding heightened uncertainty caused by the changing path of Fed rate hikes, the regional banking turbulence and debt ceiling negotiations. Our ability to manage through this volatility is attributable to our diversified capital allocation, prudent hedge portfolio and responsible leverage position. And even with the reduction in leverage from 6.4x to 5.8x, we again outearned our dividend this past quarter.

Now shifting to the macro environment. Despite the banking stress at the onset of the quarter, the U.S. economy has remained on solid footing with healthy gains in the labor market and economic growth consistent with recent quarters. Inflation was elevated through most of the quarter. However, data began to signal a more pronounced slowdown in June, lower used car prices and improvement in shelter inflation in a seemingly more price-sensitive consumers have begun to put downward pressure on prices. And this should slow inflation more than recent year-end FOMC forecast of 3.9% in core PCE. But beyond inflation, data during the quarter suggests the likelihood of a soft landing has increased and that the Fed will hold interest rates higher for longer, particularly at the labor mark continues to demonstrate resilience.

It is likely that the Fed has reached peak interest rate levels for the cycle after yesterday's hike, but upside surprises and inflation readings may lead to an additional hike this year. With respect to the housing market, home prices continue to outperform expectations as we have now experienced five consecutive months of national home price increases according to Zillow. Recent momentum has turned positive, even in the previously hard hit areas as the top 50 metro areas all experienced positive month-over-month HBA in June with the year-to-date national home prices now up 4.7%.

Market participants were projecting meaningful hold price declines given elevated mortgage rates and low affordability with the expectation of those factors translating to reduced housing demand. Although transactional activity has declined, the market has been supported by historically low available-for-sale inventory as existing borrowers with low mortgage rates are unwilling to trade up or move, given the potential increased payment. Total active inventory was down 10% from last year and currently sits at a very notable 45% below June 2019 levels.

Now before turning to the portfolio, I want to make one point on the banking sector. During last quarter's call, we stated that the main implication of the regional bank stress was that it created an overhang of assets that need to be absorbed by private market participants. This supply came to the forefront during the second quarter as the FDIC began selling assets from the SBB and Signature Bank receiverships. The sales weighed on the market for parts of the quarter, the money manager demand and transparency on the disposition process had helped the market digest a substantial portion of the $114 billion in assets already.

Now shifting to our portfolio and starting with agency. When you look at the overall performance of the portfolio, the quarter once again looks more benign on the surface than that which actually occurred. As previously discussed, a confluence of market events and the resulting uncertainty led us to believe mortgage spreads would widen. Accordingly, we proactively reduced our agency exposure early in the quarter with our portfolio declining by roughly $5 billion in notional. This tactical shift prove beneficial as spreads reached their quarterly peak in late May, and it afforded us flexibility to opportunistically deploy capital across our businesses amidst the volatility.

In June, as the debt ceiling resolved and the banking sector recovered, risk on sentiment reemerged and MBS experienced broad-based outperformance ultimately driving spreads modestly tighter for the quarter. With respect to portfolio positioning, we continue to rotate into higher coupons, which provide the most attractive nominal spreads. We also reduced our holdings of seasoned intermediate coupons and 15-year MBS. And as a result, the average coupon on our portfolio shifted modestly higher to 4.3%, but we remain disciplined in managing our convexity profile through collateral selection.

We also took advantage of softer pay-ups to replace over 8 billion TBAs with specified pools during the quarter. And in addition to their favorable prepayment profile, specs provide incremental carry relative to TBAs in the current environment. On the hedging side, the notional value of our hedges declined in line with our assets, though we remain fully hedged. We maintained a slight flattening bias throughout the quarter as [indiscernible] and treasuries exceeded negative 100 basis points but have shifted to a balanced curve position given the extreme inversion in the yield curve. The diversity of our assets allows us to be opportunistic in our rates exposure as the market stays highly sensitive to incoming data.

