Annaly Capital Management Inc

NYSE:NLY

Earnings Call Transcript 2019-Q3

[Operator]

Good morning, and welcome to the Annaly Capital Management Quarterly Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded.

I would now like to turn the conference over to Purvi Kamdar, Head of Investor Relations. Please go ahead.

[Purvi Kamdar, Head of Investor Relations]

Thank you. Good morning, and welcome to the Third Quarter 2019 Earnings Call for Annaly Capital Management, Inc. Any forward-looking statements made during today’s call are subject to certain risks and uncertainties, which are outlined in the Risk Factors section and our most recent annual and quarterly SEC filings.

Actual events or results may differ materially from these forward-looking statements. We encourage you to read the forward-looking statements 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. As a reminder Annaly routinely post information for investors on the Company’s website at www.annaly.com. Content referenced in today’s call can be found in our third quarter 2019 investor presentations and third quarter 2019 financial supplement both found under the Presentations section of our website.

Annaly intends to use our web page as a means of disclosing material non-public information for complying with the Company’s disclosure obligations under Regulation FD and to post an update investor presentations and similar materials on a regular basis. Annaly encourages investors, analysts, the media and other interested parties to monitor the Company’s website in addition to following Annaly press releases, SEC filings, public conference calls, presentations, webcasts and other information it posts from time-to-time on its website.

Please note this event is being recorded. Participants on this morning’s call include Kevin Keyes, Chairman, Chief Executive Officer and President; David Finkelstein, Chief Investment Officer; Glenn Votek, Chief Financial Officer and other members of management.

And with that, I’ll turn the call over to Kevin Keyes.

[Kevin Keyes, Chairman, President and Chief Executive Officer]

Thank you, Purvi. Good morning, everyone, and welcome to our call. As we enter the final two months of this decade and approach the 2020s, I want to reiterate, update and provide commentary on some of the critical themes we highlighted at the start of this year.

To recap on our fourth quarter 2018 earnings call in February, we stated that there was "An obvious combination of economic, fiscal, political and macro pressures that will contribute to a shift toward more accommodative monetary policy and we’ve been able to project for a long time." On our call in May I then remarked, "There has been return of flashing red lights across markets with the flattening yield curve and compressed credit spreads, resulting in little differentiation of risk." The volatile summer followed and on our second quarter call in July, I commented "Deteriorating economic data, weak inflation ratings and the unresolved global trade outlook signaling a growing possibility of an apparent earnings recession in corporate America."

This provoked the Fed to embark on its first rate cut later that day. Fast forward to today, following a challenging third quarter for which my prior commentary has served to preview, we can now say that the market environment has certainly improved for Annaly for numerous reasons. I’ll give you the top five. First lower funding costs going lower still. Number two, better outlook for asset yields. Number three, the New York Fed’s recent commitment and actions to stabilize the repo market. Number four, the expected slowing of pre-payments by quarter end. And number five, improving repo LIBOR spread as an additional tailwind.

Because of this increased visibility, we reaffirm the quarter dividend of $0.25. Against this backdrop of more favorable market conditions and enhanced visibility and policy there are five significant and expanding market, industry, and corporate themes, which Annaly is uniquely positioned to capitalize on as we finish this year and enter the next decade.

The first theme is GSE shrinkage and the need for private capital in the U.S. housing market. We’ve discussed this theme overtime. But this past quarter, we gained additional clarity about the administration’s view of the GSE evolution, which clearly necessitates a further shift to the private market. While Fannie and Freddie will remain a critical component of housing finance, the Treasury’s 2019 Housing Finance Reform Plan published in September, highlights how integral private capital will be to the future system and whatever form it may take.

To-date private capital has absorbed 67% of risk transferred on $3.5 trillion of unpaid principal balance in the GSEs residential credit exposure. CRT market issuance is now in excess of $75 billion, since the program’s infancy in 2013 and Annaly has been an active participant in the market, purchasing roughly $2.5 billion since that time period. The CRT market is a good prototype for the FHFA, which is now leading efforts to align regulatory treatment to level of playing field for private capital and assess, which products are consistent with the GSE’s statutory mission.

In order to ensure the U.S. housing market continues to evolve and remains robust, we anticipate private level market volumes to increase overtime in several asset classes we finance. Our residential credit business has doubled over the last three years and we expect to match that growth rate over the next year by taking advantage of upcoming supply and potential new structures in a growing market.

What has also become more clear recently are the secondary effects that further GSE shrinkage could have on the market. As Fannie and Freddie reduced their collective footprint, while home ownership is already unaffordable for many Americans. 35% of homeowners had to move into affordable housing this year, an increase of 35% since last year.

