Earnings Call Transcript - NLY Q4 2020

Operator, Operator

Good morning, and welcome to the Annaly Capital Management Fourth Quarter 2020 Earnings 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 would now like to turn the conference over to Sean Kensil, Vice President, Investor Relations. Please go ahead.

Sean Kensil, Vice President, Investor Relations

Good morning, and welcome to the fourth quarter 2020 earnings call for Annaly Capital Management. 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 information for investors on the company’s website, www.annaly.com. Content referenced in today’s call can be found in our fourth quarter 2020 investor presentation and fourth quarter 2020 financial supplements, both found under the Presentations section of our website. Annaly intends to use our webpage 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 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’s press releases, SEC filings, public conference calls, presentations, webcasts, and other information it posts from time to time on its website. Please also 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; Ilker Ertas, Head of Securitized Products; Tim Coffey, Chief Credit Officer; Mike Fania, Head of Residential Credit; and Tim Gallagher, Head of Commercial Real Estate. With that, I’ll turn the call over to David.

David Finkelstein, CEO and Chief Investment Officer

Thank you, Sean. Good morning, everyone, and thanks for joining us for our fourth quarter earnings call. Today, I’ll provide an update on the broader market, our capital allocation trends, including credit activity and our outlook. Ilker Ertas, our Head of Securitized Products, will follow up with specific commentary on our agency and hedging activity, and Serena will review our financial results. And as Sean noted, our other business heads are also present to provide additional context during Q&A.

Ilker Ertas, Head of Securitized Products

Thank you, David. As David mentioned, the agency portfolio had a strong quarter supported by healthy investor demand, both low implied and realized interest rate volatility, and a steepening yield curve. Lower coupon TBAs were the strongest performing part of the agency market as they benefited directly from Fed purchases; however, in contrast to prior episodes of QE, specified pools have also demonstrated solid performance. Given the current elevated prepayment environment, the desire for more cash flow certainty and a strong bid for longer duration mortgage assets, we are seeing the level of pay-ups withstand higher rates and steeper curves experienced over the quarter and into 2021.

