Earnings Call Transcript
ANNALY CAPITAL MANAGEMENT INC (NLY)
Earnings Call Transcript - NLY Q1 2020
Operator, Operator
Good day and welcome to the Annaly First Quarter 2020 Conference Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I'd now like to turn the conference over to Purvi Kamdar, Head of Investor Relations. Please go ahead.
Purvi Kamdar, Head of Investor Relations
Good morning and welcome to the first quarter 2020 earnings call for Annaly Capital Management, Inc. Any forward-looking statements made during today's call are subject to certain risks and uncertainties including with respect to COVID-19 impacts 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. As a reminder, Annaly routinely posts important information for investors on the company's website at www.annaly.com. Content referenced in today's call can be found in our first quarter 2020 investor presentation and first quarter 2020 financial supplement both found under the Presentation 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 and update investor presentation and some more materials on a regular basis. Annaly encourages investors, analysts, the media, and others to monitor the company's website in addition to following Annaly's press releases, SEC filings, public conference calls, presentations, webcasts, and other information they post from time to time on its 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, Head of Residential Credit; Tim Gallagher, Head of Commercial Real Estate; Tim Coffey, Chief Credit Officer; and Ilker Ertas, Head of Securitized Products. And with that, I'll turn the call over to David.
David Finkelstein, CEO and CIO
Thank you, Purvi, and good morning, everyone. Since we last spoke on our market update call on March 16th, we've seen the COVID-19 pandemic spread rapidly. We would like to again extend our deepest sympathies to those directly impacted by the virus, and we hope everyone joining us for the call today continues to stay healthy. To keep ourselves, our families, and communities safe, Annaly continues to work remotely until it is appropriate for us to return to the office. We're grateful to have had well-established business continuity planning in place prior to this crisis to ensure the well-being of our staff without disruption to our operations. Now, on today's call I'll briefly provide an update on the market and how we managed our portfolio during the extreme volatility in March. Then leaders of each credit business will go through their respective portfolios. Serena will discuss the financials, and I will follow-up with our positioning and outlook going forward. Now, as the COVID-19 outbreak wreaked havoc on financial markets and the economy, we witnessed the Fed and Congress intervene in unprecedented ways. The Fed has enacted policy stimulus at a record pace, announcing larger and broader-based measures than during the 2008 financial crisis. They reduced the policy rate to the zero lower bound, provided ample liquidity and repo in U.S. dollar swap markets, conducted record asset purchases in treasuries and MBS, and established lending facilities to support a broad array of markets. To contextualize the sheer magnitude of the Fed's actions, its balance sheet has grown by more than 50% in the past six weeks. These measures have helped support financial markets and should prove beneficial for the economic recovery once we find ourselves on the other side of the virus. And in addition to the Fed, Congress has now passed four rounds of fiscal stimulus measures with more than 10% of U.S. GDP. We believe that the extraordinary steps that policymakers have taken to address the problems have been and will continue to be effective in normalizing markets and the economy. But this will require patience given the magnitude of the virus impact. Now, turning to markets and our portfolio specifically, I'll begin with the agency market. The liquidity vacuum we experienced in March was akin to the financial crisis, but it was the velocity of the risk-off move that was most notable. Normal trading relationships among asset classes almost instantly decoupled, volatility spiked, and spreads gapped substantially wider. Specified pools were particularly impacted as pay-ups went from all-time highs as the market approached an impending refi wave to the local lows as investors rushed to the sidelines to raise liquidity. Adding to this turbulence, dealers struggled to intermediate as their balance sheets were constrained by elevated holdings heading into quarter end. Our portfolio management efforts have consisted of strategic asset selection, unique hedging strategies, and a particular focus on liquidity. In fact, throughout January and February, in addition to a modest outright reduction in the assets, we were shifting out of generic pools into lower coupon TBAs such that one-third of our reduction in our pool portfolio came prior to the volatility we experienced in March. We reduced our leverage over the quarter from 7.2 times to 6.8 times in order to preserve capital amidst the erratic price action. The decline in our portfolio by over $28 billion over the course of Q1 was largely driven by sales of generic non-stored collateral. And the composition of our pool portfolio improved as a result of these decisions. Percentage of what we define as quality specified pools now represents 85% of our portfolio, up from 69% in the prior quarter, with the remainder made up of seasoned collateral. The shift in portfolio makeup has proven prudent thus far as specified pools have had a strong rebound in the second quarter, with the average pay-up on our portfolio improving by nearly one point since quarter end. Now looking forward in an environment with uncertainty around housing and pre-pays, we are confident that our portfolio is better positioned to perform throughout a range of different outcomes. Of additional note, vigorous Fed actions have dramatically improved the technical landscape for MBS. Net supply to private investors was forecasted to be roughly $500 billion at the start of the year. But with the Fed pivoting from run-off mode to becoming the largest buyer in the market, the net supply outlook for 2020 has turned sharply negative. The impact of Fed purchases has tightened spreads and reduced volatility meaningfully while settlements will continue to clean up the TBA slope benefiting rural markets. In addition, repo financing remains ample for the product, as it was even during the height of the volatility in March. Fed actions served as a tailwind for the entire sector, both on the asset and financing side. And thus, we are very constructive on agency going forward. Now regarding our hedging activities. In light of the significant rally in rates, we took proactive steps throughout the quarter to manage the contraction in the duration of our portfolio. First, we exited our treasury futures positions prior to the widening in swap spreads that occurred at the end of the quarter. Second, we added receiver swaptions at the beginning of the quarter, which proved effective in managing the sharp decrease in duration in our agency assets in March. We were able to exercise or exit many of these options at a notable gain and continue to deploy more option-based hedges given the cheapening in volatility that has occurred thus far this quarter. Adding these options is a beneficial way to manage the risk of longer-term rates moving higher further out the horizon. And finally, we extended the hedges further out the curve as front-end hedges offer little value now that the Fed has anchored short-term rates at a zero lower bound. As a consequence, the decline in our swap portfolio is primarily attributable to the reduction in short-term swaps, in turn extending the average maturity and lowering the notional amount of our hedges. Our decision over the past few quarters to keep most of our swaps and LIBOR-based hedges benefited the portfolio as LIBOR widened meaningfully above the overnight rates throughout the latter part of the quarter. However, we expect the spread to normalize as we have seen in similar widening episodes and feel comfortable heading into the second quarter with the majority of our swaps now in OIS. Shifting to the credit side. While no portfolio is immune to the impacts of the pandemic, we feel we are positioned to withstand current volatility given the composition of our portfolios and the relatively low leverage across our businesses. Our cautious view on the economic cycle and credit pricing over the past number of quarters has somewhat mitigated our exposure to higher beta products. We are pleased with the conservative stance our residential and commercial teams have taken with respect to credit quality as well as the strategic approach that our middle market lending business has taken as their focus has been on financing non-discretionary, non-cyclical companies, where the vast majority of the portfolio is invested in essential businesses. Our origination and underwriting teams across all three credit teams have been focused on actively monitoring our existing loans and maintaining close contact with our borrowers and sponsors as the impact of the virus continues to play out. And now with that, I will hand it over to Mike to begin with the residential credit sector.