Now moving to residential credit. Spreads tightened and the credit curve flattened on the quarter, driven by a supportive backdrop of limited net issuance, resiliency in the housing market and a strong consumer. Benchmark CRT below investment-grade spreads tightened 95 basis points in the quarter, while production coupon non-QM loan spreads were 75 basis points tighter, reflecting a declining cost of funds in the securitization market. Our residential credit portfolio ended the quarter at $4.9 billion in market value, down approximately $300 million quarter-over-quarter given our increased pace of securitization activity. Whole loan purchases remained healthy, increasing 16% relative to Q1 with approximately $750 million in loans settled.

We securitized $1.5 billion in loans in the second quarter through our OBX platform, generating $162 million of retained assets. And post quarter end, we priced our latest non-QM deal, taking advantage of the recent market rally to achieve AAA levels 20 basis points tighter than at the end of June. This brings our aggregate year-to-date securitization volume to e-transactions totaling over $3 billion. And notably, Annaly has been the largest non-bank securitizer since the beginning of 2022 and second largest overall, including bank issuers.

Our securitization activity has been supported by our correspondent channel, which continues to gain momentum despite a challenging landscape for mortgage origination. Our Q2 loan lock volume of $1.5 billion was our largest since inception and the channel accounted for 85% of our total loan settlements. And we maintained a disciplined credit focus as demonstrated by the current pipeline exhibiting a weighted average FICO of 748 and an LTV of 68% as well as limited layered risk.

Now finally, within MSR, we grew our portfolio by $350 million or 19% during the quarter through the purchase of four bulk packages. Our holdings now stand at just over $2 billion in market value and $150 billion in unpaid principal balance. The portfolio exhibited another quarter of slow prepayment speeds paying below 4 CPR and delinquencies were unchanged and remained minimal. All told, our strategy of acquiring low note rate, high credit quality MSR continue to deliver predictable cash flows with attractive risk-adjusted returns.

MSR trading volumes were strong in the second quarter as market participants efficiently absorbed high levels of bulk supply, a dynamic that we expect to persist for the foreseeable future. And despite elevated supply, pricing has held firm and low WAC MSR valuations improved driven by the rise in rates, muted prepayment speeds and modest spread tightening. Now shifting to our outlook. We expect the second half of 2023 should provide a more accommodative environment for Agency MBS. While supply and demand challenges will persist with money managers likely to be the primary buyers of mortgages, net supply from banks is likely to decline as FDIC sales are completed, and the Fed nearing the end of its hiking cycle should lead to lower volatility and a potentially steeper curve, making MBS more attractive to investors on an option-adjusted spread basis.

But I would note that we do expect spreads will stay wider relative to historical averages given technical considerations, though there is still room for tightening from here. And that said, the benefit of agency spreads settling at wider levels is that we expect to earn a healthy yield without employing excessive leverage. As it relates to residential credit and MSR, we're optimistic about the opportunity set within these businesses, and we'll look to grow these strategies responsibly. In resi, we anticipate further expansion of our correspondent channel as we now have approximately 160 counterparties onboarded. And we expect to benefit from our scale as we further penetrate the market. And post quarter end lock volume has been strong with the current expanded credit pipeline of $900 million.

In MSR, we're well positioned for opportunistic growth as an established top 20 servicer, and we continue to add partnerships, including new subservicing as well as bulk and flow relationships and have ample capacity to further leverage our platform.

And now with that, I'll hand it over to Serena to discuss the financials.

[Serena Wolfe, CFO]

Thank you, David. Today, I will provide brief financial highlights for the quarter and 6-month period that ended June 30, 2023. Consistent with prior quarters, while our earnings release discloses GAAP and non-GAAP earnings metrics, my comments will focus on our non-GAAP EAD and related key performance metrics, which exclude PAA.