Serena Wolfe, Chief Financial Officer

Thank you, Ilker, and good morning everyone. Before I get started with the numbers, I just wanted to comment that December 2020 marks my first year with the company as CFO. Over the year, the company performed exceptionally well given the challenges we faced. Our resulting performance during 2020 reinforced the reasons I was compelled to join the Annaly team, which include our human capital, differentiated risk culture, and robust infrastructure built around the businesses in terms of finance, legal, technology, and other support functions. During 2020, Annaly demonstrated a 23-year-old company’s steadfast nature while exhibiting an adept industry leader’s agility. With that as a backdrop, today I’ll provide brief financial highlights for the quarter ended December 31, 2020 and discuss select year-to-date metrics. While our earnings release discloses both GAAP and non-GAAP core results, I’ll focus this morning on our core results and related metrics, all excluding PAA. As David mentioned earlier, the primary drivers of performance were an extension of themes from last quarter. We took advantage of the interest rate and financing environment to generate strong results while prudently managing leverage. To set the stage with some summary information, our book value per share was $8.92 for Q4, a 2.5% increase from Q3. Book value increased on GAAP net income partially offset by the aggregate common and preferred dividends of $344 million or $0.25 per share, and other comprehensive loss of $215 million or $0.16 per share. We generated core earnings per share excluding PAA of $0.30, a decrease of 6% or $0.02 per share from the prior quarter. Our core earnings also represent 140% of our dividend, and we saw back-to-back quarters of 13%-plus of core ROE. Combining our book value performance with the $0.22 common dividend we declared during Q4, our quarterly economic return was 5.1%. We generated a full year economic return of 1.76% and a total shareholder return of 2.43%. While down compared to prior years, we are proud of our positive 2020 return given the unprecedented market conditions we faced. Delving deeper into the GAAP results, we generated GAAP net income of $879 million or $0.60 per common share for Q4, down from $1 billion or $0.70 per common share in the prior quarter. GAAP net income decreased primarily due to lower realized gains on investments resulting from fewer agency MBS sales in Q4 versus Q3; however, GAAP net income benefited from higher unrealized gains on interest rate swaps driven by higher rates. Additionally, we recorded higher gains on other derivatives, largely futures, offset by lower gains in fair value option loans and securities and lower interest expense on lower average repo rates, down to 35 basis points from 44 basis points, and lower average repo balances, down to $65.5 billion from $67.5 billion. Moving on now to CECL reserves, in the current quarter we continue to see a general improvement in market sentiment and the economic models we use in this process. Total CECL and specific reserves were relatively consistent with prior quarters. As we continue to provide transparent disclosure, we’ve included a slide in our investor presentation that provides additional color and detail on the assumptions utilized in evaluating our CECL reserves. We recorded an immaterial increase in reserves primarily associated with our commercial real estate business of $1.5 million on funded commitments during Q4 driven by an increase in specific reserves, partially offset by a decrease in the general CECL reserve. Total reserves net of charge-offs now comprise 4.48% of our and MML loan portfolios as of December 31, 2020 versus 4.56% as of the prior quarter end. We remain comfortable with our existing credit portfolios and the associated CECL reserve and will continue to monitor specific asset performance and economic projections as we determine future reserves. Turning back to earnings, I wanted to provide more detail surrounding the most significant factors that impacted core earnings quarter over quarter. First, consistent with my commentary around GAAP drivers, interest expense of $94 million was lower than $115 million in the prior quarter due to lower average repo rates and balances. TBA dollar roll and CMBS coupon income of $99 million was lower than $114 million for the third quarter due to slightly more modest specialness in the fourth quarter. We had increased expenses related to the net interest component of interest rate swaps of $67 million relative to $63 million in the prior quarter as the swap portfolio reset to lower market receive rates and two high strike receiver swaps expired. Finally, we experienced a continued improvement in G&A expenses. On the financing front, our all-in average cost of funds this quarter was 87 basis points versus 93 basis points in the preceding quarter. The fourth quarter brought the full year average cost of funds to 1.34% versus 2.25% in the prior year. Our weighted average days to maturity are down compared with the prior quarter at 64 days versus 72. Our Q4 weighted average days’ slight reduction compared to Q3 results from the natural roll down from our longer duration repo trades we executed in prior quarters. Our treasury group’s view in the latter part of last year was that the term curve would continue to flatten. What I can tell you is that we set this view based upon the Fed’s forward guidance on remaining at the zero lower bound into 2023, as well as a meaningful increase in already abundant reserves in the system in 2021 from both continued QE and a drawdown in treasury general account balances. As we’ve ended the new year, this view has come to fruition as one-year bilateral term repo for agency MBS can be locked in the upper high teens currently. Consequently, we are beginning to add duration to our repo book this quarter. Concerning credit financing, we see further improvement in repo terms for our credit securities with increasingly lower haircuts and tighter spreads. We have also renegotiated our warehouse facilities to support our direct lending businesses proactively and have realized cost savings accordingly. The portfolio generated 198 basis points of NIM, down from 205 basis points as of Q3 driven primarily by the decrease in average asset yields and reduced dollar roll income, offset by the decline of the cost of funds that I mentioned a moment ago. As a management team, we focus on providing value to our shareholders, including a keen eye on the company’s expenses. Having said that, we continue to see improvement in our efficacy ratios, being 1.27% of equity for the fourth quarter in comparison to 1.32% in Q3 of 2020, and 1.62% for the full year compared to 1.84% for the prior year. The 2020 annual OpEx results are within the range of expected cost savings disclosed in Q1 with our internalization transaction announcement, and I would reiterate the 1.6% to 1.75 OpEx target we disclosed last year as an appropriate benchmark. To wrap things up, Annaly ended the quarter with an excellent liquidity profile with $8.7 billion of unencumbered assets, consistent with prior quarters of $8.8 billion, including cash and unencumbered agency MBS of $6.3 billion. I’ll now turn it back to David for some closing remarks before opening it up for Q&A.