Mike Fania, Head of Residential Credit
Thank you, David. The residential credit market, similar to the broader fixed income and equity markets, experienced significant disruption in late Q1 as the downstream impact to the economy due to the COVID-19 virus became increasingly apparent. Residential credit spreads started to widen in the second week of March with significant asset price decline and liquidity temporarily evaporating from the market. Credit markets were extremely turbulent over the following two weeks given a vicious cycle of deleveraging, margin calls, forced liquidations, and redemption concerns as technicals weighed on asset prices. Similar to the broader credit markets, the resi market began to stabilize, with spreads moving tighter in early April as forced deleveraging subsided and market participants turned to evaluate assets upon fundamental value. Most sectors within the resi market, while tightening significantly from mid to late-March, still remained wider than pre-virus levels. For context, AAA prime jumbo spreads trading in the low-mid 100s to swap pre-virus touched 600 to 650 to swaps at the wide, before tightening into the low-mid 200s currently. New origination CRT M2s trading at par dollar price pre-virus hit mid-high 50s at the lows and are currently trading in the low $70s prices. A non-agency legacy market typically a source of stability, trading in the low-mid 100s to swap pre-virus, hit 10% yields before stabilizing in the 4.5% to 5% yield area. The new origination non-agency whole loan market also experienced significant disruption as securitization was no longer accretive or viable and market participants repriced assets given industry-wide forbearance policies and economic disruption. This in turn forced a number of non-agency aggregators and originators to close their operations, stop accepting new locks and being forced to liquidate holdings on warehouse facilities. Moving to our portfolio, we priced two securitizations in January and February, OBX 2020-INV1 and OBX 2020-EXP1, with total deal sizes of $375 million and $468 million, respectively. Those transactions priced at a weighted average cost of funds of 133 and 105 the swaps, with Annaly retaining approximately $110 million market value of securities across those two deals. Annaly has now securitized 10 residential whole loan transactions since 2018, representing our discipline and commitment in obtaining term non-mark-to-market financing. The economic risk of our residential credit portfolio ended the quarter at approximately $2.6 billion, down from $3.9 billion at the end of Q4 given the aforementioned whole loan securitizations, pay-downs, and targeted security sales consistent with the deleveraging of the agency portfolio. Turning to the residential whole loan portfolio, we ended Q1 with approximately $1.3 billion of economic risk. The loan portfolio is conservatively positioned as it consists of 100% first lien new origination collateral with strong credit characteristics including a weighted average 762 original FICO, 67% original LTV, and a 37% DTI. Layered risk within traditional credit metrics is also minimal within the portfolio, as less than 1% of our loans have an original cycle less than 700 and original LTV greater than 80%. At quarter-end our residential securities portfolio stands at approximately $1.3 billion, with $530 million of those holdings representing positions in our OBX securitizations. Similar to our whole loan portfolio, we believe our securities portfolio is conservatively positioned with 55% of our assets excluding legacy RMBS rated investment grade at quarter end. Our aggregate CRT position sits slightly over $200 million market value, comprising only 8% of residential credit exposure. In addition to the strength and conservatism of our portfolio, Annaly's presence as a programmatic securitization issuer, the ability to transact in either securities or whole loans, and the current lack of a legacy operating platform puts Annaly in a unique position among our peers as we evaluate the new landscape within residential credit. With that, I'll hand it over to Tim Gallagher, Head of Commercial Real Estate.