And surprisingly in this country 82% of renters now view renting as more affordable than homeownership. This is an all-time high and a 22% increase since just last year. The government needs to enable private capital to help fill the GSEs void and to avoid further worsening of affordability, especially given that housing is a proven powerful driver of our economy. Annaly is focused on expanding our role here. Our business is now built to finance housing across the country, while supporting several related pillars of the economy.

We have extended over 200,000 loans totaling over $16 billion to borrowers with lower loan balance mortgages in the country, financing homes that are typically less than half the nation’s average price. We have also financed over 4,200 loans totaling over $2.8 billion to credit-worthy borrowers who may not have access to traditional bank channels, including self-employed borrowers.

Lastly, we have invested nearly $2 billion into areas of economic opportunity, such as affordable housing, education, healthcare, retail groceries and other sectors of low-income and low access areas through our portfolio investments and our JVs with Capital Impact Partners. With more without legislative reform the footprint of the GSEs is undoubtedly shrinking in the next decade and Annaly is poised to continue its growth as a significant contributor to private capital to maintain the affordability and liquidity of the U.S. housing finance system.

The second long-term opportunity for Annaly is the product of banks shrinking their mortgage businesses. Parallel trends to the GSEs hold through the banking sector, which is also experienced significant transformation due to regulatory reform. Leverage and liquidity constraints have altered banks business models and shifted various residential and commercial lending activity to other players. As an example, banks have decreased their GSE footprint and now originally only one out of every three GSE eligible loans compared to twice that share just six years ago.

Anecdotally, certain large U.S. banks today once dominant in the mortgage markets characterized the business now under other income in their financial statements. As banks, mortgage-related exposure trends lower, non-banks and other originators have stepped in to fill the void. Since 2014, non-bank’s share of total agency mortgage origination is up from 29% to 53% of the market. These non-banks originators are growing of strategic and capital partners such as Annaly.

Our third theme for the 2020s, private equity needs new partners. The growth of private equity has played a huge role in balancing out the redistribution of corporate leverage out of the banks and with the amount of leverage growing in the market, structural terms depreciating and system lack of differentiation and risk, I wanted to provide some real-time examples of how we’re partnering with sponsors to invest in land safely in credit in this environment.

Within our diversified strategies, we’re simply focused on selecting the right credit, the right sponsor, the right place in the capital structure and sourcing larger less competitive deals given our strong established relationships scale on liquidity. Within our Commercial Real Estate Group, Annaly has participated in financings of several large portfolios for major private equity firms, including approximately $300 million for Blackstone just this month, contributing to deal volume for the Group of nearly $800 million year-to-date.

Our middle-market lending team has originated approximately $700 million of assets this year, of which 90% was repeat business with existing top tier sponsors. Notably, our average deal size in that business is up nearly 2 times in the past two years. And lastly our Residential Credit team has efficiently competing through proprietary partnerships. With these strategic partners, we have access to asset flow from a network of over 100 originators and we’re on pace to produce $1.7 billion of home loans in 2019, a 2 times increase over the past 12 months.

Finally, we are producing very competitive returns using conservative leverage across all three of our credit businesses. For the third quarter, overall $1 billion of credit investments generated a weighted average levered return of 12.6%, using only 2.3 times leverage. The fourth theme is a combination of our focus on operating efficiency, financing expertise, and capital optimization. For the next decade and beyond Annaly has already built with operational efficiency. We have paid it forward. The investment in the Company’s infrastructure to efficiently invest in the redistribution of assets in the future as I just outlined.

Out of the Fed, the GSEs, and the banks, while investing alongside the growth of private equity. Now that our four businesses have successfully reached scale, we’ve reduced our management fee to 75 basis points for additional capital raised and have added a total of 25 institutional partnerships in lieu of paying for additional infrastructure. We have incomparable operating leverage in our four businesses.

Our operating expense as a percent of equity is only 2% compared to 25% on average for the nearly 300 mortgage REITs, banks, insurance companies and asset management companies that have an aggregate market cap of $3.8 trillion. With these ratios, we are over 12 times more efficient on average across all our asset classes in these other investor models we compete against.

Regarding financing and capital optimization, we refined our capital structure through capital markets activities, additional financing alternatives and securitizations. We have repeatedly demonstrated diligent allocation of capital. Beginning in late August and into the fourth quarter, we repurchased over $220 million of shares, taking advantage of evaluation in our stock. These repurchases resulted in immediate book value accretion and created real economic return for shareholders.

Our repurchase program emphasizes our differentiated approach to the capital markets. We are buying back stock at similar valuation levels that others are issuing stock below book value. Believe it or not, 60% of the equity offerings completed in the mortgage REIT sector in the third quarter were dilutive to shareholders.