David Finkelstein, CEO and Chief Investment Officer

Thanks, Serena. Lastly, before we move onto Q&A, I thought I’d provide broader perspective in two areas. First, there is an abundance of metrics that underscore a growing disconnect between valuations and fundamentals. Broadly, market indices are reaching historical records and consensus calls for them to continue to rise, the S&P 500 at 40 times earnings, high yield credit and the proximity of all-time tight spreads, and the $81 billion of SPACs raised year as liquidity has flowed further out the portfolio balance channel. Annaly, however, continues to be a source of responsible yield in a market where it’s increasingly challenging to deploy capital. As I mentioned at the outset, the fundamentals are positive for Annaly investors with a low cost, stable financing environment and upward sloping yield curve, low interest rate volatility, and a strong supply and demand backdrop for our assets. We’ve seen our book value continue to strengthen into 2021 and have out-earned our dividend for the past few quarters. We are delivering a dividend yield of over 10%, in line with our historical average, while the S&P 500 earnings yield of 2.5% is the lowest it’s been in the past decade. Annaly represents one of the few countercyclical or acyclical yield strategies that are less at risk to the pace of economic recovery. Additionally, we provide equity portfolio diversification without sacrificing returns while money market funds earn zero and real treasury yields are at near record lows. As unforeseen events will once again shift investors’ focus to fundamentals, balance sheet strength and earnings stability will be coveted. Secondly, we have talked about leading with purpose this year in response to the trying societal and economic climate that marked 2020. At Annaly, our mission is to utilize our capital to generate attractive returns and support the American homeowner. To that end, we have kept our focus on the individual needs of our borrowers and supported government policies to extend forbearance periods. We have used our human capital to meaningfully contribute to the communities where we live and work. Through our corporate philanthropy initiatives, we have focused on partnerships with high impact programs that seek to combat homelessness, provide food security, and advance women and underrepresented groups in the workforce. Annaly employees have volunteered their time and energy to serve vulnerable New Yorkers in their hour of need, and our culture of responsible investment with respect to where we invest both our dollars and time is something we’re very proud of, and it has undoubtedly yielded a considerable impact for our overall stakeholders. With that, operator, we can open it up to Q&A.

Operator, Operator

Thank you. We will now begin the question-and-answer session. And the first question will come from Steve Delaney with JMP Securities. Please go ahead.

Steve Delaney, Analyst

Good morning, everyone, and thanks for taking my question. David, based on your comments and Ilker’s, I would certainly conclude that in the first quarter, we heard the word tightening several times, yields compressing, so it would indicate to me that unless something on the derivative side came into play, that your book value for Annaly should have moved higher in the first six weeks of the year. And I wondered if you could offer any observations on that.

David Finkelstein, CEO and Chief Investment Officer

Sure. Hi, Steve, and good morning. Yes, our book value has moved up. As of Tuesday, we were up roughly 3.5% on the quarter, partially attributable to your point on spread tightening, but also portfolio positioning in terms of a bias towards a steeper curve, as well as up in coupon, which has outperformed lower coupons thus far this year. So there’s still half the quarter left to go, but we feel pretty good about where we’re at now.

Steve Delaney, Analyst

Appreciate you sharing that. We’ll adjust the comp table immediately. And then just looking over – on Page 3 of the deck and looking at the credit book a little bit, it seems like there was growth in virtually every credit bucket that I could determine, especially, as you highlighted, in the residential loan areas, but CRE debt did decline about $80 million. And is that a trend that we should expect to continue? And if so, what would change you and Tim’s outlook for when to step back into that market? Thanks.

David Finkelstein, CEO and Chief Investment Officer

Sure, I’ll start off and then pass it off to Tim. Look, it’s still early in terms of the CRE recovery. We’ve stressed that on past calls, given the dynamics with respect to the virus and how we’re using commercial real estate as a society. The notable decrease in the portfolio is attributable to a sale of part of our healthcare facilities, as I mentioned, which we took advantage of a very good opportunity to deliver a profit on that. We did again return to the origination front in the fall and did get a couple of deals done, but we also had a little over $100 million in run-off, so, yes, it decreased marginally. It was opportunistic. And with respect to the outlook on CRE, I’ll pass it over to Tim.

Tim Coffey, Chief Credit Officer

Yes, I think that’s right. I think this is a one-quarter look as to sort of what happened in the fourth quarter with respect to that sale. We’re being cautious about where we deploy capital. Like a lot of people in our space, we’re focused on industrial and multi-family. And to the degree that we can find good opportunities there, we’re doing that. So I wouldn’t read a whole lot into the decrease in one particular quarter. As the market continues to heal, we’ll continue to look at opportunities.