Many of the themes we discussed in the first quarter continued to play out in Q2, and we are proud of our strong earnings and economic return considering the challenging market. Our book value per share for Q2 was relatively unchanged from the prior quarter at $20.73. And as David mentioned earlier, with our second quarter dividend of $0.65, we generated a positive economic return for the quarter of 2.9% and approximately 6% for the first 6 months of the year.

Higher rates for the quarter drove gains in our hedging portfolio of roughly $2.26 and in our MSR book of $0.19, while having a modest drag on our agency portfolio, resulting in losses of approximately $2.49 for the quarter. We generated earnings available for distribution of $0.72 per share for the second quarter, consistent with the prior quarter, EAB was adversely impacted by the rise in Repo expense, albeit our swap portfolio continues to mitigate the increase in rates.

Average yields ex PAA were 26 basis points higher than the prior quarter at 4.22% as we continue to rotate up in coupon this quarter, with 57% of the agency portfolio and 4.5% coupons and higher. The factors that impacted EAD are also illustrated in NIM for the quarter, with the portfolio generating 166 basis points of NIM ex PAA, a 10 basis point decrease from Q1. Net interest spread declined 17 basis points quarter-over-quarter at 1.45% versus 1.62% in Q1. The continued rise in repo rates impacted our total cost of funds for the quarter, rising by 43 basis points to 277 basis points in Q2. And our average repo rate for the quarter was 55 basis points compared to 462 basis points in the prior quarter.

As previously mentioned, our swap impact on the cost of funds improved by 4 basis points due to an increase in average notional, and the swaps portfolio ended the quarter with a net receive rate of 255 basis points compared to a net receive rate of 274 basis points in Q1.

Now turning to details on financing. Funding markets remain ample and liquid. We continue to see strong demand for funding for our agency and nonagency security portfolios. Our repo strategy is consistent with prior quarters, and our Q2 reported weighted average repo days were 44, down from 59 days in Q1, mainly due to the roll down of longer-term trades we referenced during our Q1 earnings call. The appetite of credit by lenders has also been robust on the warehouse side, and we continue to engage with new and existing counterparties as we look to enhance our dedicated warehouse facilities for our credit businesses at very competitive terms.

Given the characteristics and growth of our MSR portfolio, we have significant unpledged assets available that we can utilize to further unlock liquidity. That being said, as of the end of Q2, we had $1.7 billion of unused warehouse capacity across our resi credit and MSR financing facilities, which leaves us in a very comfortable liquidity position for these businesses. Our liquidity profile improved compared to the prior quarter with unencumbered assets of $6 billion compared to $5.7 billion in Q1, including cash and unencumbered assets of $4.4 billion for the quarter. The approximately $328 million increase in unencumbered assets primarily came from lower on-balance sheet leverage for Agency MBS securities and MSR purchases during the quarter.

That concludes our prepared remarks, and we will now open the line for questions. Thank you, operator.

[Operator]

[Operator Instructions]. Our first question comes from Bose George.

[Bose George, KBW]

First, I just wanted to ask about returns for the different groups. I mean last quarter, you had that slide that just showed the blended ROEs. I didn't see that as a return kind of the same level as it was last quarter, that 11.5% to 13.5% range.

[David Finkelstein, CEO, CIO & Director]

Sure. So I'll just run through it real quickly. It's similar. Agency, you can call mid- to upper teens. Residential credit, securitization through OBX, retaining the BBBs on down with internal leverage gets you to low to mid-teens and then MSR unlevered around 10%, 11%, with the turn of leverage gets you to 15%. So still healthy.

[Bose George, KBW]

Okay. Great. And then just on the book value. Can you just give us an update quarter-to-date?

[David Finkelstein, CEO, CIO & Director]

Sure. We were up 1% as of last night.

[Operator]

Our next question comes from Crispin Love

[Crispin Love, Piper Sandler & Co.]