Finally, I want to highlight another significant theme in today’s market and for the next decade, where Annaly continues to be a market leader, corporate responsibility and ESG. Specifically, our focus on diversity and inclusion has fostered a culture, which is open to healthy debate, enriched by broad experiences and made up of talent from all over the world.

Savita Subramanian, a leading voice in ESG research from Merrill Lynch, whom we invited – who we invited to present to our board just this year, validates that through an extensive study businesses with at least 30% women in leadership positions have higher returns on equity and lower future price in earnings volatility. With 50% of our additions to leadership represented by women since I became CEO and more than half of our firm identifying as female or racially diverse, we have illustrated our commitment to diversity across our organization in an effort to outperform over the long-term.

While we are always striving to improve, a few additional data points illustrate Annaly’s employee diversity. 33% of our Operating Committee are women, 45% of our Board of Directors are women and finally, 69% of the 26 new hires we’ve made in 2019 identified as female originally diverse. Shareholders have validated our efforts in these areas of corporate responsibility and as demonstrated by the 79 ESG oriented funds and now own Annaly, which is an increase of almost 70% since 2015.

Finally, we are encouraged by the direction the market is heading, which helps to make our opportunities more visible and tangible today. As a private capital solution for the U.S. housing market, the commercial real estate industry and business owners across the country, we look forward to the opportunities that will be provided in this next phase of monetary policy and asset redistribution in the next decade and beyond.

Now I’ll turn the call over to David Finkelstein.

[David Finkelstein, Chief Investment Officer]

Thank you, Kevin. While the market environment at the onset of the third quarter was relatively calm, an increase in trade tensions in the prospect of a further slowdown in the global economy resulted in volatility picking up meaningfully in August. Longer-term interest rates rallied sharply to levels close to their all time lows, which led to considerable flattening of the yield curve in Agency MBS, exhibited one of their worst months of relative performance in the post-crisis period on a rising concerns over prepayments and hedging costs.

Although, September brought some relief as rates retrace partially and spreads were modestly, we did in the quarter with materially lower rates and wider Agency spreads. Amidst this challenging environment, we were able to generate a positive economic return of 1.4% and we ended the quarter at 7.7 turns of leverage.

Turning to portfolio activity and beginning with the Agency sector, performance was highly directional with interest rates. Prepayments increased driven by a combination of lower mortgage rates in summer seasonals. And while our portfolio has considerable protection, we were not immune to higher speeds as portfolio of pre-payments increased to just over 14 CPR, but did remain somewhat contained relative to the pre-payment increase in the broader MBS universe. We took a relatively conservative trading approach during the quarter, as we opted to protect book value by reducing assets into volatility and managing leverage coincident with our stock buyback program that we commenced in August.

Also on the asset side, we modestly gravitated down in coupon, specifically in TVA’s. Our activity was more focused on the hedging side as we shifted roughly 10% of our swap position to the front-end of the yield curve, which we began prior to the curve flattening and the adjustment also helped to reduce our weighted average pay rate by 24 basis points on the quarter.

Some of these front-end swaps were subsequently rotated into overnight index swaps linked to Fed funds when the spread between LIBOR and OIS reached year-to-date wides. In the declining rate environment like the third quarter, those swaps provided an immediate benefit to our cost of hedging, particularly because we reset daily versus our LIBOR-based swaps that we set quarterly.

These dimensions do balance out over the longer horizon. So looking at one single quarter doesn’t give a complete picture, and we will never manage the near-term. As the market ultimately transitions away from LIBOR, we will look to continue to opportunistically gravitate toward OIS or SOFR-linked swaps at prudent market levels and considerate of the liquidity of those products.

While OIS as a good short-term repo hedge it doesn’t provide the same credit and liquidity hedge as LIBOR. And to note, the vast majority of our swaps remained LIBOR-based and we anticipate the wider LIBOR OIS spread that prevailed at the end of the quarter to be a benefit relative to peers in the fourth quarter as over half of our LIBOR swaps resets in September.

Additionally, on the hedging side, we added out in the money payer and receiver swaptions to help manage tail risk and we were also compelled to add duration of the portfolio primarily in the form of covering futures hedges as the decline in interest rates, shortened MBS durations. Agency repo rates remain elevated throughout the quarter, which culminated in the sharp increase in overnight rates in mid-September.

The spike in financing rates necessitated the Fed, not only to intervene in the repo margin for the first time in more than a decade, but also restarting their balance sheet growth beginning this month in an attempt to ensure sufficient liquidity in the banking system. Following the Fed’s measures, overnight the shorter-term repo markets have largely normalized. However, liquidity in longer-term contracts remained somewhat impaired through September and as a result we opted to maintain a shorter repo duration profile through quarter-end, which we have since begun to expand.