Steve Delaney, Analyst

That’s helpful. Thank you both for the comments.

David Finkelstein, CEO and Chief Investment Officer

You bet, Steve.

Operator, Operator

And the next question will come from Rick Shane with JPMorgan. Please go ahead.

Rick Shane, Analyst

Good morning, everyone, and thank you for addressing my questions. I believe there are many positive aspects to consider. David, you mentioned an intriguing point about maintaining lower leverage. Currently, we are in a situation where interest rates and yields are exceptionally low, which historically hasn't ended well, as it tends to draw a lot of liquidity into the market. I would appreciate your insights on how we can adopt a cautious approach to leverage during this time.

David Finkelstein, CEO and Chief Investment Officer

Yes, it’s a great question, Rick. And yes, we are at the lower end of our leverage. We do feel like we still have in 2021 a fair amount of runway for carry and agency MBS to dominate the day. But again, asset spreads across sectors are tight, and we have to be very mindful of yields and spreads. And to the extent that there is some local shake-up in terms of spreads or any market volatility, we want to be prepared for that eventuality. Now, that’s not to say we would keep leverage at these low levels, but we are a ways away from spread widening that would suggest we’d increase it. And we just think it’s the right approach to maintain. We’re still generating a double-digit yield. It is providing the income for the shareholder, and we’re able to do more with less and we’re perfectly content to maintain that posture for the time being.

Rick Shane, Analyst

Got it. And it is interesting because the last couple quarters, you’ve talked about very clearly a path to out-earning the dividend at this point. You didn’t make that comment this quarter. How do you feel in context of running with the lower leverage and some of the spreads tightening?

David Finkelstein, CEO and Chief Investment Officer

Sure. And so for the first quarter, we do expect to out-earn the dividend, but not to the extent we have in the last quarter, but we still feel very good about where core earnings are coming in at over the near-term.

Rick Shane, Analyst

Terrific. Thanks. And I apologize for the puppy yawning in the background.

David Finkelstein, CEO and Chief Investment Officer

We expect it now.

Rick Shane, Analyst

Thanks.

David Finkelstein, CEO and Chief Investment Officer

You bet, Rick.

Operator, Operator

The next question is from Eric Hagen with BTIG. Please go ahead.

Eric Hagen, Analyst

Hey, good morning, guys. Hope you’re well. A couple of questions here. Lots of numbers getting offered out there suggesting, I think you said in your opening remarks, 75% of the market, I’ve heard upwards of 90% of the overall market is in the money to refi. That feels aggressive considering how much turnover there already was last year. Can you weigh in on that and maybe just rationalize how strong you think the incentive is, including for various cohorts of specified pools? And then on the portfolio, can you talk about where in the coupon stack you see the carry being strongest right now and which cohorts of specified pools you think offer the strongest value? Thanks.

Ilker Ertas, Head of Securitized Products

Sure. In terms of refi incentive, what people use, and we also use a similar thing is like we just look at the gross coupon of the pool and as long as it’s like 75 basis points in the money, we call it, like, 50 basis points. As long as 50 basis points in the money, we call it 50 basis points in the money. For example, if you take the primary rate as 275, clearly that’s what the best borrowers are getting. Right now, you can say that around 77% of the universe is in the money. But you pointed out perfectly that not all guys get this 275, and some borrowers have problems with refinancing. In fact, like we said in our prepared remarks that we are seeing some signs of burnout because not everyone is getting this. In terms of specified pools, we are still finding opportunities in higher coupon, higher coupon meaning 2.5s and 3s in this case, loan balance pools with some other characteristics, for example, non-owner occupied and all that kind of stuff. So yes, there are still pockets of opportunities. But unlike the previous QEs, where only the Fed was buying and specified pools were reasonably attractive, this time around banks are also buying, and that will make specified pools tighten in line, but there are still opportunities, as I said, loan balance with some other characteristics.

David Finkelstein, CEO and Chief Investment Officer

Does that help, Eric?

Eric Hagen, Analyst

Yes. Thank you guys very much.

David Finkelstein, CEO and Chief Investment Officer

Thanks, Eric.

