Annaly Capital Management, Inc.

Michael Farrell – Chairman, CEO and President Kathryn Fagan – CFO and Treasurer Wellington Denahan-Norris – VC, CIO and COO

Jason Arnold – RBC Capital Markets Joel Houck – Wells Fargo Jade Rahmani – KBW Daniel Furtado – Jefferies Ken Bruce – Bank of America

Good and welcome to the Annaly Capital Management's earning call for the first quarter 2011. I am Mike Farrell.

Joining me here today are Wellington, Kathryn and Nick Singh. As usual I have prepared remarks to begin the call after which we'll take your questions.

These remarks can also be found our website. Today's mission is called too much of a good thing.

Most humans are uncomfortable in silence. To avoid it, modern humans subject themselves to constant stimulation, mostly in the form of information.

We used to simply read a few newspapers each day or watch TV. Now we are bombarded with emails, texts, blog posts, newsletters, tweets, Internet news outlets and cable TV channel for every possible purpose.

Markets efficiently decipher all this information or so it’s believed. Regulators and policy makers are also privy to the same, if not more, data in their quest to provide the guideposts of commerce.

When we started as an investment team back in 1991, the internet was still a gleam in Al Gore’s mind and fax machines were still the norm, but we thought we had all of the information we needed to manage our portfolios. I reminisce simply to ask the question: Has all this information made us smarter?

In 2000, the Tech Stock bubble was in full deflation mode, but if you think about the information preceding the burst you will recall that Alan Greenspan’s infamous “irrational exuberance” warning was made in 1996. Over the next three-plus years there were countless news articles questioning the validity of the rise in prices and the quality of the IPOs being underwritten and yet many people still had a look of shock when it inevitably came down to earth.

The housing bubble started to deflate in 2006 and a simple news search shows that it, too, had hundreds of articles written about it in the three years prior, stories that called into question the underlying strength of personal incomes to support a home purchase, mortgage structure and availability as well as outright fraud. It wasn’t just news stories that were out there.

We were not the only ones talking about the end of the bubble in our 2006 quarterly commentaries “The Goldfish is Dead, Senator” and “The One-Trick Pony.” I also recall attending the Grant’s Interest Rate Observer spring conference in 2007, which preceded the collapse of Bear Stearns, Lehman Brothers and AIG, and listening to a hedge fund manager present an interesting picture of how Wall Street was packaging chicken parts into securities and the rating agencies were stamping them with approval to be sold as steak.

His colorful description of ABS CDOs was a “heads-up” on the impending collapse of the debt bubble in 2008 that kicked off the credit crisis. Again, many were surprised not only when it burst, but that there was also a strong link between debt growth and GDP growth.

As we mentioned on our last call, monetary stewards have spanned the spectrum, from Paul Volcker’s days of unannounced policy actions, to Alan Greenspan’s ubiquitous opaque chatter and predictable incremental 25 basis point moves, to now Ben Bernanke not only speaking clearly and telegraphing his actions but also disclosing the thoughts behind his every action. You could say we have a new bubble in information.

The Federal Reserve, in a push for transparency, now publishes more detail on the range, central tendencies and inputs into the economic projections of the Board Members and Bank Presidents. The Chairman does interviews and goes on ‘60 Minutes.’

In the past, the FOMC meeting minutes were released with a five year lag, then 90 days, then during Greenspan’s reign it went to three weeks. Now Mr.

Bernanke gives a press conference following the FOMC meeting. I don’t think the market is any better at managing with all this information; I would argue that more of it has only intensified the bubble that follows.

As with any topic, whether it is macro or otherwise, it's is up to each market participant to glean that which is important from all of the information and idle chatter that's out there. One thought I would offer to anyone who is thinking about these things is to find a quiet room without a screen and consider the thought that Milton Friedman popularized, that there is no such thing as a free lunch.

It seems to me that there are free lunches being served by policymakers all over the world. And the same can be said for companies and businesses that promise returns without fully acknowledging the risks and trade-offs of portfolio decisions.

The flood of information is its own free lunch. While I don’t know exactly how the bill is going to paid for free lunches, it will eventually be paid and it will be paid at some point.

With that said, I close out the first part and we open up the call for Q&A.

Just question wise, you sold around 5 billion in the investor portfolio this quarter end, I guess around 15 billion over the past couple quarters. I was just wondering if you could share with us what components of the market you've been taking gains and where you see value in the market here at present.

