Good day, welcome to the Annaly Capital Management fourth quarter 2022 earnings conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the Star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press Star then one on your touchtone phone. To withdraw your question, please press Star then two. Please note today's event is being recorded. I would now like to turn the conference over to Sean Kensil, Director of Investor Relations. Please go ahead, sir.
Good morning, and welcome to the fourth quarter 2022 earnings call for Annaly Capital Management. Any forward-looking statements made during today's call are subject to certain risks and uncertainties, which are outlined in the Risk Factors section in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the disclaimer in our earnings release in addition to our quarterly and annual filings. Additionally, the content of this conference call may contain time-sensitive information that is accurate only as of the date hereof. We do not undertake and specifically disclaim any obligation to update or revise this information. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our earnings release.
Content referenced in today's call can be found in our fourth quarter 2022 investor presentation and fourth quarter 2022 financial supplement, both found under the Presentation section of our 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, Mike Fania, Deputy Chief Investment Officer and Head of Residential Credit, and Ken Adler, Head of Mortgage Servicing Rights. With that, I'll turn the call over to David.
Thank you, Sean. Good morning, and thank you all for joining us on our fourth quarter earnings call. Today, I'll provide an update on the market and how it impacted our performance, then discuss the macro landscape, our portfolio activity this past quarter, and conclude with our outlook for each business as we begin the new year. Serena will then discuss our financial performance, and we are also joined by our other business leaders to provide additional context during Q&A. Starting with the market backdrop, risk assets ended 2022 on a more constructive note driven by improved inflation data and a moderation in the size of Federal Reserve rate hikes. Given the cumulative hikes delivered thus far, inflation and wage growth are slowing and a decline in volatility has improved investor sentiment and led to fund flows into fixed income.
Mortgage and credit spreads tightened from the peak spreads exhibited in October, with November representing the best month of excess returns in the history of the Bloomberg US MBS Index. The strong finish to 2022 helped drive our 8.7% economic return for the quarter, and our economic leverage decreased from 7.1- 6.3 turns quarter-over-quarter, attributable to a modest decline in portfolio size as well as book value appreciation. Turning to the macro environment, following the 25 basis point hike last week, the Fed expects to hike a couple more times and hold interest rates at elevated levels subject to inflation and labor market developments. This scenario should make for a more stable environment for fixed income in 2023, though certain risks out the horizon remain.
For one, the failure to resolve the debt ceiling has the potential to cause disruption to markets. Moreover, although inflation has cooled in recent months, these readings offer little information about the medium-term run rate of inflation once base effects dissipate. All considered, we are optimistic but still cautious on the outlook. With respect to the housing market, activity declined meaningfully over the course of 2022, given the upward shock in mortgage rates and the resulting reduced affordability. Existing home sales, for example, are now a third lower than at the end of 2021. This slowdown in activity has coincided with a reduction in available inventories. According to Redfin, new home listings have decreased 28% year-over-year as borrowers opt to stay in their homes in the current higher rate environment.
As long as the labor market remains robust, we perceive few poor sellers keeping inventories below historical averages. As a result, home prices have been slower to decline than initially expected, with the Case-Shiller National Home Price Index falling 3.6% from its peak level in June, though this dynamic may change in the spring selling season. Nevertheless, we feel good about the state of the housing market as long as the labor market remains strong, consumer balance sheets and lending standards are sound, and the shortage of supply supports prices all else equal. Shifting to our portfolio activity during the quarter, within agency, we continued to shift modestly up in coupons to take advantage of wider spreads and improved carry in production coupons.
We grew our allocation of 4.5s and higher, which now represent over 50% of our portfolio, up from 40% last quarter. We believe historically wide nominal spreads in these coupons provide more than adequate compensation for taking on the incremental convexity exposure relative to lower coupons. In addition, we reduced our exposure to TBA as role specialness dissipated over the quarter, and we are likely to favor pools over TBA going forward, given their better return profile. Regarding prepayments, the mortgage universe remains firmly out of the money, and even with mortgage rates trending lower towards 6%, only 1% of borrowers have an incentive to refinance, leaving our convexity risk near the lowest levels we've seen over the past 5 years. Our portfolio paid 7.5 CPR in the fourth quarter, more than 30% faster than the 30-year universe.