While we do certainly utilize our broker-dealer balances were limited to under 20% of our overall financing during the funding dislocation, with just under half of those balances reliant on overnight FICC financing, which was the epicenter of the episode. The remainder being either termed out or financed through our direct repo counterparties, which did not experience funding volatility to the same extent.

Shifting to our Residential Credit business, as Kevin previewed, we increased the pace of our whole loan program as we acquired over $700 million of expanded prime and agency eligible investor loans. We completed our seventh securitization in July with an additional transaction in our October, both of which consisted of expanded prime loans. Organic creation of residential credit securities such as through these two transactions remains a more efficient mechanism in the secondary market to add exposure within residential credit given resulting low to mid-double digit yields with modest leverage.

And we are also encouraged by the growth of the expanded prime channel and the progression of the securitization market for these borrowers, where deals completed on non-QM loans thus far this year have at least $18 billion which is already doubled out of the market in 2018. Also to note, the prospect of some form of administrative GSE reform, as Kevin touched on, with likely lead to further growth of alternative channels for mortgage borrowers.

Now with respect to our outlook, while the Agency market is experiencing elevated pre-payments and higher convexity costs, valuations are reflective of these dynamics and we are more constructive on the Agency sector today given historically wide spreads. Moreover, in a fundamental shift from a year ago, Agency assets will benefit is the Fed adds rather than reduces liquidity within the broader system and financing should be more stable going forward.

However, despite the attractiveness of the Agency sector, as we have said consistently, we do remain committed to our diversification strategy given its inherent benefits of protecting book value and contributing to greater earnings stability. While we do expect to remain at the lower end of our allocation to credit with benchmark spreads close to post-crisis tight levels, we will continue to underwrite, high quality credit assets to ensure an appropriate balance between Agency and credit and our proprietary platforms will help to ensure we can accomplish this without meaningfully sacrificing returns.

Maintaining our capital allocation in the proximity of the current distribution should help to keep portfolio leverage in the recent range over the near-term. And with the tailwind of accommodative monetary policy and persistently wider Agency spreads, we do expect an improved carry environment in the fourth quarter and beyond.

Now with that, I will hand it over to Glenn to discuss the financials.

[Glenn Votek, Chief Financial Officer]

Thanks, David. Beginning with the GAAP results, we reported a GAAP loss of $0.54 per share driven by hedge portfolio losses, which improved sequentially and offsetting mark-to-market gains in our Agency portfolio which run through equity resulted in comprehensive income of $0.11 per share. Book value declined modestly to $9.21 a share and we generated core earnings ex-PAA of $342 million or $0.21 a share.

There are a number of factors that contributed to our results this quarter, beginning with interest income. While coupon income increased $0.04 on higher average earning assets, higher pre-payment speeds resulted in approximately $0.06 of additional PAA adjusted premium amortization. Higher amortization expense was due to projected CPRs increasing quarter-over-quarter, as David that just noted a moment ago.

Additionally, drop income declined $0.01 sequentially and higher average repo balances added another $0.01 to interest expense. Our operating efficiency metrics improved on declines of both management fees and other G&A. The dislocation between repo funding costs and LIBOR that we’ve discussed in prior calls remained the factor once again this quarter, while our average repo funding cost declined 13 basis points, LIBOR-based reset on the receive leg of our swaps declined on an average basis by about 25 basis points.

This dynamic also impacted NIM and net interest spread as lower rates, coupled with the higher premium amortization, as I just mentioned, drove asset yields lower to a greater extent than the decline in our funding cost which have lagged Fed reduction in rates. Looking forward, we expect CPRs to peak in early Q4 and anticipate lower funding costs and wider agency spreads to more than offset this impact, contributing to NIM and net interest spread improvements of 10 basis points to 15 basis points.

Turning to the balance sheet, assets declined roughly $3 billion, primarily driven by a reduction of Agency MBS holdings and our loan portfolio has experienced net growth of $400 million on originations and purchases of $1.3 billion, partially offset by securitizations and pay downs.

During the quarter, we further lowered our preferred cost of capital by completing the previously announced redemption of $175 million, 7 and 58 Series C preferred, as well as the underwriters partial allotment exercise of the 6 and 3 quarter Series A preferreds that we had previously issued at the end of the second quarter. As a result, in the past, roughly two years with these additional actions, we’ve cumulatively reduced the cost of our preferred capital by approximately 70 basis points or 9%.

In terms of our common dividend, we’ve reaffirmed our prior guidance for $0.25 for the fourth quarter dividend, subject of course to our Board’s review and approval. So to wrap up, as we alluded to in our prior call, the third quarter proved to be a challenging ones driven by compressed asset yields and resistant financing costs.

We expect Q3 will have been an earnings trough and in the current conditions would anticipate core earnings trending higher into the fourth quarter. We believe our business model is well positioned in offers of capital deployment choices to drive shareholder value, whether that be in form of asset allocation options or further share repurchases.