Can you just talk about leverage and just how you're positioned in the third quarter? You brought down leverage in the second quarter to levels. I don't think we've seen since 2021, but based on your comments, you're optimistic on the environment. So curious if you've begun to bring leverage higher and add Agency MBS after decreasing agency early in the second quarter?

[David Finkelstein, CEO, CIO & Director]

Sure, sure. And yes, we troughed at leverage levels, I think, at the beginning of 2022, I want to say, 5x, 7x. We ended at 5x, 8x. A fair amount of that is capital allocation. We did add MSR, as I mentioned, $350 million we committed this quarter to a little bit more. So given the leverage profile of MSR, that does account for about 0.25x a turn of the decrease. And then we have an active pipeline in resi, which is also less levered. As we sit today, we did add a little bit of mortgages to begin the quarter. So we're right at around 6 turns of leverage.

And we really like where we're at. We have ample liquidity. If there is an opportunity to add mortgages, if they widen, our leverage will organically go up, but we do have capacity to add. But we're able to generate the returns we need with current leverage with ample liquidity. And then if you look at our spread shocks, our improvement in book value isn't materially different with lower leverage. I think we -- for a 25 basis point spread tightening, we're around 10.4% appreciation versus 10.9% last quarter.

So we're able to do a lot more given longer spread duration with less, and we really like where we sit right here.

[Crispin Love, Piper Sandler & Co.]

That's helpful. And then just one other question for me. Just money managers have been vocal and fixed income flows have been positive kind of in the last quarter or so about the attractiveness of Agency MBS. But how are you thinking about banks potentially entering the agency market again? Is there a scenario where you'd expect them to become buyers of Agency later in the year or early next, or too soon to tell? And then do you think banks need to reenter for spreads to tighten meaningfully?

[David Finkelstein, CEO, CIO & Director]

So to answer the question, will banks be involved this year? Our guess is not. We don't expect to see active selling, but we do think there'll still be runoff from bank portfolios. We estimate about another $50 billion in decline in bank MBS holdings by the end of the year. And beginning in 2024, we'll see what the outlook looks like in the fence posture, but you could see them reemerging at that point, it's just too early to tell.

And in terms of do we need banks for mortgages to really tighten? Look, it really depends on how money managers are postured. We are at or near the end of the Fed hiking cycle that does bring about optimism with respect to fixed income. Yields are elevated, and real rates are certainly attractive. And so our expectation is that you will see more money coming into money managers, which will provide support. In Agency MBS are amongst the cheapest assets in fixed income. So even in addition to new money coming in, we hope to see overweights and agency on the part of money managers, which will certainly support the basis. And another point to note is that ball is still relatively elevated. The end of the Fed hiking cycle, the passage of significant risk events should lead to a decline in ball and that will be very beneficial for the agency basis.

[Operator]

Our next question comes from Eric Hagen from BTIG.

[Eric Hagen, BTIG]

Maybe a follow-up on the spread environment. I mean, at this point, do you feel like spreads are more likely to widen or tighten into an interest rate rally? And then maybe somewhat separately, I mean, how much sensitivity do you see between MBS spreads and bank deposit rates, right now?

[David Finkelstein, CEO, CIO & Director]

Yes. So in terms of the symmetry widen versus tighten. We do think spreads should tighten, not materially, but we definitely feel like given where we're at in the cycle, spread should come in. We're above fair value. We do look at today's market and compare it to past cycles. And if you look pre-COVID where agency spreads were roughly around 75 CV, we're materially wider than that. But a lot of that is explained. Factors like volatility is likely to remain more elevated, option cost is higher, given loan balances are higher, mortgage refinancing is more efficient and factors like that.

And then lastly, the supply picture is a little bit more negative for mortgages this environment relative to the last time. Even the Fed was engaged in Q2, just given banks and other factors. So spreads should tighten. We think there's about 15 basis points in spread tightening to get them to fair value. And what will be the determining factors? As I mentioned to Crispin is where volatility goes. If we get a decline in ball, that's going to be very beneficial, should there be some unforeseen event on the horizon in ball spikes, then we would expect some widening. But our view is that they should tighten somewhat.