Tim Gallagher, Head of Commercial Real Estate
Thanks, Mike. The commercial real estate property and credit markets continued the momentum of 2019 and got off to a solid start in 2020 but that progress abruptly stopped with the onset of the coronavirus-related crisis, as the sector became one of the first to experience the impacts of curtailed travel and shelter in place orders. Hospitality and retail saw an immediate impact on operating performance. Initial data for multifamily, office, and industrial are better, but even these more stable asset classes are not immune to near full economic shutdown. Commercial credit spreads started to widen in the second week of March in line with other credit markets. And certain CRE market participants such as money managers, REITs, and hedge funds were forced to raise cash due to fund outflows, margin calls, and redemptions. By the third week of March, several mortgage REITs and other funds could not satisfy margin calls, prompting them to seek forbearance with lenders while some vehicles were liquidated altogether, adding to pressure on spreads through these forced liquidations. Similar to the broader credit markets, the liquid commercial credit markets began to stabilize with spreads moving tighter in early April as forced deleveraging subsided. While AAA paper has significantly tightened from its March lows, credit continues to languish without a clear buyer base or financing option. In addition, servicers' ability to ramp up staffing, their liquidity to provide advances, and their assessment of special servicing and workout fees continue to be top of mind in industry discussions. According to research reports, more than 2,600 CRE borrowers, totaling nearly $50 billion in loans, have requested forbearance as of the end of March. This backlog will be an ongoing headwind to existing credit bonds in the CMBS market. The new origination market remains largely frozen as market participants await further clarity on the macroeconomic impact of the disruptions and the resulting direct impact on the commercial property sector. The uncertainty has shut down debt fund lending as their existing financing execution remains unknown, and the new issue CRE CLO market is closed. Warehouse counterparties are either on hold or have had to adjust pricing and haircuts so materially that new direct lending is largely absent. Balance sheet lenders such as banks and insurance companies are focusing on their existing portfolios as forbearance requests have swamped institutions that have significant CRE exposure. Turning to our portfolio. Prior to the dislocation, we had originated three whole loans in the quarter for a total of $172 million to bring the overall CRE portfolio to approximately $3 billion in assets with $1 billion of economic risk. We continue to maintain more than $1.2 billion of unused capacity on our term warehouse facilities and the majority of our loan portfolio is financed through a term, non-recourse, non-mark-to-market CRE CLO we issued in February 2019. As of payment dates in April across both our loan and securities portfolios, we received 47 out of 50 payments. Our CMBS portfolio is mostly comprised of industrial, multifamily, and office assets as we chose to invest primarily in the single-asset single-borrower market where we could underwrite each asset. Moreover, underlying loans in single-asset single-borrower transactions are to larger sponsors and are secured by higher-quality stabilized real estate. Finally, our equity portfolio is comprised of need-based real estate, including grocery-anchored shopping centers, healthcare, and net leased assets financed with long-term fixed-rate loans. Our portfolio is positioned with a focus on strong sponsorship, a premium on cash flow, executable business plans, and best-in-class operating partners. We have a dedicated in-house asset management and legal team, and the leadership of the CRE business have been through multiple CRE cycles dating back to the 1990s. Prior to the dislocation, the portfolio was performing according to our business plan, and we expect the vast majority of our assets to weather the storm and rebound when the economy reopens. And with that, I'll hand it off to Tim Coffey, Head of Credit.
Tim Coffey, Head of Credit
Thanks, Tim. As a reminder, the middle market effort was the first of the firm's three credit strategies to reside on Annaly's balance sheet, commensurate with the arrival of the group's current leadership team in 2010 at the time with the firm's founders Mike Farrell and Wellington Denahan, soft professionals in the middle market space with a solid track record not just through the 2007 to 2009 period, but over multiple cycles. Today, Annaly middle market is a $2.3 billion business comprised of 51 borrowers that are 100% backed by top-tier private equity sponsors. Despite recent volatility and heightened uncertainty, we believe the Annaly middle market portfolio is uniquely positioned given our tightly wound approach to a narrow industry set dedication to private equity firms with well-established track records aligned to our industry set and deep first-order due diligence. I cannot emphasize enough that we do not compromise on due diligence. The composition of the middle market portfolio is 70% first lien, 30% second lien. The number of borrowers in the portfolio and our percentage mix between first and second lien has not changed materially over the past two years. The group's asset expansion has been driven by growth from within our portfolio across multiple vintage investment years as opposed to the rapid addition of new borrowers, much like how we handled past periods of intense convergence in the lower marketplace. And I can assure you the past three or four years were as intense as any period we have seen. We tackled this convergence by pruning. We pruned the number of industries to which we are willing to lend from 16 to 8 over the past four years and correspondingly recalled the number of private equity sponsors with whom we partner to better align with the sectors we believe are countercyclical, non-discretionary, and defensive. Consequently, we reduced the number of our Tier 1 private equity relationships by almost two-thirds since 2010. This careful concentrated approach has resulted in the aforementioned borrower count remaining virtually static for two years. We readily admit our pruning was quite early. However, the middle market loan space is illiquid in the best of times. Consequently, pruning must come early in our view. In addition, the middle market group has always been a pure-play direct lending business. Every dollar of our $2.3 billion book is a direct loan with no exposure to securities or securitizations. We use very little third-party non-recourse leverage as our past disclosures indicate. This did not change in the first quarter of 2020. And each of our three primary financing counterparties have been consistent with their approach since the relationships were initiated. On average, each of our term facilities maintain a maturity of at least 4.6 years out from today. We have not experienced a change in value adjustment on the portfolio for quarter-end nor in the days subsequent to quarter-end. As it relates to the specifics of the portfolio, the weighted average unlevered return of the first lien book is approximately 7.6% fully floating. The weighted average unlevered return of the second lien book is approximately 11.2% fully floating, yielding an amalgamated unlevered return for the portfolio of approximately 8.8% fully floating. In addition to the modest third-party leverage of 0.7 times, I referenced previously, we are also differentiated in the underlying leverage profiles of our investments. The weighted average detachment point through our first lien exposure is approximately 4.6 times EBITDA. And the weighted average detachment point across the book is approximately 5.1 times EBITDA. While this weighted average detachment point is comparatively low, it reflects the substantial free cash flow generation inside our second lien exposures specifically, whereby our second lien leverage today reflects in many instances where first lien was originally executed at that deal's inception. Consequently, we are comforted against spread duration risk. This point is further amplified by a portfolio aggregated across past vintages with short effective durations, 21 months on the first lien and counterintuitively 20 months on the second lien. The earlier mention of a static portfolio borrower count further illustrates this point, as asset growth from existing borrowers is accompanied by required lender consent and support, mitigating against spread duration risk. Lastly, 85% of our portfolio is comprised of new cash equity transactions to clarify where new cash equity comes in to buy a business, with the median equity contributions representing 44% of the capital structure underneath this. Moving to portfolio fundamentals. The fundamentals of the portfolio we have in many respects been aided through the month of March due to the mission-critical nature of our underlying borrowers. 90% of Annaly's middle market group exposure resides within industries and borrowers categorized as essential under federal guidelines, enabling these borrowers to continue operations. Further, an additional 9% of our aggregate exposure not deemed essential has operated unimpeded and grown through the month of March. We proactively have been in contact with all 51 borrowers in our portfolio and received one interest forbearance request on a $14 million first lien exposure. Interestingly, $153 million of the $222 million we have categorized under our quarter-end watch list witnessed considerable benefit in March, given the nature of these borrowers' operations. And we suspect that should continue in the coming months. As you will hear from Serena, the middle market group's loans are classified as held to maturity Level three and are subject to recently imposed CECL reserves. Reserves taken in this quarter alone are multiples of what the middle market group's cumulative actual losses have been over our 9.5 years at Annaly. We are certainly concerned with the prospects of deteriorating fundamentals and its potential impact on the middle market space generally. Not surprisingly, a variety of influencers now stifle new issuer activity, with the exception of a few select industries that have been sources of opportunities for Annaly in the past. These select industries are currently well represented in our middle market portfolio and likely to expand going forward. Trends within the CLO market portend difficulty on the larger end of the middle market both new issue and secondary. The volume of amendments, forbearance requests, and workout activity in a condensed period generates a supply to personnel and balance with our precedent in a market that is now operating with a non-bank majority in charge. This signifies a prolonged reduction in new issue for the traditional middle market. We are very cautious about secondary market participation, although very narrow opportunity sets do exist. Given handling middle market's biases which mandate intensive due diligence, as I mentioned earlier, we expect our involvement will be weighted toward primaries both new issue and tack-on acquisition activity and the like. Wider pricing will certainly accompany these lower-levered transactions. In wrapping up, it can be said unequivocally that the middle market group will be as measured as we have been in our 9.5 years at Annaly. And for many of us individually, that caution has been a staple of our behavior in our prior 15, 20, 25 years before joining Annaly. I know that our experienced team will continue to execute a defined strategy shared by a group with an entrenched credit culture and no turnover since formation. With that, I will turn it over to Serena.