And with that operator, we’ll open it up for questions.

[Operator]

We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Rick Shane with JPMorgan.

[Rick Shane, JPMorgan]

Hey, guys. Thanks for taking my questions this morning. Look, if you head into Q4 and into 2020 you make a compelling case that margins are going to improve that this is a trough in earnings and we definitely see that in the trends as well. I am curious when you think about this, not on a pure return basis, but on a risk-adjusted return basis, and I know that’s more qualitative in terms of thinking about risk, but when you think about things on a risk-adjusted basis, how do you feel about the operating environment?

[Kevin Keyes, Chairman, President and Chief Executive Officer]

Hey Rick, I think our comments are meant to be constructive and positive, but measured. First of all, I think the way I would answer that in a Reader’s Digest version on a risk-adjusted basis and it’s a very good way is to how we look at our capital allocation models across four businesses.

I think it’s fair to say, we anticipated what was going to happen and happened and I think going forward pursuant to our commentary, risks are lower and returns could be higher, predominantly in the Agency business. I think in the credit businesses, what we’ve demonstrated is, we’ve done about $4 billion of credit in the last couple of years across the businesses.

On a risk-adjusted basis that I think has been demonstrably better than the market, albeit, it’s not necessarily reflected in the numbers yet, because there hasn’t been a credit contraction or credit hiccup or sell-off. So all that being said, we are bit different because we have these four businesses that are complementary and combined. So credit, I think to David’s point still is quite tight, but we’re finding 12%, 13% returns at 2 times leverage, which is very attractive even versus Agency business, which has become a lot more favorable.

So I think going into the four quarter, the reason we’re maintaining the dividend and the reason why we are constructive on the outlook is that we see the portfolio’s long-term earnings potential, not just stabilizing, but returning really to the levels that we anticipated earlier this year.

And I think the bogey for us, the attractive kind of call option for us is what happens in credit, because I think we’ve basically been firing on two of our four cylinders here. And if there is a corruption or if there is a disconnect in any of the credit businesses, we’re capable of capitalizing like nobody else. So and that’s on top of again the Agency business that we think is a lot more attractive today certainly than it was over the summer.

[Rick Shane, JPMorgan]

Got it. And in that spirit look, if you look at the leverage – the economic leverage on a headline basis, it’s ticked up a turn year-over-year, but if you – in the idea of sort of risk adjusted, if you look at the allocation to equity to credit going down, I would argue that there is actually less risk in terms of the increased leverage than the number would suggest. Headed into this sort of environment in Q4 and into 2020, are you comfortable taking leverage up given the current allocation to credit?

[David Finkelstein, Chief Investment Officer]

Hi, Rick, this is David. So to your point about leverage ticking up as a consequence of shift further towards Agency, that is correct. Agency is obviously more levered. So as we make that shift, you’ll see more leverage in the portfolio as you have. Another point to note over the past year is to my comments in my script, the Fed has shifted to a more accommodative approach, not just in terms of short rates, but also very recently as we’ve seen their intervention in the repo market and Agency being a balance sheet intensive product does give us more comfort with respect to having a higher levered portfolio.

Now going forward, we think we can generate the returns that we feel is practically prudent with the current level of leverage, but should things change or should we shift our capital allocation back towards credit if things cheapened and they may go down or if there is an opportunity that we really think Agency leverage could go up or leverage go up by increasing our Agency exposure we would do so, but we’re not there right now.

[Kevin Keyes, Chairman, President and Chief Executive Officer]

Rick, what I would just also offer and it ties to your first question, risk-adjusted returns, what we also – what we really look at is core ROE per unit of leverage. And if you look at our – if you just take a look at our numbers, if you analyze our core earnings year-to-date per unit of leverage, we have a higher return than the sector by far by using less leverage. So that’s the output of this model is designed to produce better or higher returns with lower leverage.

And to me that’s part of your risk-adjusted equation and overtime, really the last five years, we’ve been – if you look at that measure, historically, our core ROE per unit leverage is about 30%, 35% higher return with 30% or 35% lower leverage. So there is – that’s the big part of how we balance out where we put our capital.

[Rick Shane, JPMorgan]

Got it. Hey Kevin and David, thank you very much.

[Kevin Keyes, Chairman, President and Chief Executive Officer]

Thanks, Rick.

[Operator]

Our next question comes from Kenneth Lee with RBC Capital Markets.

[Kenneth Lee, RBC Capital Markets]

Hi, thanks for taking my question. Just a follow-up on the equity capital allocation. You mentioned in the prepared remarks, that allocation towards credit assets is closer to the lower end of the range right now and Agency is closer to the higher end, but just wondering, looking forward to the near-term, given the current investment opportunities and the macro environment. How do you see that evolving, could we see material shifts more out towards credit if pricing changes, I just want to get a little bit more thought about that?