And in terms of bank deposits versus mortgages, Look, here's the way I'd characterize it. A lot of focus has been on money market funds and just the elevated balances in money market funds. That money is potentially dry powder for fixed income investment -- fixed income investments or other investments. And so we're looking for money to come out of money market funds and more into longer-term fixed income vehicles to ultimately support mortgages.

And in terms of bank deposits, you're going to see bank deposits and reserves go down, as the Fed withdraws liquidity. Right now, reserves are sitting around $3.25 trillion. We expect that to decline. It's currently 12% of GDP. By the end of the year, it will probably be around 10%, 11%, and that's what's going to drive bank deposits. And again, as I mentioned previously, we don't expect banks to be buyers and mortgages.

[Eric Hagen, BTIG]

Right. That's helpful commentary. I appreciate that. Maybe on the MSR, I mean, how big do you think you can get there in light of the MSR supply hitting the market with the tolerance for leverage in the MSR portfolio? I mean would you ever look to encumber the agency portfolio to basically support leverage for the MSR? Or is the idea to borrow against the MSR and encumber that directly?

[David Finkelstein, CEO, CIO & Director]

Well, we have a lot of optionality given our liquidity and our capital allocation. Currently, the MSR portfolio is hedged or levered at about 0.3 turns. The way we look at it is a steady state for low WACC MSR with benign cash flow variability as it should be about 1 turn levered. So theoretically, then the agency is doing some of the agency portfolio is doing some of the heavy lifting in funding that portfolio, but we have ample capacity for warehouse financing, and we continue to grow that. And in terms of the trajectory of supply and how the year might play out, let me turn it over to Ken.

[Ken Adler]

Yes. I mean the supply has been very steady at roughly $200 billion of GSE MSR each quarter, with the exception of the fourth quarter of each year when the transaction volume slows down due to GSE constraints at that time of the year. When we look at the balance sheet of the sellers, we don't see that supply stopping for the next few quarters. Our relationships are very encouraging that there'll be more coming of the exact sort of assets we'd like to buy.

[Operator]

Our next question comes from Trevor Cranston from JMP Securities.

[Trevor Cranston, JMP Securities]

David, I think you -- I heard you say you maintained a curve flattening bias sort of throughout the quarter, and it had moved now to a more balanced curve positioning. Can you elaborate a little bit on how you guys are thinking about the evolving shape of the yield curve going forward, given that we may be sort of at the end of the Fed rate hike cycle at this point? And it seems like we could also have a soft landing with the economy.

[David Finkelstein, CEO, CIO & Director]

Sure, Trevor. So that is correct. We did have a flattener on for much of the quarter, and we balanced it out towards the end of the quarter here when the curve got extremely inverted. In terms of our expectations, we do expect some steepening in the curve, but it's really important to note that the way the market is priced right now, has the 2-year note rallying over the next year by roughly 80 basis points. So there's a lot of pricing to occur. And if you put a steepener in rates, for example and it doesn't meet those lower rates, then it's not an advantageous trade.

But given the fact that we do like a steepening bias, the best way to play a steepener, normalizing from volatility is long mortgages. Historically, in the absence of a risk-on spike in ball type event, Agency MBS do very well when the curve steepens, so we feel like we're -- we have that trade on through levered agency. And in terms of our outlook for rates, given the likelihood of a soft landing, we feel reasonably good about where the rates market is priced. If you look 2 years out, for example, at the forwards, the entire curve is priced between 3.5% to 4% in treasury.

So rates will come down according to the market. And we think that's the likely scenario. We do expect it to be driven more by normalization of rates from a disinflationary standpoint. The way we look at the market right now, the range of outcomes has narrowed considerably given where we're at in the cycle. Runaway inflation is just far less likely now given the data we've seen. There are fewer known risks out the horizon, and yields are still quite attractive, particularly real yields at 1.5% on 10 years. So the market feels pretty good. But also yields should stay elevated.