Our weighted average seasoning of 42 months and our WAC roughly 1% higher than the broader agency market positions us well for the current discount environment. Our hedge portfolio kept us well-insulated as interest rates reached a multi-decade high in the fourth quarter, and the notional balance of our hedges remains in excess of our liabilities, as seen in our 107% hedge ratio. Within the portfolio, we rotated from treasury futures into SOFR swaps given the contraction in swap spreads. Going forward, we will remain defensively positioned on the rate front until the path of policy becomes clear, although we are encouraged by the lower rate volatility seen year-to-date. Now moving on to residential credit.
Our portfolio ended the fourth quarter at $5.0 billion in market value, essentially unchanged quarter-over-quarter. The strategy currently represents approximately 19% of the firm's capital. Non-agency credit participated in the broader risk on rally with benchmark below investment grade Stack M2s, 125 basis points tighter and triple-A non-QM spreads 20 basis points tighter. Whole loan spreads did lag the tightening in securities, however, resulting in our transactional activity being predominantly focused on residential loans, where we settled $685 million in loans during the quarter. In the current decelerating housing market, our loan business represents our preferred approach to investing in the resi credit market, given our ability to control our credit strategy, our partners, the diligence process, and pricing.
We maintain a focus on preserving the credit quality of our portfolio with our fourth quarter whole loan acquisitions exhibiting characteristics consistent with the quality of our GAAP consolidated residential whole loan portfolio. Of note, our underlying borrowers have seen their mark-to-market LTV improve to roughly 58% on average. Our OBX securitization platform had a record year of issuance, supported by a correspondent channel acquiring nearly $2 billion in loans during the year. Since the beginning of 2022, we closed 17 securitizations totaling $6.6 billion and generated $760 million of proprietary assets with a low to mid-double digit return profile utilizing minimal recourse leverage. With credit spreads tightening post-quarter end and capital markets execution improving year-to-date, we expect to continue accessing the securitization market to efficiently fund our whole loan portfolio. Now to discuss MSR.
As we noted during last quarter's earnings call, we were measured in our approach to further growing our holdings, resulting in muted activity in the fourth quarter. Over the course of 2022, however, we had significant growth in the strategy, increasing our portfolio by nearly 3x to $1.8 billion in market value and ending the year as the third largest buyer of bulk MSR in the market for 2022. We added new originator partners, expanded relationships with sub-servicers, and put in place new dedicated financing as an additional source of liquidity to support future growth. Our focus on very high credit quality, low loan rate MSR has proven to be valuable. The portfolio paid three CPR for the quarter and experienced minimal delinquencies, generating stable cash flows while providing a hedge to current dynamics in the housing market. Now shifting to our outlook.
We're encouraged by the supportive investing environment for each of our three strategies, though we remain deliberate with respect to our leverage profile and capital allocation strategy, considering the aforementioned risks to the operating environment. Within our core agency business, we see a strong setup for the year with historically attractive nominal and risk-adjusted spreads coinciding with declining interest rate volatility, a more predictable prepayment environment, and healthy financing conditions. As it relates to the supply and demand picture, higher rates should mitigate Fed runoff in agency MBS supply, while demand expectations appear more mixed. Buying from banks and overseas investors is likely to be subdued, thus further spread tightening will be reliant on inflows from the money manager community. To note, should recessionary risks increase, agency MBS have typically outperformed other fixed income sectors in times of economic weakness.
Accordingly, we plan to maintain our overweight positioning in agency relative to our long-term capital allocation target, though we remain committed to expanding our housing finance footprint and are proud of the considerable progress we have made to date. In residential credit, as the leading non-bank issuer of prime jumbo and expanded credit MBS, we anticipate maintaining our market leadership given our capital and certainty of execution, and we believe our portfolio should remain relatively well insulated from a further deterioration in housing fundamentals as a result of our robust credit standards. Furthermore, our securities portfolio provides an additional lever for opportunistic growth when returns are accretive. In MSR, we expect there to be significant supply in the market given sustained monetization efforts by originators.