[Kevin Keyes, Chairman, President and Chief Executive Officer]

Yes. Ken, it’s really – it’s pretty basic, right now on a relative value basis, risk-adjusted basis, Agency is cheaper than credit. So that’s where you see our portfolio reflecting that in terms of our capital allocation being higher towards Agency than it has been in the past few years. It will shift when credit gets relatively cheaper relative to Agency. So that’s a – on the part of our model, which is shared capital and by definition, risk management, is that we don’t put – we don’t have to put our money to work in everything or in any one thing, so we measured every day, every week.

When credit is weaker or weekends or we find a deal in credit that is on a risk-adjusted basis more attractive than Agency, then we will steer our money that way. The way I always answer the question also is what does it take for, if there is a correction on a reset in credit, what would our mix look like and the efficient frontier for this company given the efficiency of our operations is that we could be 50/50 credit-agency in terms of capital allocation without really having to invest in the infrastructure here. When I said in my comments, we paid it forward. We’ve set this Company up to grow in many different ways, and especially in credit, when we do see that retraction in the spreads.

[Kenneth Lee, RBC Capital Markets]

That’s very helpful.

[David Finkelstein, Chief Investment Officer]

Yes. And I would just say to the point about being at the lower end of the credit spectrum and capital allocation in efficient frontier. We do have to strike the balance between smoothing both volatility and earnings. I mean we are a late cycle in credit, the spreads are relatively tight. We do have enough organic origination through our three businesses that certainly maintain our credit exposure in quality assets, but we’re not price takers in credit by any means. We’ll do what we do and to the extent there is an opportunity to add through cheaper spreads, we will, but we’re not chasing anything.

[Kenneth Lee, RBC Capital Markets]

Got it, very helpful. And just one follow-up, if I may. I’m wondering, I want to get some of your thoughts around your capital position and specifically, available capacity for making investments going forward? Thanks.

[Kevin Keyes, Chairman, President and Chief Executive Officer]

You’re saying with respect to the increasing leverage, or making larger capital investments with our liquidity?

[Kenneth Lee, RBC Capital Markets]

Yes, I guess, either potential to – potentially increased leverage or utilize, other like for example, the unencumbered assets, just wanted to see the interplay between them and how do you view, how much you could actually use to deploy capital in potential investment opportunities?

[David Finkelstein, Chief Investment Officer]

So Ken, the headline answer to that is yes, yes, and yes. I mean we have, I would argue to this model, not just more. There is three things, more options to invest in the four businesses. Number two, more financing availability and options for the four businesses. And number three, our liquidity and capacity towards most in the sector. So the reason we’re not kind of fully amped up across the businesses in terms of leverage is that it’s been a – so the point on the other question about risk-adjusted returns, it’s been a higher risk market across the board.

Now what we see going forward is lower risk in Agency on a relative basis and we’re picking our spots and credit. But our liquidity really is our mode, it’s our advantage and frankly, the sources of that liquidity, we have 10 different ways we finance our businesses non-recourse, which nobody else has. And that’s the reason we built this platform, the way we did.

So going forward, you’re going to see the lag effects catch up for us. Meaning, our weighted average cost of funds will continue to go down in the fourth quarter and beyond. So the cost of financing is going up and yet, we still haven’t drawn down on a lot of our capacity in any one of the businesses. So we’re – we think we’re paying you pretty good cash-on-cash return to weight for a capital appreciation event or the next bigger event in terms of an acquisition or portfolio lift or some other strategic direction that we are – that’s why we are – that’s why we maintain the liquidity position that we do.

[Kenneth Lee, RBC Capital Markets]

Great, very helpful. Thank you very much.

[Kevin Keyes, Chairman, President and Chief Executive Officer]

Thanks, Ken.

[Operator]

Our next question comes from Matthew Howlett with Nomura.

[Matthew Howlett, Nomura]

Everyone, thanks for taking my question. Just to reiterate, did you say 10 to 15 basis point improvement in 4Q in the margin?

[Kevin Keyes, Chairman, President and Chief Executive Officer]

Yes, we did.

[Matthew Howlett, Nomura]

Okay. And then I mean does that when you look at further is that something that’s sustainable. And when you look at sort of new purchase yields and you can finance them at. How should we think about the stability? You did a good job really aligning, what the headwinds were in the third quarter and they should normalize in fourth quarter, is that – you think things will stabilize on that or could they get better, or could they get worse? And I know, you don’t have a perfect level, but I just want to hear your thoughts?

[Kevin Keyes, Chairman, President and Chief Executive Officer]

Yes, I mean obviously we don’t have a crystal ball as far as what’s going to happen overtime, but we are very confident in what we’re seeing in terms of trends with respect to our funding cost and the benefit will have on both NIM as well as net interest rate.