Operator, Operator

The next question will be from Bose George with KBW. Please go ahead.

Bose George, Analyst

Hey guys, good morning. Just wanted to follow up a little bit there on the returns, incremental returns. In terms of specialness, I think Ilker, you said expect modest specialness, could you just quantify that a little bit, and then just incremental ROEs that you’re seeing out of the specialized pools, and then if you just add it all up, can you get a double-digit return now in the market on incremental capital?

David Finkelstein, CEO and Chief Investment Officer

Hi Bose, this is David. To Ilker’s earlier comments, getting a double-digit yield is difficult. It was certainly achievable in TBAs in the latter half of 2020, but specialness has dissipated somewhat. We do expect it to remain prevalent, certainly while the Fed’s in, but I’d say we’re talking very high single digits on TBAs and in that context on pools we’re buying.

Bose George, Analyst

Okay, great. That’s helpful. Then actually just switching over to the returns you’re seeing in NPLs and RPLs, when we look at the recent deals, they’re selling at par. Can you just help us walk through the returns that you’re seeing from those assets?

David Finkelstein, CEO and Chief Investment Officer

Sure, I’ll start and then hand it over to Mike. This is something Mike talked about on our last earnings call in terms of that being a part of the residential sector that we’ve taken advantage of, and throughout the fourth quarter, I think Mike was very active in acquiring RPL A2s at spreads that were meaningfully wider than where they are today. The trade is not quite as attractive now, but we certainly took advantage of it in Q4 and into Q1.

Mike Fania, Head of Residential Credit

Sure, in the area of unrated NPL/RPL, we believe it's still possible to achieve high single-digit leveraged returns on equity with a careful amount of recourse leverage. The assets we incorporated during the fourth quarter are likely closer to low to mid double digits and perhaps very low teens. To give some context, A1s are yielding around 225, translating to about 190 or 195 in zero volatility, while RPL A2s, which we are focusing on more than NPL A2s, fall in the range of 375 to 400 relative to the curve, currently offering very high single-digit leveraged returns on equity. Regarding credit risk transfer, we have been active primarily in seasoned pre-COVID M2s, which feature unlevered spreads between 180 and 200 and possess several favorable credit characteristics, including one- to two-year weighted average life assets and very high gross WACs, with considerable deleveraging observed. There has been plenty of liquidity and balance sheet support for both these products, and we've also noticed terms tightening in the current market. While not as appealing as last quarter, we still see some areas of opportunity.

Bose George, Analyst

Okay, great. That’s helpful. Thanks.

David Finkelstein, CEO and Chief Investment Officer

You bet, Bose.

Operator, Operator

The next question comes from Doug Harter with Credit Suisse. Please go ahead.

Doug Harter, Analyst

Thanks. Acknowledging that we haven’t even hit the one-year anniversary of the volatility, how do you think about your liquidity position today, and over the long term as markets continue to heal, what the right level for liquidity holdings in a normalized environment?

David Finkelstein, CEO and Chief Investment Officer

Yes, it’s a great question Doug, and we have talked about this a fair amount over the past. As I’ve said, we can’t unsee what we saw in March, and all of these episodes of volatility does have to inform your business model on a go-forward basis, so in light of this, we do think that the steady-state level of leverage is lower than it was. The Fed’s not always going to be there and liquidity is paramount. We put ourselves in a very good position coming out of March and we’ve maintained that, and it’s not just about having reserves on the balance sheet to manage through volatility, it’s also about having opportunities to do things that others without the capital base or the liquidity that we have, that others can’t quite do, and when it comes to investing, for example, in Mike’s residential effort and being able to provide certainty of execution for originators with our liquidity, that’s confidence inspiring to our partners. They look at our balance sheet and they know that we’re in a place of strength, so there are a lot of other benefits beyond just simply being able to manage through volatility. The same is the case in middle market lending, where Tim’s got a very unique business where he does have the liquidity of the REIT that conveys to its sponsors that we can do things that other lenders aren’t in a position to do, and as a consequence, he can accomplish some pretty significant things in that business. So there’s both a conservative aspect coming out of March, but there’s also an opportunistic aspect as we look forward in terms of just being able to do things with our liquidity and having that strong foundation that we feel good about. We think it will remain the case for the foreseeable future.