We did just experience this inflation bout. And we're not just going to go back to where we were in 2018, '19 or the post-crisis period. Monetary policy is not going to be as active of a benefit for rates, and real rates should stay positive, and we think they're fairly priced right here.

[Operator]

Our next question comes from Doug Harter from Credit Suisse.

[Douglas Harter, Crédit Suisse]

Can you talk about how you're viewing the residential credit market? And while you mentioned that spreads and securitizations have improved, spreads still remain volatile and kind of how you're viewing the market and willingness to kind of balance sheet loans while waiting for securitization?

[David Finkelstein, CEO, CIO & Director]

Sure, Doug. Look, as I mentioned in my prepared comments, resi has had a very good set of performance quarters here. And it stands to reason, housing has done reasonably well, better than our expectations. And there's also a scarcity of supply in residential credit, unlike the agency market. So we understand why spreads have tightened. And to elaborate, Mike can jump in here.

[Michael Fania, Deputy CIO & Head, Residential Credit]

Yes. Thanks, Doug. I think in terms of securitization, we expect to continue to be programmatic. We just priced a deal that's actually closing today. The economics on that deal is at 91% advance to our market value at a blended cost of funds at $1.78 over the curve, call it a cost of funds to an IRR. When we look at that relative to warehouse, our warehouse financing is, call it, mid high 100s, high 100s. So the ability to term out that debt inside of warehouse is certainly something that we think makes sense.

So as you've seen, issuance this year has lagged, we'll say $36 billion, $37 billion of total gross issuance within the non-agency market. So we do think that positive technical should be a tailwind for issuers like ourselves in the second half in terms of spreads continuing to tighten, absent any sort of macro weakness or risk off. So we were 20 basis points tighter quarter-over-quarter. And I think if we came out with a deal today, we would be inside the levels that we just transacted about a week ago.

[Douglas Harter, Crédit Suisse]

Great. And Ken, when you're looking at counterparties to kind of buy MSR from -- in the past, refinanceability and the counterparties, refinanceability kind of greatly impacted performance. I guess how are you thinking about that in terms of who you're buying from today?

[Ken Adler]

Thanks for the question. Counterparties are really important to us from a few perspectives. On the prepayment speeds, being not a competitor with our counterparties, we can often engage in very specific relationships where we share and recapture performance with counterparties. And we're able to kind of price in the value we capture in a way other participants are not as willing to because of our positioning in the market. So we're an extremely unique participant for the mortgage industry. And then again, we're not competing with them, we're partnering with them. So we either price in the value to recapture or share in the recapture. So I think it's very different from our peers.

[David Finkelstein, CEO, CIO & Director]

Yes. One more point. Credit is also a big consideration on that front. We limit the set of counterparties that we transact with. We want durable counterparties just in the event that out the horizon, there's buybacks and things like that.

[Operator]

Our next question comes from Rick Shane from JPM.

[Richard Shane, JPMorgan Chase & Co.]

First of all, this is sort of a more big picture question. You made the observation about spreads eventually tightening. But at this point, do you really care? I mean, it's priced into the book value. And ultimately, is this a secular change that allows you to generate higher returns with less leverage or manage risk in different ways?

[David Finkelstein, CEO, CIO & Director]

Yes, you're exactly right, Rick. It's not our preference for spreads to tighten. We think they will because of the attractiveness of the asset, but to the extent they don't, that's perfectly fine for us. We own the assets. We'll continue to generate yields. And when we have runoff will reinvest at wider yield. So it's not necessarily our preference for spreads to tighten. And in a perfect world, we do sit at wider spreads and continue to generate the return that we're generating with low leverage. So that's how we look at it.

[Richard Shane, JPMorgan Chase & Co.]