While we are comfortable with the scale and quality of our current portfolio, we have capacity to opportunistically add MSR should this elevated supply lead to more attractive returns. Now before handing it off to Serena, I wanted to make one last point as it relates to earnings available for distribution. While we generated EAD that covered our dividend this quarter, we witnessed the moderation discussed in recent quarters, and we anticipate some further pressure on EAD going forward. As a result, and subject to determination by our board, we expect to reduce our quarterly dividend in the first quarter of 2023 to a level closer to Annaly's historical yield on book value of 11%-12%, which compares to the approximately 16% yield on book we're paying today.
We believe this decision allows us to appropriately manage the portfolio within conservative risk parameters while also delivering a more sustainable yield that is competitive with the peer set and broader fixed income benchmarks, which has always been our objective. Overall, we're constructive on each of our businesses, and we are enthusiastic about the multi-pronged platform that we have built out over recent years, but we remain vigilant and careful stewards of our shareholders' capital. Now, with that, I'll hand it over to Serena to discuss the financials.
Thank you, David. Today, I will provide brief financial highlights for the quarter ended December 31st, 2022, and discuss select year-to-date metrics. Consistent with prior quarters, while our earnings release discloses GAAP and non-GAAP earnings metrics, my comments will focus on our non-GAAP EAD and related key performance metrics, which exclude PAA. Our book value per share was $20.79 for Q4, which increased by $0.85 per share for the quarter, primarily due to basis timing amid slower rate volatility. Strong gains on agency investments of approximately $1.61 per share contributed significantly to the book value appreciation for the quarter. These gains were partially offset by losses on our derivative positions of roughly $0.60 per share and lower valuations on residential and other investments of approximately $0.14, primarily related to our MSR portfolio.
After combining our book value performance with our fourth quarter dividend of $0.88, our quarterly economic return was 8.7% compared to -11.7% in Q3. We generated earnings available for distribution of $0.89 per share for the fourth quarter. The $0.17 reduction in EAD compared to last quarter is attributable to the continued rise in repo expense and lower TBA dollar roll income due to less specialness. Partially offsetting these factors, however, was the approximately $146 million increase in swap income quarter-over-quarter and a further rotation into higher yielding agency MBS. Given the continued increase in financing costs, runoff of swaps, and the mismatch between economics and earnings related to futures, all things equal, we currently expect further pressure on EAD in the near term.
Average yields ex PAA were 58 basis points higher than the prior quarter at 3.82% due to the previously mentioned acquisition of higher yielding assets and a further decline in amortization. The factors that impacted EAD are also illustrated in NIM for the quarter, with the portfolio generating 190 basis points of NIM ex PAA, an eight basis point decrease from Q3. Net interest spread does not include dollar roll income. The NIS was comparable quarter-over-quarter at 1.71% versus 1.7% in Q3. Turning to financing. Despite market volatility throughout 2022 in the rates markets, funding markets for our agency and non-agency security portfolios remained resilient and ample.
With current expectations that the Federal Reserve is in the final innings of the hiking cycle, liquidity in agency funding markets should extend out the curve in future quarters. We currently continue to see liquidity concentrated in overnight and term markets out to the Fed meeting dates. With this landscape in our mind, our Q4 reported weighted average repo days were 27 days, down from 57 days in Q3.
Our sustained efforts in procuring dedicated financing for our growing whole loan and MSR businesses continue to enhance the firm's liquidity profile while generating capacity to foster growth in these respective businesses. As David mentioned previously, we continue to be a programmatic sponsor of OBX securitizations, pricing and settling an additional 3 transactions from the end of Q3.