Serena Wolfe, CFO
Thank you, Tim, and good morning, everyone. I'm sure you all agree with me after that overview that we have the best team in the business. I'm pleased to join you today for this earnings call and provide you with color on our financial results and the success of our remote close. I will provide brief financial highlights for the quarter ended March 31, 2020. And while our earnings release discloses both GAAP and non-GAAP core results, I will be focusing this morning primarily on our core results and related metrics, all excluding PAA. As David mentioned earlier, given the great shutdown, the latter part of Q1 was challenging. However, we are proud of the results, given the enormous headwinds that management and the company faced as we closed out the quarter. Our book value per share was $7.50 for the first quarter, a 22.4% decrease from 2019 year-end. And we generated core earnings per share excluding PAA of $0.21 for the quarter and a GAAP net loss of $2.57, as compared to $0.26 and $0.82 for the fourth quarter of 2019. The decrease in book value is attributable to the increase in unrealized losses on the swaps portfolio of approximately $3.2 billion, due to lower forward rates compared to a gain of $778 million in the prior quarter, as well as higher unrealized losses on instruments measured at fair value through earnings of $730 million, down from losses of $6 million in the prior quarter, which is offset by unrealized gains in OCI of $997 million from our agency portfolio. It is important to note that the vast majority of our assets and liabilities are at fair value, and our book value reduction illustrates a significant market disruption that occurred prior to quarter-end and the impact on fair value measures. Our book value decline was not a function of forced asset sales but rather unrealized mark-to-market losses with potential full recoupments. Tim Gallagher and Tim Coffey provided an update to our ACREG and MML businesses earlier and the impact of COVID-19 on their portfolios. Given the market turmoil and uncertainty around the long-term economic picture, it was certainly an interesting quarter to adopt the CECL standards. We recorded reserves associated with our credit businesses of $139.6 million during Q1, consisting of $39.6 million of opening balance CECL reserves and $100 million of additional reserves during the quarter, primarily resulting from the impact of COVID-19 on our borrowers, that being $62 million or more general reserves related to forecast for a deterioration in economic conditions of $38 million. In totality, these reserves comprised 3.7% of our ACREG and MML portfolios loans as of March 31, 2020. As we've discussed on previous earnings calls, we have implemented an extensive process to determine appropriate reserves at our ACREG and MML businesses, which includes developing policies, systems, and controls including the use of two third-party models. We have found that key inputs into the CECL model that have material impacts on the reserve are the credit attributes of the loans, life of the loan driven by prepayment, and the economic scenarios with the latter representing a considerable challenge given variability in data this quarter. We spent additional time with the businesses analyzing the results of the reserve calculations and ensuring it's consistent with our expectations given the quality of the portfolio and the performance of the borrowers. The full impact of the shutdown to the economy is yet to be seen. And we will continue to monitor specific asset performance and economic projections as we determine future CECL reserves. We view it to be critical in the current environment to consider the adverse economic scenarios available in this process. And we remain comfortable with our existing credit portfolio even given the thoughtful approach outlined by ACREG and MML business leaders. It should also be noted that our residential credit businesses have elected fair value accounting. And thus, the entirety of that portfolio is recorded at market value, including our whole loan holdings, consistent with the vast majority of our assets. Turning to earnings. The largest factors quarter-over-quarter to core earnings excluding PAA were higher premium amortization on agency investment securities on $41.9 billion of agency security sales, as well as lower average balances on our credit portfolio. However, core did benefit from a reduction in financing costs with lower average repo rates, down to 1.77% from 2.10%, combined with lower average repo balances, down to $96.8 billion from $102.8 billion. We expect continued reduction in financing costs with a repo rate of 1.23% at quarter-end. The portfolio generated 118 basis points of NIM, down from Q4 of 141 basis points, driven primarily by a decrease in coupon from lower average interest-earning asset balances and the increase in premium amortization that I mentioned a moment ago. Annualized core return on average equity excluding PAA was 9.25% for the quarter in comparison to 10.56% for fourth quarter 2019. There will be many factors at play over the next quarter with respect to expectations for unemployment, forbearance, and other issues being experienced by the mortgage market that will likely mute prepayments relative to what we would otherwise expect given the low rate environment. The change in our efficiency metrics relative to Q4 2019, being 1.98% of equity for the first quarter was primarily driven by a reduction in equity rather than any material increase in operating expenses. Also to note, our internalization transaction is on track and we expect to close by the end of the second quarter. Annaly was able to weather the storm from this dislocation and end the quarter with an excellent liquidity profile due to our high-quality asset composition across the businesses, our strong repo counterparty relationships and reputation, our broad diversity of financing arrangements, and the ability to tactically utilize our broker-dealer calls for incremental liquidity. While numerous firms experienced difficulties meeting margin calls and other funding disruptions, the stability and resiliency of our funding sources was on display as our repo funding operations were uninterrupted. We continue to have good access to repo financing and our direct lending businesses did not experience any meaningful funding pressures with term facilities. To protect the health and wellbeing of our employees, their families, and communities, remote work requirements began in phases in early March, culminating with a company-wide exercise on March 13, 2020, to test connectivity and functionality. All employees were able to successfully perform their duties in this testing and we have operated remotely since that time. As a result, we completed our quarter close remotely without any interruption or significant changes to our normal processes or controls resulting from remote work requirements. This is a testament to the quality of our personnel processes and IT systems. Finally, I would like to acknowledge David for stepping into the role seamlessly in uncharted waters. Despite the backdrop, he has demonstrated incredible poise and character throughout this time, and we're all thankful for his leadership. Challenging times can bring people together, and we as a management team have cemented strong relationships in a short time. And we look forward to brighter horizons and continuing to bring value to our stakeholders. And so in conclusion with that, I'll turn it over to David who will provide commentary on our outlook and positioning.