Got it. And then the other question is this, Serena had made the comment about moving up in coupon. And we're seeing right now 6s with slight premiums, 5.5 with slight discounts. Given the ultimate asymmetry to interest rates, are you -- how sensitive to premium are you? And does it make sense to play a little bit lower in the stack, just so you don't take that risk if rates start to move more quickly than expected?

[David Finkelstein, CEO, CIO & Director]

Yes. We'll have Serena chime in here.

[Serena Wolfe, CFO]

You're absolutely right. Rick, we like premium coupons, particularly 6 and 6.5 is when we can find high-quality specs. There's not a lot of production. So we are building that portfolio out slowly, and it's mostly high-quality specs, where we like the basis and where we like PBH paper is slightly below that in 4.5s and 5s., that's where we can add or take off basis very quickly. And that's where I think if you look along the forwards 4.5 and 5s are closer to par, and 5.5 and 6 are above par along the forward given that the forwards are pricing in a rallied.

So the lower coupons, we have generally shied away from. We think they will still look at -- they will still have very good demand because money managers, when they see flows in try to match pay index, and the index has a lot of lower coupons. So the technicals for them are pretty strong. While the cash flows themselves don't look particularly attractive on the stack. So the belly coupon is where we buy TBH paper. The higher coupons that we can revise specialized post high-quality specialized coupons.

[Operator]

Our next question comes from Matthew Erter from Jones Trading.

[Unidentified Analyst]

You mentioned mortgage spreads tightened pretty significantly during the quarter after the debt ceiling resolution. Could you provide an explanation and kind of expand why book value is down quarter-over-quarter if the dividend is reflective of the core earnings hikes?

[David Finkelstein, CEO, CIO & Director]

Sure. Mortgages did tighten pretty considerably after the debt ceiling episode, but they did widen very materially for the first 2 months of the quarter. So on balance, we were marginally tighter. I think on a nominal basis, 5 to 7 basis points tighter maybe and then OAS not quite as tight, and there's a little bit of hedging cost that go along with it. And also, we do carry a positive duration gap. So the market obviously sold off somewhat in duration as is often the case, can cost money.

So the fact that I'll say, given the volatility we experienced, Fed funds futures went from 43% at year-end at the beginning of the quarter to 5 and 3.8%. That's a significant move. The yield curve flattened 50 basis points on the quarter 2s to 10s. So has a lot more volatility that actually occurred, I think then you see from quarter end 1 to quarter end 2. And I think we've managed it quite well, and I'll make another observation about the sector as a whole. We're much of the way through the reporting cycle here, particularly with agency REITs.

And in light of the volatility that I just mentioned on the quarter, the sector did very well, I think. The fact of the matter is, leverage has been quite responsible and folks have managed interest rate risk reasonably well. And now we're actually most likely at the very end of the Fed hiking cycle. And so the outlook looks a lot more positive. And so I think the investor and analyst community should be quite optimistic about where the sector sits right now and the ability to generate strong returns for shareholders.

[Unidentified Analyst]

Awesome. That's helpful color there. And then kind of shifting gears, Previously, you guys have mentioned capital allocation. I want to get to 50% on the agency side, MSR to 20% and then resi credit to 30%. Is that still the expectation? And what is the timing surrounding that?

[David Finkelstein, CEO, CIO & Director]

So that is still the expectation over the longer term, and the timing is dependent on the valuation of assets. So right now, agency certainly looks attractive, and we expect the sector to do well. So we're going to remain overweight. But over the next number of years, that's the objective when things are fairly valued, we'll continue to gravitate further into both, resi as well as MSR. In this past quarter in MSR, you'll see an increase in capital allocation given the amount of commitments we've made that are forward settling. And so you'll see that go up. And again, the residential pipeline is very healthy. And so we're hopeful that we'll grow that responsibly and deliberately.

[Operator]

Our next question comes from Vilas Abraham from UBS.