As of the end of Q4, our disciplined approach had resulted in 90% of our GAAP consolidated whole loan portfolio currently being funded through securitizations at a weighted average cost of funds of 3.38%, approximately 260 basis points below the current non-QM cost of funds. In addition to the below-market financing rate of our securitized debt, 95% of the debt is locked in at a fixed rate. Shortly after quarter end, our team also took advantage of the robust liquidity in the financing markets to upsize one of our existing facilities by approximately $200 million-$400 million in total. We remain well-positioned with ample liquidity in our residential whole loan business, with $2 billion in financing capacity across several diversified providers.
Our warehouse utilization remains low as we finish the quarter with approximately $720 million drawn against our whole loan position. Shifting to MSR financing. With the addition of our newest committed warehouse facility recently closed, we currently have $750 million in dedicated financing for our MSR business amongst diversified counterparties, with additional capacity available subject to customary conditions. As reported in Q3, outstanding advances on this business stand at $250 million, leaving us with $500 million of additional capacity at our disposal to draw against our MSR position.
The continued rise in repo rates and higher average balances impacted our total cost of funds for the quarter, rising by 57 basis points to 211 basis points in Q4. Meanwhile, our average repo rate for the quarter was 372 basis points compared to 225 basis points in the prior quarter. We ended the quarter with a repo rate of 4.29% compared to 3.13% as of September 30, 2022. As previously mentioned, swaps positively impacted cost of funds during the quarter by approximately 76 basis points. We ended the year with an OPEX to equity ratio of 1.4%, which is at the low end of the range discussed on previous earnings calls, reflecting cost savings from the disposition of our MML and ACRE businesses.
We modestly increased our liquidity profile with $6.3 billion of unencumbered assets compared to the prior quarter of $6.1 billion, including cash and unencumbered agency MBS of approximately $4 billion. The increase in unencumbered assets primarily came from the reduction in leverage on resi credit and the settlement of an MSR package in October. That concludes our prepared remarks, and we will now open the line for questions. Thank you, operator.
Thank you. We will now begin the question-and-answer session. To ask a question, you may press star then 1 on your touchtone phone. If you're using a speakerphone, we ask that you please pick up your handset before pressing the keys. To withdraw your question, please press star then two. Today's first question comes from Bose George with KBW. Please go ahead.
Hey, everyone. Good morning. Could I get an update on book value quarter to date?
Sure. Bose, good morning. As of week's end, book was up roughly 8%-9%. Post payrolls, we've come up just a touch, and as of last night, up roughly 7%.
Okay, great. Thanks a lot.
You bet.
Talk about, you know, normalized leverage. Is the current level of leverage kind of, you know, where you're comfortable, you know, unless or until things change?
It is for this capital allocation. It's gonna be dependent upon how we allocate our capital, but with 67% agency, and the other third allocated between resi and MSR, we feel good about the level of leverage. We do have the capacity to take it up given our liquidity, but we're very comfortable with it right here, Bose.
Okay, great. Thanks.
You bet, Bose.
Thank you. Our next question today comes from Doug Harter at Credit Suisse. Please go ahead.
Thanks. Just a little bit more about the dividend. Obviously, book value's been incredibly volatile and just how you kind of think about kind of setting and targeting that 11%-12% yield on book in an environment like this where book is moving around?
Sure. Good morning, Doug. Look, it's a function of where asset yields are and the leverage we apply. Just to run through it, you know, in the agency market, current mark to market levered returns range between 13%-15%, depending on what collateral we're buying. In residential credit, looking at OBX securitization and retained holdings with very modest leverage, we're talking 12%-15%. Then in the MSR market, unlevered returns around 10%.
You know, we get to an average yield in the market today of around, call it 14%, 13%-14% across the assets and 135-145 basis points to run the business, which we think is incredibly fit-efficient, brings you down to that level of 11%-12%, roughly. Serena, you wanna add something?
Yeah. You know, Doug, we've always been really clear that our dividend policy is to set a dividend that is consistent with our historical yields, but also something that we can consistently achieve. We do, you know, as David mentioned in his remarks, that we believe that, what we've referred to is a very sustainable level given new money returns that David just walked through.
Great. Just one follow-up on the returns you just mentioned, David. You know, I guess are those the returns that you see at your current leverage? You know, and is there flexibility, you know, risk or opportunity to kind of move leverage up or down over time, and obviously how that impacts returns?