David Finkelstein, CEO and CIO
Thank you, Serena, and we hope the relatively deeper dive into the credit businesses this quarter proves informative in light of current market conditions. Now, as with any period of extreme market volatility, there are three conceptual stages of stabilization and recovery as it relates to how we manage our portfolio. Phase one involves preserving capital and shoring up liquidity, which we have successfully completed through the measures I have already discussed. In Phase 2, which is how I would characterize where we are currently, there are opportunities to deploy capital in the agency sector while we obtain more information on the long-term outlook on the economy. We're looking forward to transitioning from a defensive posture to a more offensive one. But dislocations and constrained liquidity do persist. And as a levered participant, we must remain focused on the stability of financing available for our investments. And agency MBS currently provides the most certainty. And even as the Fed shifts to a more measured QE pace aimed at lowering mortgage rates and economic stability, the agency sector will continue to benefit. We view the outlook for volatility to be lower. And with easier regulations to facilitate dealer intermediation in the treasury market, market functioning should continue to stabilize. While a great deal of uncertainty remains, the environment for managing interest rate and convexity risk is much more favorable heading into the second quarter. Now Phase 3, which we believe is near, involves strategically allocating capital to best position the company in a new environment. As we look ahead, we will benefit from having numerous ways to capitalize on the dislocations across markets, and those with ample capital will have many opportunities to choose from. And we sit in a healthier liquidity position today than we have over the past few quarters. There will be abundant prospects across our businesses, which again highlights the benefit of our model as we are able to optimally balance the best risk-adjusted returns available. Episodes of extreme volatility, as witnessed in March, are pivotal moments for the growth of Annaly and our team. We have reaffirmed the principal ways in which we have always managed our business. Liquidity is paramount. Scale is critical. And relationships matter immensely, particularly on the financing side. And lastly, we have been of the view that historical leverage levels for our sector are elevated, and we expect them to decline in the coming quarters which is not specific just to the agency market. And lastly, I wanted to thank our team at the honor of stepping into this role as the world as we had all known it turned upside down. Our team has truly worked tirelessly and collaboratively to successfully manage the unprecedented markets we have experienced. The Annaly culture has been a bright light amidst the turmoil, and I'm excited for what lies ahead for our firm. And now with that we can open up the call for questions, operator.
Operator, Operator
Our first question today comes from Steve DeLaney with JMP Securities. Please go ahead.
Steve DeLaney, Analyst
Good morning, everyone. Thanks for taking the question. Boy, it was great to hear from each of the individual credit heads given the environment we're in right now. And I would say, you all came across sounding very comfortable with what you own today. I guess the question that raises is your posture towards credit generally as a team a lot of people seem to be running to the hills because I think more because of financing weaknesses. But do you see this as more over the next six to nine months, more an issue of managing what you have and minimizing losses? Or do you actually see potential opportunities from the dislocations that have occurred? Thanks.
David Finkelstein, CEO and CIO
Hi Steve, this is David. Thanks for your comments. It’s good to hear from you. We appreciate your insights on the credit businesses and their performance. It's important for everyone to fully grasp how these businesses are running and how the portfolios are faring. To answer your question, there's still considerable uncertainty regarding the economy and the credit landscape. As I mentioned earlier, agency is the central part of our portfolio, offering the best protection at this time, and the sector is quite attractive. Looking ahead, each of our three credit businesses is likely to have opportunities. We’ve seen three aspects in the repricing of credit: a technical decline due to the overhang in residential credit and some commercial assets, an undetermined fundamental price, and a risk premium that compensates for the variability in returns. We believe we’ve moved past the technical issues and are now assessing the fundamental pricing of credit and the risk premiums we should expect from these investments. There’s still work ahead, and we need more information. Starting with the residential credit business, we believed it would be a growth area this year due to the fundamentals of the residential market, and we still hold that view. However, there has been some disruption, with loan origination limited to prime jumbo loans in the GSEs, and we’ve seen less support for the loans we've typically acquired. Nevertheless, we expect things to recover and securitization to return. That said, assets will likely trade at lower prices and financing will be more expensive, but we believe the returns will align with the risk involved. So, we still see this as a growth area. Regarding our middle market lending business, as Tim mentioned, we expect it to perform well and stand out from others in the space. We see additional opportunities and the REIT has the liquidity to acquire more assets if necessary, although we still need to analyze the situation further. As for the commercial sector, our focus in the short term will be more on asset management, which has been the smallest part of our credit allocation. We are being conservative in capital allocation and asset acquisition. We’re in a wait-and-see mode to understand how pricing will develop. If we find pricing to be attractive relative to fundamentals and risk premiums, we won’t hesitate to allocate capital. In the meantime, agency remains our solid foundation.