[Vilas Abraham, UBS]

Just on the hedging on the hedge ratio, flat quarter over quarter, just how do you think that trends over the coming quarters? And do you see yourself being particularly active in implementing anything new there?

[David Finkelstein, CEO, CIO & Director]

Yes. Good question, Vilas. So there's the active component in the passive components. I'll start with the passive component first, actually. If you just look at the runoff of the portfolio, by year-end, 15% of our swaps will run off, about only 6% or thereabouts over the next 4 months. So there's going to be some passive runoff. And the determination we'll make is that given where we're sitting with respect to monetary policy, do we want to let those hedges run off and be a little bit longer in the front end of the yield curve? And that is quite likely.

Also, if there is a meaningful change in either the rates market or the yield curve, we will absolutely intervene and reflect our views and whether it be steeper or flattener, adding duration or taking operation, we'll absolutely do it. But right now, we're sitting right at a half year of duration with a hedge ratio of a little bit above 100%. All else equal, that hedge ratio would go down. And we think we're fairly balanced as it relates to interest rate risk, both in actual duration exposure as well as our curve exposure.

[Vilas Abraham, UBS]

Okay. Got it. That's helpful. And just maybe a bigger picture question on Fed policy at the press conference yesterday. Chair Powell suggested that there could be a scenario where you see rate cut, but runoff on the balance sheet still occurring. Just kind of what are your thoughts around that? How would the market react? Is that priced in to spreads or any other parts of the market right now? Just curious to hear your thoughts there.

[David Finkelstein, CEO, CIO & Director]

Sure. So the scenario where that would occur, they're cutting rates, while the balance sheet is still running off is likely a disinflationary scenario as opposed to something like a hard landing. They can actually achieve that objective. I know it's counterintuitive, but they're normalizing both policy tools, getting rates back to what they consider to be neutral. If inflation does come down below their expectations, that will likely start next year. And they still need to get the balance sheet down to levels that they want to operate at.

Right now, the balance sheet is still quite elevated. $5 trillion treasuries, $2.5 trillion mortgages, and if you look at what we think to be their timing of runoff or when they think that they need to stop runoff and start growing again. It could be the middle of next year or later, they may need to ease or it may be warranted to ease in advance of that. So you can do both things at once, so long as it's not driven by recessionary cuts, in which case you'd want to stop the balance sheet runoff to help the economy and add liquidity to the system.

Now in terms of the share, making that statement yesterday, it's actually relatively good for MBS. And the reason being is that we did not expect Agency MBS to stop running off when they end QT, much like the last iteration of QT. We expect Agency MBS to run off and then be reinvested into treasuries after they end the QT. If they are cutting rates and still letting the balance sheet runoff, they're also letting treasuries run off as well beyond the time that they stop or they start reducing rates. And so that basis trade that could have occurred when disinflationary cuts occur is postponed effectively. So generally, it's at the margin better for the basis. Does that help?

[Vilas Abraham, UBS]

Yes, it helps.

[Operator]

Our next question comes from Bose George.

[Bose George, KBW]

I had a quick question just about the -- you had that small CMBS portfolio. Can you just remind me what the exposure is there? And is that just an opportunistic portfolio?

[Michael Fania, Deputy CIO & Head, Residential Credit]

Yes, I think that's the correct characterization of it. We did have a CMBX position that was closed on the quarter, so we no longer have any exposure to CMBX. We don't actually think it's a core asset on a go forward. In terms of where we're at now, we own AAA CRE CLO. We own around, I think $340 million. And we expect that to be opportunistic dependent upon spreads. It's an asset that you can efficiently lever.

[David Finkelstein, CEO, CIO & Director]

Yes, like 96% multifamily, I believe.

[Operator]

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

[David Finkelstein, CEO, CIO & Director]

Thank you, Scott, and thank you, everybody, for joining us today. We appreciate your participation. And I hope everybody has a very good end of summer.

[Operator]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.