Doug Harter, Analyst

Thanks. Then also just on the capital structure, how are you thinking about that going forward? Any other kind of changes that you would envision in the coming year?

David Finkelstein, CEO and Chief Investment Officer

Sure, I mentioned earlier about our preferred shares and how we are pleased with our overall capital structure, where 11% is in preferred equity and the remainder in common equity. It's important to highlight that our existing preferred shares have post-reset spreads expected to range from 417 basis points to 490 basis points. When observing the forward rates at the time of reset, the cost of capital for our preferred shares is projected around 5%. We are optimistic about our current preferreds, especially considering this low cost of capital. In assessing our overall capital structure, as discussed last quarter, there are three types of leverage: balance sheet leverage, structural leverage within our portfolio, and capital structure leverage. At this moment, balance sheet leverage is the most advantageous, primarily due to the substantial reserves available in the system, which we are effectively utilizing. Regarding structural leverage, the significant amount of balance sheet liquidity in the market has not only influenced agency mortgage-backed securities but has also affected other leveraged products, notably high credit quality assets such as triple-As. Consequently, triple-A spreads within our businesses are very tight. For instance, in our residential securitization business, we can capitalize on this balance sheet availability by selling triple-As while retaining that structural leverage, which provides us with benefits. However, it all begins with the balance sheet leverage that exists in the system. As for our preferreds and capital structure leverage, current yields on preferreds do not present an opportunity for us to issue more. We would require a much larger spread between the yields on agency MBS and the market cost of preferreds to make such a decision. Therefore, with the existing spreads, we do not plan to increase our structural or capital structure leverage at this time.

Doug Harter, Analyst

Great, thank you.

David Finkelstein, CEO and Chief Investment Officer

You bet.

Operator, Operator

The next question is from Kevin Barker with Piper Sandler. Please go ahead.

Kevin Barker, Analyst

Thank you, good morning. Could you perhaps just give us a view on your appetite for acquisitions and what the market currently looks like, just given a lot of activity that’s going on in the capital markets combined with a bunch of disruption in various other lending categories? Just love to hear your view on what’s happening within M&A.

David Finkelstein, CEO and Chief Investment Officer

Sure, Kevin. We have been acquisitive in the past. The way I look at it is there are three catalysts for acquisition: number one is assets, number two is price, number three is the strategic fit. Now, there have been a couple of combinations that we’ve seen in the recent past, and candidly they’ve traded at prices that I wouldn’t characterize as compelling. For us to acquire a company and provide liquidity, we’ve got to get paid for our time, operational risk of onboarding of portfolio, and we’ve got to make sure that the assets fit what we want to do going forward. I will say it’s not as attractive today just given the pricing, but to the extent where there’s a disconnect between where we’re trading versus where somebody else may be trading, and there’s a need for our liquidity and we can do so profitably, we’ll absolutely consider the opportunity. Now, the third point of strategic fit is a third catalyst. If there is something out there that can accommodate our businesses, we would certainly look at it, but right now we feel we’re well equipped across all of our businesses to do what we need to do organically. To the extent that changes and there’s something out there, we’ll certainly look at it, but we feel very good about how our businesses are performing right now, and we’re in a good place.

Kevin Barker, Analyst

Sure. Would you categorize the M&A opportunities or the amount of flow that you’re seeing to be equal or better than what you were seeing pre-pandemic levels, just given the state of the market today?

David Finkelstein, CEO and Chief Investment Officer

It’s episodic. That’s a hard question to answer candidly. We do expect there to be more M&A activity in this sector, and a lot of it does have to do with what occurred early last year in terms of depletion of capital across firms, so you get to a point where firms can really be inefficient because operating expenses relative to what type of returns can be generated are just not of scale, so I would expect there to be more activity in 2021. Again, to the extent it would work for Annaly, we would certainly look at it, but we’re not out there chasing companies to buy. But yes, you should expect more activity going forward.

Kevin Barker, Analyst

Okay, thank you very much.

David Finkelstein, CEO and Chief Investment Officer

You bet, Kevin.

Operator, Operator

The next question is from Vilas Abraham with UBS. Please go ahead.