Steve DeLaney, Analyst
I understood and super helpful. And just one question on that is your favorable early 2020 outlook for residential based on the strength of the housing market etc. Obviously, we don't have a securitization market today. We'll see if the Fed adds AAA, RMBS to TALF. But do you believe that once we see a securitization market reawaken that the problems we've had with warehouse lending will abate? And that the banks will come back and be supportive of pre-securitization investment?
David Finkelstein, CEO and CIO
I believe that as we observe effective execution, we will gain more confidence in the liquidity available to banks. Additionally, we are beginning to see some warehouse lines open up, although they come with increased costs. Nevertheless, we are now about a month past significant volatility, and banks are starting to reassess the sector. The situation will depend on the assets and the counterparty involved, but there are some positive developments regarding warehouse lines. It seems likely that both securitization and the reopening of warehouse lines will happen concurrently.
Steve DeLaney, Analyst
Thanks for the comment. And everyone stay safe. Thanks.
David Finkelstein, CEO and CIO
Thanks, Steve.
Operator, Operator
And our next question comes from Kenneth Lee with RBC Capital Markets. Please go ahead.
Kenneth Lee, Analyst
Hi. Good morning. Thanks for taking my question. Wondering if you could just share with us any updated thoughts on your current dividend coverage? Thanks.
David Finkelstein, CEO and CIO
Sure. So thanks for joining us today, Ken. We will have more formal guidance at a point in the future with respect to the dividend. What I will say is we recognize there certainly have been cuts in the sector. And we're aware of the guidance that analysts have come out with. So, what I can tell you is that we do expect to maintain a competitive dividend yield relative to peers, which has been in the low double digits over the past number of years on book value. So we're comfortable with conveying our competitiveness of our dividend yield. And we really want to spend the time over the very near term and not just look at the second quarter, but look at multiple quarters out and determine what we think the appropriate dividend yield is. Obviously, our core was a little bit lower in Q1. And as Serena mentioned, there was some catch-up amortization associated with asset sales that dragged that down a bit. We do expect our core to be a touch higher in the second quarter. And we'll have more formal guidance with respect to the dividend later in the quarter.
Kenneth Lee, Analyst
Okay. Very helpful and just one follow-up if I may, this one on the just middle market lending business. Is there any potential benefit or do you see any potential benefit from any of the various Federal Reserve lending programs for the portfolio companies within that business? Thanks.
David Finkelstein, CEO and CIO
I'll turn it over to Tim to answer that.
Tim Gallagher, Head of Commercial Real Estate
I believe that regarding the variety of available programs, we are less affected by many of them as they have been proposed so far. One area that hasn't been significantly included in these programs is leveraged loans. While some actions have been announced on the AAA CLO side, we're not relying on it and I don't believe we need to. For the AAA CLO segment, any benefits may ultimately be overshadowed by the impact of CECL, which I think will have a significant influence on how pricing is determined, particularly in relation to the most affordable aspects of the capital stack and the fundamental prime brokerage activities that support the broader ecosystem and leveraged lending.
Kenneth Lee, Analyst
Okay. Very helpful. Appreciate it. That’s it for me, and hope everyone stay safe. Thank you.
Tim Coffey, Chief Credit Officer
Thanks, Ken.
Operator, Operator
And our next question comes from Rick Shane with JPMorgan. Please go ahead.
Rick Shane, Analyst
Hey, guys, thanks for taking my question. And I hope everybody is well. A couple of things, I don't know if I missed it. Did you provide a quarter-to-date update on book value at this point?
David Finkelstein, CEO and CIO
I haven't Rick. But I will tell you as of yesterday, our book was up roughly 7% right around $8. Our leverage has declined modestly primarily as a consequence of higher equity value and we are right now at about 6.6 times maybe 6.5 times. And our liquidity is $5 billion in terms of cash and agency MBS.
Rick Shane, Analyst
Great. Thank you for that update. And we really appreciate the deeper dives into the credit businesses and wanted to follow up a little bit on the MML business. Look, your competition in that space to some extent has some very different constraints. They're subject to fair value accounting versus your CECL reserves. They typically have hard leverage limits related to their 40 Act status. I am curious if you are seeing any, sort of, arbitrage created by those differences? And also wanted to talk a little bit about the 3.7% CECL reserve in the context potentially of some of the spread widening that we've seen in the space that will impact fair value accounting companies.
David Finkelstein, CEO and CIO
Well, this is David. I'll start and then hand it over to Tim with respect to the CECL accounting on the middle market book. I think when Tim went through the metrics of the portfolio average yield with the detachment point at 5.1 times EBITDA, we feel like that is a very comfortable level from a market standpoint even with potential repricing. So from the standpoint of fair value on the MMO book, I think we feel pretty good about it. And I'll hand it off to Tim to respond to the rest.
Tim Coffey, Chief Credit Officer
Yeah. Rick, regarding your first question, I'll explain our watch list categorization, which totals around $220 million. Out of that, $150 million saw significant growth in March, marking it as an exceptional month for many of those names. We aim to align the portfolio's fundamental aspects with what you're referring to as the spread duration issue, which is critical in any FPL calculation. Generally, the middle market space has not shown much concern for spread duration risk due to its absence over the past seven or eight years, only becoming a focus again starting Q4 of 2018 and more intensely from Q1 2016. David mentioned the specifics, but what stands out is our effective durations. We have a second lien book with a shorter effective duration than our first lien book, which is unusual and reflects the types of credits we engage with. We are very aware of spread duration risk, whereas most of the market is not, and it's something that usually becomes apparent during challenging periods. Assessing this will significantly impact FPL calculations moving forward. The area in which we operate is crucial for managing effective duration risk. We've shifted our focus over the last couple of years to opportunities with EBITDA under 50 or 60, mainly in platform investments where sponsors are consolidating specific sectors. This requires them to return to us for future acquisitions, giving us the flexibility to either remain involved or exit depending on the acquisition opportunities. This strategic move has been instrumental in reducing our spread duration risk.