Jason we don't break down that information. One thing we will always try and do is as everybody knows that a prepayment is a sale at par and the market will obviously pay more for certain things.

So we are constantly just evaluating the portfolio and looking for opportunities to rebalance what we own. Obviously this is a rather interesting market, the pay ups in the market have gotten extreme for prepayment protection which having gone through a lot of markets, there is a lot of times where the market will value certain things.

I'll reminisce about back in the days relay loans were the big pay up, performers, okay and its always interesting how once a pay up becomes great and up in the market that somehow the supply comes immediate. So you always have to be careful about which areas you tend to place value, but we are constantly evaluating it.

And then just one quick follow-up. I was just wondering if you could update us with your thoughts on prepayment speeds.

It seems like on the organic side, prepays have been slowing relatively to the prior quarter and its coming through quite as dramatically as many thought it would either. So just curious if you could offer your take on that front too.

We do welcome any slowing or any less fast than what the market may have anticipated. Again we're only prepared for it to be worse than it is hopefully.

I would just to that that from what we’ve seen from the policies that have been implemented that, the prepayments are really going to be a subject of policy matter more than Central Bank or interest rate or a house price. Now clearly it a was a story out this week, I don't know if you got to see it but, houses that were purchased in the last two years are now under water.

So you still have deflation in real estate. I think you're still going to see political pressure to do things like harp.

They are talking about moving that now in (inaudible). I don't think any of that's going to happen pre the election.

But I definitely think that from my perspective, from the things that you can't control in the interest rates world, that the Central Bank's pushing back at the administration now and saying we can't do anymore to help the housing market. We've done pretty much everything we can do.

It's up to you on the policy side and I think it's important to keep in mind that a guy like Ben Bernanke has not been endorsed by either party. And if you listened to every Republican debate, nobody who gets selected from that side is going to hire him and Obama hasn’t really backed him and Geithner is going to leave at the end of the election.

So in my mind, if you are a center banker, you want to defend your legacy and your legacy is going to be that we've done a lot here, as much as we can do from interest rates, we've moved them down a lot and we’ve still met senior results. If you guys want to do something about housing, it's got to come out of policy and I think that's the real risk in prepayments.

I had actually gotten cut off a little bit registering for the queue and you'd talked about, the opening remarks were around the bubble. Presumably the treasury bubble, I don't know if that's where you were going with, I didn’t hear all of the comments.

One of the things that, obviously you had a massive tailwind in terms of downward pressure in interest rates for the last decade plus and if we give into albeit an unlikely environment, near term. If we get into a period of either rapid inflation or just a loss in confidence, in sovereign debt and rates start to rise, would you position the company differently?

In other words, what is the mechanisms for which you could mitigate book value declines in a rapidly rising long-term rate environment?

Well I think he's touched on why we are concerned about the macro environment in general. While we may be bullish, at the end of the day I think most people can only fall into one or two camps.

As the economy is recovering and interest rates should be rising, or the economy is not recovering and we're all going to put the risk on trade on. I think that all of the intervention that's going on globally including the Spanish auction this morning, which was pretty much bought entirely by the ECB apparently, all of this intervention is skewing asset allocation decisions across all of the markets.

And it's making obviously, stocks are going to look cheap against that. You get the unemployment number in the morning and the markets will decide to rally equities because you're going to get Q3 or you're going to get some sort of stimulus from the Central Bank in order to keep the jobless rate under control.

So having been through the 1979, 1983 interest rate rise, where interest rates loan houses went from say four and a quarter in the mid-70s up to 17% in the middle 80s. That can happy and it doesn't happen with the ringing of a bell.

It’s a gradual thing and is a loss of confidence in the currency, less confidence in the administration or in a Central Bank and I think the Central Bank understands that mentality and I think they are being very careful about it. In the portfolio, I'll turn it to Welli and she'll explain to you the steps that we look at.

Joel, I know we get a lot of heat about the low leverage that we’ve been maintain but that's one your better hedges against a rise in interest rates. The other thing that we do have a substantial amount of interest rate swap that tends to insulate book value somewhat and rising interest rate costs as well.

I would caution that nothing works perfectly. And in Mike's comments we've talked about there's no free lunch.