Vilas Abraham, Analyst

Hey guys, how are you? Interesting commentary on the commercial bank bid for agency MBS. Just curious, how material do you think that is to where spreads are now, and how does that play out over the course of the year, and I guess maybe also tying that into what you guys are thinking about the Fed taper, and then on the backs of those kinds of events, where could leverage go? Could it go higher as those events transpire? Thanks.

David Finkelstein, CEO and Chief Investment Officer

Sure, Vilas. Regarding commercial banks, the market has shown a strong demand recently. In 2020, these banks had ample deposits and limited lending activity, leading them to purchase securities instead. They increased their holdings in treasuries and agency mortgage-backed securities by over $750 billion that year. In comparison, during previous rounds of quantitative easing, such as QE3, net securities growth for banks was mostly stagnant, sometimes even slightly negative. This indicates that banks have been significant buyers in the agency sector, contributing about $200 billion in the fourth quarter alone, with another $75 billion in January. This activity has played a key role in reducing spreads, and we expect that trend to persist. On the topic of tapering, which has been widely discussed lately, the environment in 2021 is markedly different from what we faced in 2013 during the taper tantrum. The Federal Reserve is in a different position, as is the market. They have learned from past experiences, resulting in greater transparency and improved forward guidance. They intend to prepare the market for any reduction or cessation of security purchases, and we feel confident about the Fed's communication strategy. Current indications suggest that quantitative easing will remain unchanged through 2021, though changes may occur based on economic developments. However, we believe we're not close to that point yet. It's also important to recognize that the market dynamics in 2021 differ significantly from those in 2013. In 2013, the market felt somewhat insulated due to the Fed's stance, which ultimately was not the case. Presently, the market appears to be more cautious and defensively positioned. This is evident in various data points, such as short positions reported by the CFTC, which indicate that the market seems hedged. Additionally, JPMorgan's survey shows a lean towards short positions in the market, suggesting a protective stance. When we analyze option pricing, the cost of protective puts in fixed income is significantly higher than that of calls, indicating a readiness for potential rate increases. The convexity profile of the market is also improved today. This includes not only the convexity of the securities themselves but also the distribution of agency MBS holdings. Back in 2013, the Fed and banks controlled about 50% of agency MBS, while much of the remaining held by others was hedged. REITs were more leveraged at that time, leading to increased volatility during the sell-off. Currently, banks and the Fed account for 63% of the total market. If bank demand continues as it did last year and the Fed maintains its current pace, we anticipate this share could rise to 70%. Moreover, the Fed does not hedge convexity, and banks do so very minimally, making us believe the market is better equipped. The Fed is communicating effectively, and our situation is much healthier, but we remain vigilant. Our portfolio is well-hedged in terms of duration, and we have optionality, with about 40% of the convexity in the agency portfolio secured through swaptions. We feel positive about this, yet we will remain alert to any changes in rates. Does that provide clarity?

Vilas Abraham, Analyst

It’s very helpful, thank you. Regarding prepayment speeds, it seems like you are becoming somewhat more optimistic about that area. Can you share your thoughts on the trend in the CPRs? Do you expect to reach a normalized level soon, or will it likely remain relatively high for a while, perhaps just slightly below what you had previously anticipated? Thanks.

Ilker Ertas, Head of Securitized Products

Sure, Ilker here. Yes, it is very elevated, and in the near term, it may stay elevated. The biggest reason for that is obviously because of COVID. They made it so easy to refinance, for example electronic form of signing some documents and all that kind of stuff, and recent IPOs, all these non-bank originators becoming extremely efficient, these are all well-known. But also, what happened is very sharply, so they were like really good collateral. 2018 3.5s and 4s, for example, are like prime borrowers at that point because that was the current coupon rate, and 3s of 2019 likewise, and 2022, so brand new issued collateral at that point become in the money so quickly and these guys have recently refinanced, they know how to refinance, and they are getting calls from brokers. Also, refinance happens in two channels: borrower calls to refinance, or lender or broker reaches the borrower to refinance, so we do not expect a burnout on this second channel that I’m mentioning, and the reason is that recent IPOs are very high profitable off the refinancing. But we are seeing burnout and we will expect to see more burnout on the first channels, which means that the borrower makes the outgoing calls, because if you haven’t called by now, then you have been in the money more than 100 basis points in the money for over a year, it’s a good bet that you will not be calling soon. So in the first channel that I mentioned, we’ll be seeing some burnout, and this burnout will show itself in the more seasoned collateral and like more loan balance collateral. As for the overall burnout that we were accustomed to, it will take a little bit longer time, probably end of the year that we will see on the brand-new collateral getting the burnout. Does it help?