[Matthew Howlett, Nomura]

Great, okay. And then, Kevin, I just want to follow-up on your positioning and a lot of – you’ve probably seen a lot of REITs moved into this operating model, I know you said you’re not price takers here in this market. When you look at buying an originator or becoming more of an regional. How do you see things playing out and you’re looking at everything here?

[Kevin Keyes, Chairman, President and Chief Executive Officer]

It’s a good question. Annaly looks at everything and we have, I think thankfully, we see a lot of the mortgages, because of the ecosystem of these businesses, right. In terms of origination, we do – we see everybody, we have great relationships, right now we’ve chosen to maintain our joint venture and partnerships that I described in my prepared comments. And look, we do the math and the math is definitive for us that we can produce X billion of assets from an origination partnership at 20% to 25% of the costs, meaning 75% cheaper, because we’re are not – we don’t have the people, the systems, the infrastructure needed to run a conduit to originator and have all the bricks and mortar around it.

So, the math says that we are accessing these assets 75%, 80% more cheaply than those that are producing it on their own. So that’s beneficial for incremental returns here. And as we see that business grow and it’s been one of our higher growth businesses and we will continue to be to my comments. The point here is, I want to grow, not necessarily just in size, but I have seen return on invested capital. So incremental business that push through our residential platform should be higher margin business for us, the more we do. So we’re getting to that scale, we’re at that threshold now where those returns, albeit, all things being equal in the market, those returns should even get better.

Now that being said, if there is a partnership or a platform that we would like to lock up in terms of proprietary relationships and have an investment to do that, by all means, we’re open to do that because we – that’s another way to – just to take a lot of flow, and secure more tangible definitive flow on top of what we have. But what we have is producing some really good growth as you’ve seen.

[Matthew Howlett, Nomura]

Well, I’ll certainly say I see you’re buying back stock and recognizing the value in the platform. Long-term, does it makes sense, I mean given those businesses combined, I know you’d like to sort of reference the shared capital model. Or do they need at some point to be sort segregated given the high returns and some of the premiums that are applied to other peers?

[Kevin Keyes, Chairman, President and Chief Executive Officer]

Yes. The some of the parts, we think we’re undervalued today, but long-term, I think especially in these markets where I don’t think you get paid to take excessive risk or get paid to do quarterly trades or things could go sideways on you quite quickly. So we think the sum of the parts here – the value for our shareholders, is really safety, and these businesses together churning out the complementary cash flows that they churn out, it’s more seats for them all to be collectively together. Now, as these have grow and it’s more efficient and lot of liquidity and everything else – every business benefits from each other.

Look if there comes a time and I mentioned it, I think couple of quarters ago, if the some of the parts becomes more obvious, and there is an arbitrage ability for us to take advantage of some are, whether we sell assets or spin off a business or carve out of company, we’re prepared to do that. All these businesses are run and accounted for independently under one very tight umbrella. So it’s a call – another call option in owning our shares is that potential. But I don’t see anything coming down the road, because we are frankly focused on efficient growth with returns on invested capital, which are higher as one company versus one of these companies was on a stand-alone basis.

[Matthew Howlett, Nomura]

Good. Thanks for the comments, Kevin.

[Kevin Keyes, Chairman, President and Chief Executive Officer]

Thank you.

[Operator]

Our next question comes from Eric Hagen with KBW.

[Eric Hagen, KBW]

Hey guys. Thanks, good morning. I had a question on the originator as well and I think you answered that really well. I’ll just add that it’s been exciting to watch you guys issue some securitizations and get those deals done so congrats. Just a couple of housekeeping items, I guess, I think this is for you, Glen, is there a sensitivity that you can give us to the level of premium amortization that corresponds to a change in your CPR assumption in either direction?

[Glenn Votek, Chief Financial Officer]

Yes, it’s a really complicated set of calculations in terms of how the whole PAA adjustment works. I think the simple way of looking at it is to look at what the prior quarter’s projection was and how that compares against a future. In other words, we’re trying to reset it back to that prior period. I can tell you that based on where we see pre-payment trends currently, we would expect on a PAA adjusted basis amortization expense to be roughly equivalent next quarter as far as what we see – or what we had experienced in Q3.

[Eric Hagen, KBW]

Okay. That’s helpful. And then where in the coupon stack are you guys reinvesting run off in the Agency portfolio and on the dollar roll side, I see that you guys have a net long position in TBAs around $11 billion. But are you short any roles? That’s the question. Thanks.