Sure, there is. There is flexibility to move it up or down, but that is using the agency market roughly eight turns of leverage, which is approximately where we're currently levered in the agency portfolio. Just to break it down a little bit in terms of what we're buying. Generally, we're buying production coupons and we're somewhat barbelled between really low pay-up, but what we think to be good quality pools. For example, new production retail bank serviced pools with low WAC, you know, come at a pay-up of just a few ticks. That's gonna get you on a levered basis a little over 15%. We're obviously considerate of the possibility of a rally and the sensitivity of production coupons to prepay in a rally. We are kind of barbelling that with higher quality pools.
For example, high loan balance collateral in the fives coupon comes at a cost of about two points roughly, and the levered return on that is around 13%. You take the average and you get to 14%. In resi, Mike's done obviously a number of securitizations over the recent past and the retained bonds with around 1.5 turns of leverage end up to that low to mid-teens type returns. In MSR, we currently apply very minimal leverage to the portfolio. It's simply a liquidity source. The fact of the matter is we do have the capacity to lever that portfolio.
When you look at the composition of our MSR and the loan rate, given how deep out of the money it is, that's very different than production coupon MSR from a variability of cash flow standpoint as rates move. The fact of the matter is, you know, if rates can move a meaningful amount, you're not gonna change the cash flows on that MSR, that much. All else equal, you're not gonna see a lot of price volatility we expect. As a consequence, you do have the ability to apply leverage to that, but we currently don't. Does that help?
Well, thank you, David.
You bet, Doug.
Our next question today comes from Trevor Cranston with JMP Securities. Please.
Hey, thanks. A question on the MSR market. You know, it seems like there's the potential for, you know, a fairly large amount of MSRs to maybe come to market over the next few months. Can you talk about, like, how you, how you think that'll impact, you know, the MSR market and valuations overall, if you know, if you think there's gonna potentially be an opportunity to deploy a significant amount of capital into bulk MSRs? Thanks.
Sure. I'll start it off. Good morning, Trevor, and then I'll hand it off to Ken. Yes, as I mentioned in my prepared remarks, we do expect a fair amount of supply to come to market. Last year was obviously quite a heavy year, and we took advantage of it.
The supply will continue. In terms of how it can impact the market and pricing, we do think there's a lot of capital that is ready, including ourselves. If you look at our mark for Q4, we did mark our MSR down modestly, and that was a function of that pending supply. Ken, you wanna elaborate?
Yeah. I mean, just to Thank you very much. Last year was record supply for the industry, the flows were somewhat balanced, as you can see, where much of it went, including ourselves. 2023 is certainly shaping up to be a higher amount of supply than 2022, and we're evaluating several opportunities, and we're opportunistically going to participate in those. Yeah, we're ready. As Dave mentioned, that was the reason for the markdown.
Exactly. Also why we remained relatively quiet last quarter. You know, it's currently 15% of our capital, which is lower than we'd like, but we're gonna remain patient and wait for the opportunities to come to us.
Yeah. Just one last thing. I mean, this markdown, I mean, it's just a pure technical. The cash flows are higher in quality and certainty than they've ever been because of the moneyness of the collateral. You know, we are certainly looking at this as a great opportunity.
Right. Okay. That makes sense. Thank you.
You bet, Trevor.
Our next question today comes from Kenneth Lee at RBC Capital Markets. Please go ahead.
Hi. Good morning. Thanks for taking my question. Just one on the, on the potential dividend change. Is the assumption there that the underlying economic earnings over the near term is not gonna change much? In other words, you're assuming that Annaly is not gonna get a lot more aggressive in terms of investment or leverage over the near term, even if the rate volatility, for example, were to settle down somewhere in the middle of the year. Thanks.
Well, we certainly could get more aggressive, if, you know, the market is cooperative, but the way we look at it again is based on our current leverage and what returns are, Ken, and that's where we feel the market is offering returns for this business model.
