Annaly takes loss on MBS volatility, but less than expected

Annaly, like other mortgage real estate investment trusts, struggled with challenging secondary market conditions in the third quarter, but the net loss it recorded was less severe than some analysts expected.

The company’s net loss was $0.70 per share or nearly $274 million. In comparison, its net income was $863 million in the previous quarter and $521.5 million a year earlier. Adjusted for non-recurring items, its average net earnings on a per share basis were $1.06. That beat a $1.03 estimate by Zacks Investment Research. But the $278 million in revenue Annaly generated during the three-month period was roughly 24% lower than Zacks’ consensus.

Annaly’s earnings and related commentary highlight some defensive strategies that proved effective in mitigating risks in the secondary mortgage market. It also points to the current revenue challenges for investors, such as home price depreciation, David Finkelstein, president and CEO at Annaly, said during the company’s earnings call.

“Given the mortgage affordability shock from high home prices and rapidly rising rates, we now expect the housing mortgage to correct, potentially erasing the entire appreciation seen this year by early to mid 2023,” he said.

However, this hurdle and others that run across several mortgage-related business lines are not insurmountable, according to Finkelstein.

“Although prices could fall meaningfully from the recent highs, homeowners have built up substantial equity cushions, lending standards have been conservative, and given low rates on existing mortgages, homeowners are unlikely to default unless labor markets weaken considerably from here,” he said.

The company plans to use its growing mortgage servicing rights portfolio to address the concern. Its portfolio, including MSR commitments or interests in servicing rights, had a market value of nearly $1.9 billion in the third quarter, more than triple its holdings of $575 million a year earlier, and up from a little over $1.7 billion in the previous quarter.

“The MSR portfolio benefits from stable cash flows in the low prepayment environment. It helps to hedge the risks of a further slowdown in housing activity,” said Finkelstein.

However, while MSRs are currently benefiting from stable cash-flows, government officials have shown some concern that their valuations can be volatile. Annaly will grow its investment in servicing rights cautiously in light of their risk profile. Its capital allocation to them in 3Q was 15%.

“We expect to be measured with respect to future growth, considerate of the sector’s relative attractiveness in our risk parameters,” Finkelstein said.

The company, which also is a nonbank issuer of prime jumbo and expanded credit mortgage-backed securities, also indicated that it’s being cautious about credit in ways that’s likely to slow down its activity in that business line.

“We have tightened our already stringent credit standards and we expect this pace of securitizations to moderate in the near term,” said Finkelstein.

The majority or 67% of Annaly’s capital allocation continues to be in agency mortgage-backed securities, which have been hammered hard by volatility in the market.

“A consequence of volatility has been extremely weak investor demand for fixed income products, particularly for agency MBS,” Finkelstein said. “In fact, the third quarter represents only the third time in the past 10 years in which banks and mutual funds, two critical private-sector holders of mortgage securities and loans, have reduced their agency MBS holdings simultaneously.”

Although investor demand has weakened, the availability of financing through MBS repurchases or MSR facilities in this market has remained stable, he noted.

“Favorable financing conditions are driven by the high balances of investor cash and short term interest rate products best seen by the elevated bank reserve balances, and reverse repo participation at the Federal Reserve notwithstanding Fed portfolio runoff,” said Finkelstein.

Given the volatile market conditions, Annaly maintained a “defensive” position in its portfolio and had more than $6 billion in unencumbered assets at quarter end, he said.

The company “will maintain our defensive posture into volatility subsides while spreads across our investment strategies are historically attractive,” said Finkelstein.