[Glenn Votek, Chief Financial Officer]

Sure. Eric, with respect to where in the coupon stack, we do have a tilt toward higher coupons, but that being said, I’d say that we still do think that in spite of elevated pay ups loan balance paper is still very attractive. You know the way we look at TBAs versus pools is. TBAs are benchmark and they are relatively cheap benchmark and pay ups have obviously increased quite a bit, but they’ve reached to achieve benchmark.

So when you look at pools on a cash flow basis and the spread relative to financing and hedging costs, reasonably well protected pools are still certainly attractive to us and we are certainly maintaining our exposure in higher quality pools, but we’re also sensitive to the value associated with lower pay of pools. For example, you can distinguish between servicer and how much third-party origination in gross WACC. And you actually can get real value relative to that very cheap benchmark with the pay ups are somewhat low.

So your question about TBA and the roles. In the third quarter, we did not have short positions, as has been discussed, higher coupon rolls did trade negative. Our view was that higher coupons rolls were also relatively cheap and their performance, TBA performance, in the third quarter on a curve adjusted basis was relatively strong. So we think that was a good decision not to be short TBAs in the third quarter. However, since higher coupons have performed reasonably well since August, we have exited to some short TBA positions in higher coupons, given the fact the we always do persist in a negative drop. So we do have a small amount of short positions in TBAs.

[Eric Hagen, KBW]

Got it. That’s helpful and then just to kind of pin you down on the coupon question, just run off is going into 3s and 3.5s and mostly 3s, I mean just give us a sense for…

[Glenn Votek, Chief Financial Officer]

Some 3s and 3.5s. I would say, but we have 70% of the coupon exposures in force 4s and 4.5, so we’re not reallocating there.

[Glenn Votek, Chief Financial Officer]

Got it. Thank you very much.

[David Finkelstein, Chief Investment Officer]

You bet.

[Operator]

[Operator Instructions] Our next question comes from Douglas Harter with Credit Suisse.

[Douglas Harter, Credit Suisse]

Thanks. I was hoping you could help me understand kind of the big drivers of kind of the earnings volatility over the last 10 quarters, kind of almost four years of kind of stable earnings and kind of what changed so much over the past few quarters to introduce more volatility into earnings?

[David Finkelstein, Chief Investment Officer]

Sure. This is David. I’d say there is a couple of factors heading into the spring and summer, we did have some swap run-off of some lower fixed rate payers that did run off in the second quarter, which caused earnings to go down somewhat in the second quarter. And in the third quarter it was predominantly attributable [indiscernible] associated with pre-payments. But that being said, when you consider the third quarter versus the fourth quarter, I think it’s notable that we got essentially 80% of one Fed cut in the third quarter.

If we look at the fourth quarter, we’ve now have three cuts from July September and October to where the weighted average is two and two-thirds rate cuts for the fourth quarter, and so we do think that will be the predominant tailwind that will equate the third quarter to a trough.

[Douglas Harter, Credit Suisse]

Great. And then I guess just looking forward, kind of – as we get through the fourth quarter and you get those rate cut benefits. I guess just how do you view your earnings stability going forward. Are we likely to go back to kind of the prior four years of stable earnings or do we think we’re in a period that this volatility in earnings is going to continue?

[Kevin Keyes, Chairman, President and Chief Executive Officer]

Look, our outlook right now is a lot more constructive, Doug. And when you look at our stability, right, the last four years, our core earnings variability has been 24% versus the sector – and REIT sector’s core earnings variability was a 111%. So, which is five times more volatile. You know the yield factor that I always quote. In terms of the broader market for companies and other industries that produce income, their variability is about 60% or three times more volatile than us.

So we have proven over time that we’re more stable and there is no reason to believe in our outlook that we can’t maintain that stability with this model, to David’s point and Glen’s points, protecting book value sometimes you sacrifice earnings in order to maintain the portfolio and the earnings potential going forward, and that’s what we’ve done. And the outlook, I think on a risk-adjusted basis to start the Q&A. I think we feel a lot better, albeit we never feel good about anything as we’re defensive yield stock.

So look, this model more than any other is built for stability and not again for our quarterly trade or a short-term outlook. That’s why I talk about the next decade. And we about the big macro influences and GSE reform. Thanks retreating and PE, PE meeting Switzerland in terms of lending to them. So you, I think we’ve not only made it through the trough of one quarter of earnings. I think we’re looking forward to frankly more volatility in different parts of the market that we’re prepared to take advantage of than others aren’t. And then, that’s when we can start firing on all cylinders and that’s what we’re looking for.

[Douglas Harter, Credit Suisse]

Thank you.

[Kevin Keyes, Chairman, President and Chief Executive Officer]

Thanks, Doug.

[Operator]

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

[Kevin Keyes, Chairman, President and Chief Executive Officer]

I’d like to thank everyone for their interest in Annaly and for joining the call and we will speak to next quarter. Thanks everyone.

[Operator]

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