Vilas Abraham, Analyst

Yes, thank you guys.

David Finkelstein, CEO and Chief Investment Officer

You bet, Vilas.

Operator, Operator

Once again, if you have a question, please press star then one. The next question is from Kenneth Lee with RBC Capital Markets. Please go ahead.

Kenneth Lee, Analyst

Hi, thanks for taking my question. Wondering if you could further expand upon your prepared remarks about potentially seeing some benefit from a steepening yield curve. Wonder if you could share some thoughts on any potential impact to returns or net investment spreads going forward. Thanks.

David Finkelstein, CEO and Chief Investment Officer

Sure. There are a couple of components, Ken. I will say from a positioning standpoint, as I said, we do have a modest steepener on. We added roughly $10 billion in hedges in the fourth quarter at the longer end of the yield curve, and we also actually added a little bit very early in the first quarter of this year, so we feel good about the positioning. We’re right around five years average duration of our hedge profile and our mortgage portfolio is roughly half of that, and so from that standpoint, just a pure steepening of the yield curve with spreads unchanged, we would benefit modestly from that, we think. Now, it is somewhat of a double-edged sword because the steeper the yield curve, the more expensive it is to hedge - your pay rate on new hedges goes up while your receive rate stays very low as the front end is anchored. Another point to note is that your hedges do roll down the curve and they roll down at a much quicker pace than agency assets do, so as that roll-down occurs, there is some mark-to-market deterioration as a consequence of that. But nonetheless, a steeper curve would modestly benefit us.

Ilker Ertas, Head of Securitized Products

Yes, those are very good points, David. Also, a steeper curve helps the option cost a lot on these mortgages. We were talking about burnout, but a steeper curve helps the prepayments a lot, and also market segmentation can be really beneficial. As the curve steepens, there will be more opportunities on the coupon swaps, and because of the option cost, and there will be also opportunities on the derivatives execution, so a steeper curve is what most mortgage investors want, and we are looking for that. But we should be very cognizant of the hedging consequences that David mentioned, so as long as we can manage those, a steeper curve is a very nice welcome for mortgage investors.

Kenneth Lee, Analyst

Great, that’s very helpful. Just one follow-up, if I may. I think in the prepared remarks, you mentioned that you were adding a little bit of duration to the repo book. Wondering if that’s primarily opportunistic, just taking advantage of the current costs, or is there any kind of longer term view towards either extending out the finance maturities or things of that nature. Thanks.

David Finkelstein, CEO and Chief Investment Officer

Sure Ken. We have added duration to the repo book - we are now just over three months, and that is attributable to taking advantage of, as I talked about in the prepared comments, one-year rates, for example, inside of 20 basis points. We don’t expect to see a negative rate environment, and as a consequence, to the extent you can lock in funding costs for a year, that close to the zero lower bound, shame on us if we don’t take advantage of it. That’s just simply a function of the fact that rates out the term are incredibly low. As Serena talked about, we did let the repo book run down in terms of average days in the fourth quarter, and that was just simply a function of the desk’s view that with more and more liquidity entering the system and the actual need to lock up cash with collateral, we’ve seen a willingness for participants to term it out just to lock up that collateral at rates above overnight, even though we’re 10 basis points or less between overnight and term, and there’s just demand for collateral in the market that we’ve taken advantage of.

Kenneth Lee, Analyst

Great, that’s very helpful. Thanks again.

David Finkelstein, CEO and Chief Investment Officer

You bet, Ken.

Operator, Operator

Ladies and gentlemen, this concludes our question and answer session. I would like to turn the conference back over to David Finkelstein for any closing remarks.

David Finkelstein, CEO and Chief Investment Officer

Thank you, and thank you everybody for joining us today. We hope everybody stays safe, and we’ll talk to you soon.

Operator, Operator

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