Rick Shane, Analyst
Tim that's very helpful. And it really does come through. I apologize to my colleagues listening, but I am going to ask one last question. Can you just talk about LIBOR floors on that portfolio? And is the benchmark rate for those investments three-month LIBOR?
Tim Coffey, Chief Credit Officer
Borrowers have an option, Rick, basically of one, three, six, etc. There's – since the crisis the 12-month option has been less relevant in a lot of the underlying credit agreements. We do have LIBOR floors on our portfolio. Approximately 80% of our book has a LIBOR floor. How we are financed? Our counterparties are with us and the third-party leverage do not have LIBOR floors with us. So there is a bit of an odd there. And I think as it relates to the one and three-month option, what I can tell you is recently the trend has been to the overwhelming majority being at the one-month end.
Rick Shane, Analyst
Make sense. Thank you, guys, very much.
Tim Coffey, Chief Credit Officer
You bet.
David Finkelstein, CEO and CIO
Thanks, Rick.
Operator, Operator
And our next question comes from Eric Hagen with KBW. Please go ahead.
Eric Hagen, Analyst
Hey, thanks. Good morning, guys. And hope you are well. And hey, David, I enjoyed the interview on the website.
David Finkelstein, CEO and CIO
Well, thanks.
Eric Hagen, Analyst
Following up on the adjustments in the hedge book. All in, are you guys running a positive duration gap right now? And what's the message you think for investors with respect to the spread and duration exposure they can expect to receive right now in Annaly going forward?
David Finkelstein, CEO and CIO
It's a good question. Currently, our duration is half a year, specifically 0.54 years. The key point is that it's not the number of hedges that matters, but their quality. With the Federal Reserve maintaining its policy stance, we don't anticipate short-term rates to rise in the near future. Therefore, we believe having hedges at the front end of the curve isn't prudent. The agency portfolio presents asymmetric risks, with minimal call risk and a duration below two years, as does our portfolio. The primary concern is extension risk. In repositioning our hedge portfolio last quarter, we aimed to ensure protection extending further out the curve, especially since the market can become too complacent. We did notice some selling in the longer end due to increased treasury issuances. We believe the Fed sometimes acts as a safety net for the market, but that's not always guaranteed. We wanted our hedges to extend further out because, like in the summer of 2013, we know that market disruptions can trigger significant sell-offs and steepening curves. We believe that's where the most risk lies. The average life of our hedge book is slightly over nine years, while our assets are much shorter, reducing our duration to around half a year. We may consider shortening the duration further and are also leaning towards options since volatility has returned to January levels. We've invested in several out-of-the-money payer swaptions to our portfolio in the second quarter.
Eric Hagen, Analyst
Excellent market color. That was great. And just one on pre-pays. Some people think we're effectively just kicking the can down the road, so to speak, because of the operational liquidity challenges that have obviously made mortgage spreads and rates very wide right now. Does your pre-pay assumption assume some normalization in mortgage spreads and mortgage rates? And just help us contextualize the pre-pay assumption I think would be really useful. Thanks.
David Finkelstein, CEO and CIO
Are you referring to the longer-term pre-pay assumption that we publish?
Eric Hagen, Analyst
Yeah.
David Finkelstein, CEO and CIO
So that's the average of five dealers and their average long-term pre-pay estimates on our portfolio. We consider this relative to our model. The reason we use it is that it's unbiased since we are not influencing the outcome. We believe that all models face significant challenges currently because we have not experienced these rate levels before. Firstly, it's difficult to model the uncertainty related to this virus and the ability for loans to close. The primary-secondary spread should narrow over time as more capacity is introduced, and we expect that to happen. Therefore, there is some uncertainty regarding the model's impact or its accuracy. However, we believe that a CPR of around 17 is a reasonable long-term estimate given the current rate environment. In the long run, it may even be slightly conservative considering the quality of the collateral we hold, which is predominantly high or medium-quality specified pools or seasoned bonds. We feel confident about this.
Eric Hagen, Analyst
Got it. So since it's a long-term estimate, it does take into account some normalization of spreads over time?
David Finkelstein, CEO and CIO
Yes. Exactly.
Eric Hagen, Analyst
Got it. Got it. Thank you. And then just one on housekeeping. How much are you guys funding overnight right now through Arcola?
David Finkelstein, CEO and CIO
Right now, it's about 25% of our overall repo book, possibly a little less. Regarding Arcola, it was an important resource during March when a significant amount of liquidity was provided by the Fed in the repo markets, much of which was funneled into FICC. We value that support and have the capacity to increase our Arcola balances if needed. However, we also value our bank counterparty relationships and need to balance the trade-off between overnight financing at 10 basis points and extending out for longer periods like one month or three months, which would involve paying a slight term premium.
Eric Hagen, Analyst
Got it. Thank you so much, and stay well. Thanks.
David Finkelstein, CEO and CIO
Thanks, Eric.
Operator, Operator
And our next question comes from Doug Harter with Crédit Suisse. Please go ahead.
Doug Harter, Analyst
Thanks. David, if you could talk about kind of your outlook for leverage kind of as you move into the Phase 2, Phase 3 that you described in your prepared remarks?
David Finkelstein, CEO and CIO
Sure. Are you speaking with respect to us or broadly?
Doug Harter, Analyst
Yes. For you.
David Finkelstein, CEO and CIO
Okay. So obviously, our leverage is a touch lower on the quarter and even lower now. And we do think that it is an environment where leverage will be lower. There is more spread in the agency market. And the economics are more favorable than they have been given the fact that we're at the zero lower bound. The Fed is obviously in play in buying assets. And we're certainly comfortable with the agency market. But you can take two approaches. You could say, okay, let's add leverage because we think spreads are going to tighten which we do on the agency market. That just tends to be the case when you have this type of environment, as we saw in the earlier QEs. Or you could take the approach that we can earn a competitive yield with a little bit lower risk. And I think we're more on the side of lower leverage in a slightly lower risk portfolio and a lot of that is informed by what we just experienced in March. Liquidity was obviously highly constrained for agency investors. It wasn't just the REIT sector. I mean if you look at the number of assets that the Fed purchased, which is in excess of $500 billion, the fund redemption, deleveraging, and other sales of agency MBS obviously provided a lot of supply in the market. And we learned a lesson from that experience, and I think it does inform how you look at leverage on a go-forward basis. And generally speaking, I think it's a little bit lower.