Gotcha. Very helpful there. One follow-up. You touched upon this in the prepared remarks. Wondering if you'd just get your thoughts on what you think could be potential implications if the government does not resolve the debt ceiling. Thanks.
Yeah. Look, it's very difficult to hand-handicap the implications, Ken Adler. It is something that we should pay attention to. You know, on one hand, the market did rally in 2011. But look, it's a different world right now, and you only have to look back to what occurred in September with the U.K. situation on the trust tax cuts. You saw, you know, 10-year gilts, for example, sell off 120 basis points based on, you know, somewhat of a lack of confidence. It is somewhat of a precarious circumstance in D.C. right now. I think we've all seen, you know, what's gone on down there, and it's a little bit disconcerting.
Our base case is that this gets resolved, and it's not gonna lead to certainly passing the X-date without a resolution. Look, we have a contingent down in D.C. currently that is larger than it was in 2011 in Freedom Caucus, and they're playing for a different outcome. It's more of a base outcome.
You know, even mainstream members of both parties are thinking about the broader country. You know, it's a little bit uncertain. We do think it's gonna be resolved. Nevertheless, there's a lot of outcomes that could, that could occur. That's one of the reasons why we're being somewhat conservative.
Gotcha. Very helpful there. Thanks again.
You bet, Ken.
Ladies and gentlemen, as a reminder, to ask a question, please press star then one. Our next question comes from Vilas Abraham with UBS. Please go ahead.
Hi, everybody. Thanks for the question. Just to follow up on the MSR conversation. You know, moving forward, would you look to grow that book by allocating more equity or increasing, you know, the leverage there? It does sound like you have some capacity. How are you thinking about that?
Yeah. We would expect more equity allocated to it, certainly with the option to apply a modest amount of leverage. As Serena talked about in our warehouse financing, we have an upwards of $1 billion worth of capacity, and so that'll remain an option. Generally speaking, it's a liquidity arrow for us in the quiver, and we do expect to add more equity to the sector.
In terms of capital allocation between agency MBS and resi credit right now, are you leaning one way or another?
Generally, we're a little bit more fond of agency. Our base case, notwithstanding some of the risks out the horizon, is that volatility does continue to come down, which would favor agency. While housing has outperformed our expectations over the past six months modestly, there is a little bit of risk with the sector, particularly as we do get into the spring selling season, and we'll really see what kind of implications, you know, mortgage rates and other factors have on home prices.
We're a little bit cautious, but, you know, with Mike's residential securitization business and the acquisition of whole loans, that collateral we're very comfortable adding, particularly given his lending standards and the ability to control all aspects of the acquisition of a loan.
We'll add, but generally we're marginally favorable towards agency right now.
Okay, that's helpful. Just lastly, on the non-QM securitization market, execution has, you know, gotten a lot better since Q4. Just any color that you can kind of add there on just, you know, what you're expecting and, you know, are these level of spreads that you're seeing there sustainable and just what could move it one way or the other moving forward here? Thanks.
Sure, Vilas. This is Mike Fania. I would say, yeah, I think a lot of what we saw in 2022 was gross issuance in non-QM. It was at $39 billion-$40 billion. It was a record for the sector. Inconsistent with risk off plus the technical landscape, it certainly pressured the non-QM market. It pressured non-QM spreads. I think what you've seen to start is that there is a high percentage of the market that seems to be pricing in a soft landing, and you're seeing that in terms of risk on from, you know, probably late October, November to where we sit today. From a technical landscape, you know, supply will certainly be significantly lower than what it was last year. We think supply in non-QM may be $25 billion-$30 billion this year.
You know, with that, I think investors have realized that there is a scarcity of the asset class. We've seen spreads now tighten to probably call it 150 over on the triple A, or at the wides, we're probably mid-high 200s. We do think that it can be sustainable to the extent of the, you know, the macro environment.
Great. Thank you.
You bet.
Thank you. Ladies and gentlemen, this concludes our question and answer session. I'd like to turn the conference back over to Mr. Finkelstein for any closing remarks.
Thank you. Thank you, everybody, and we look forward to talking to you again after the first quarter.
Thank you, sir. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.