Doug Harter, Analyst
And then just sticking to leverage. How are you thinking about the borrowings currently against FHLB and kind of what the outlook there is, as you kind of approach the sort of the end of that – of your ability to access that?
David Finkelstein, CEO and CIO
Sure. As you mentioned, our line is currently set to change in February of next year. Last quarter, we reduced our borrowings from the FHLB because it became more cost-effective to use our bank counterparts for financing agency MBS in addition to our whole loans. We cut our line by about two-thirds, but we are still keeping our whole loans on that FHLB line. We are preparing for the potential end of that line. As I discussed earlier with Steve, we are exploring bank warehouse lines, which are obviously more costly, but the current economics for whole loans are more favorable. We believe that transitioning to bank warehouse lines, assuming the securitization market comes back—which we expect will happen—will present competitive, though not as favorable, economics compared to the FHLB. Given that we have already established a brand in the securitization space with the help of the FHLB line, which supported our whole loan business, we feel well-positioned moving forward without relying on the FHLB if it's not available.
Doug Harter, Analyst
Great. Thank you.
David Finkelstein, CEO and CIO
You bet, Doug.
Operator, Operator
And our next question comes from Matthew Howlett with Nomura. Please go ahead.
Matthew Howlett, Analyst
Thanks everyone. Good morning. First, on the margin, you gave great color on what happened there in the quarter and where repo is at the end of the quarter. One of your peers I think guided to over 150 basis point net into spread second quarter. Can you is there sort of a cadence on or any type of forward guidance you can give us on what to expect on that margin and net interest spread next several quarters?
David Finkelstein, CEO and CIO
It's clearly a variable situation. Both our financing and how we manage our assets and reposition hedges are in play. The net interest margin is currently higher, and our repo expense will certainly remain below 100 basis points. We've adjusted our swaps to narrow the net interest spread. At this moment, I can say that I view the first quarter as a low point compared to the fourth and second quarters, although it's important to note that this is based on a smaller overall asset base. You need to factor that into your expectations.
Matthew Howlett, Analyst
Right, absolutely. So the biggest variable is clearly the speeds. Given that we have clarity on repo and the timing of the swap rates, is that the main factor to consider when modeling for the next several quarters?
David Finkelstein, CEO and CIO
Yes. I believe the repo is relatively stable and predictable. Our actions on the asset side and the speeds can influence that, as well as what we do on the swap side. There are many small variables that can impact the overall net interest margin. However, I feel confident in stating that Q1 represents the lowest point in that regard.
Matthew Howlett, Analyst
Okay. Great. And then David congrats on the role. The company is internalizing here in the second quarter a one-off. Obviously, asked about buybacks going forward. Can you maybe just spend a second to address your vision of Annaly? Maybe give us an update on the internalization what changes and cost saves are going to happen? And just overall anything you'd like to say in terms of where you think you're going to take this company in the next several years? And congrats again.
David Finkelstein, CEO and CIO
Thank you for the question, Matt. I've been with Annaly for nearly seven years, overseeing the businesses, which provides a level of continuity in their direction. Annaly is fundamentally an agency-oriented REIT, rooted in its origins as a company founded by bond traders, which shapes both its asset and liability sides. While we maintain this agency focus, we also have three strong credit businesses that have performed well amid recent volatility. Looking ahead, we initially believed the residential sector had the most potential due to its fundamentals, and we still hold that view. Tim's middle-market lending business is expected to stand out during this time. Our commercial business, with its capital markets approach, has taken a conservative stance on capital allocation and investments, but the commercial real estate sector currently presents more uncertainty. As an agency firm, we have numerous options and a talented team across our brands. We'll make gradual changes as we gather more information on market conditions, but nothing we expect is transformational. We have the resources and liquidity to capitalize on opportunities as they arise, even though it's too soon to predict specific outcomes. On a broader scale, Annaly aims to remain influential in real estate finance and policy discussions. We've established a strong presence in Washington, D.C., where we are recognized as thought leaders, and we are committed to contributing to necessary policy work to ensure real estate markets function effectively and liquidity is accessible to borrowers. In managing the company, we plan to adopt a more organic approach compared to the recent past, prioritizing portfolio management to create growth opportunities. We believe we can attract capital through strong performance, rather than relying on acquisitions for growth. We’re focusing on portfolio-centric organic growth, but that doesn’t exclude the possibility of being acquisitive if the right opportunities arise. In the near term, we'll focus on the tailwinds in the agency market while remaining adaptable to future developments. Now, would you like to move on to your other questions, Matt?
Matthew Howlett, Analyst
And appreciate that. The buybacks I know may be premature, but I just wanted to throw it in there.
David Finkelstein, CEO and CIO
Yes. So, with respect to buying back stock, obviously in March and even into April, liquidity was paramount. How we look at buying back stock? It's a capital allocation equation. On one hand, you have the very near-term immediate accretion when your stock prices are at a discount and you trade that off with liquidity and what we might think to be better longer-term investment opportunities to use that capital. So, what I'll tell you is we have the authorization. It is a capital allocation consideration, and we'll evaluate it relative to both liquidity and other options that we have.
Matthew Howlett, Analyst
Thanks a lot, David. I really appreciate it.
David Finkelstein, CEO and CIO
You bet. Thanks, Matt.
Operator, Operator
And ladies and gentlemen, this will conclude our question-and-answer session. I'd like to turn the conference back over to David Finkelstein for any closing remarks.
David Finkelstein, CEO and CIO
Well, thank you everybody. We hope everybody stays healthy and safe throughout this episode and we look forward to talking to everybody shortly. Thanks.
Operator, Operator
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines at this time.