There is virtually nothing that you can do to insulate your portfolio completely from a move and still produce these kinds of returns. We are all in the business of taking risks and it's just a matter of trying to balance the landscape that you are dealing with against the landscape you may be faced with going forward.

And one of the best ways that we have found to do that having gone through some pretty serious markets with some pretty sizable positions is leverage provides you the most flexibility or lower leverage I should say provides you the most flexibility in dealing with the twists and turns of the market. Now I would say we’re looking at now, no one in the contemporary markets has ever dealt with.

And yes, maybe we've been too cautious for too early and for too long but ultimately are you delivering an attractive return and will you be able to do it in the future.

Those are helpful comments. I am wondering, does it make sense to you for options given lower volatility to purchase out of the money selection so that, again, it's not a perfect hedge but it provides incremental protection while it's cheap if you will as opposed to trading.

Yes, we really value all the options available to us and you always have to keep in mind that certain things run out. When they run out at the worst possible time so you just want to make sure that whatever you are doing is going to be durable and used.

Part of the discussion I'd like to introduce there Joel is that, there are changes going on in the CDS market that really deserves some consideration to look at how derivatives in general are handled. And we think in our discussions with policy makers and clearing houses and regulators, that at the end of the day, the Central Bank of Europe for instance, tried to blow off the entire CDS market and the hedge fund market by making that insurance invalid by going with the selective default options instead of always saying that Greece is bankrupt, so as these things are emerging globally.

Last summer we were talking about Greece and we were talking about Italy. Now we're talking about Spain.

As these things continue to unwind here, I think you cannot underestimate the length at which Central Banks will go to mitigate this. And I think some of the new products that are being developed are going to be interesting ways to use that but you have to be sure that the insurer is on the other side of the policy.

Similarly I would make an analogy to AIG right, in the middle of all the trades in the CDS market. That certainly did open everybody's eyes as there was one central clearing house and has to be applied to the insurance company.

So I think all that stuff is out there as Central Bank is looking at things now. One day you have someone from the committee saying that we should be tightening and then the next day you have them saying that we need to hear our mandate.

They are going to introduce this 2% rule. I think all of that is unwinding discussion in the markets that needs to be carefully monitored and brought into the thinking, how you think about, how the market will reverse itself and when that might happen.

I was wondering if you could comment on where you are seeing incremental spreads and where do you see the most attractive value right now. You mentioned prepayment protective bonds as being expensive.

What aspect of the market are you focused on and where do you see incremental spreads?

We continue to evaluate it. As always, we don't tend to go in detail about where we specifically see value in the market but I can assure that we weigh all the options and look at the breakeven relative to where the prepayments the (inaudible) and make it determination across the coupon stacks, across the variety of specifies that you can look at to make the best determination about where we see the long-term durable value in the portfolio and what ultimate you're paying up for that you can ultimately get back either through extended periods of low prepayments.

One thing, as a mortgage investor there are times when you hope your assets are paying slow and then there's other times when you wish that they would just come in and so you're constantly striking a balance between those two wishes and trying to make sure that the portfolio that you are putting together is not too heavily weighted one way or the other for the period of time that you are going through. So we will constantly shift through where we think we should have more heavily weighted position.

But generally speaking, we try and strike a balance even within prepayments profile among the portfolio.

And just secondly your leverage modestly picked up. Can you discuss scenarios under which leverage increased further and what level you'd be comfortable running with?

Leverage is a snapshot in time and again, I'll tell you what. If the current coupon was 8%, we would certainly have our leverage at 12:1.

And hopefully that wouldn’t be through mark-to-market losses. Not all spread is created equal and 200 basis points from 0 to 2% on 10 is far different than 200 basis points that a 4% fed funds and 6% on hand.

And any seasons market participant would understand that and so we would continue to monitor the outlook going forward on the push and pull between policy makers and the market ultimately trying to be the final arbiter of price discovery.

Just a couple clarifying questions if I may, you had mentioned that generally speaking, everybody is in one of two camps, the economic environment is getting better or its continuing to stagnate. Do you mind sharing with us, just to be absolutely clear, where management stands today on those two camps, please.

Our clear view is that the market is an unsettled market with more counter party risk, probably today than there's ever been before in history because you have an entire continent that's at risk. So you have a number of banks that are foreign banks that play multinational markets that essentially are watching their interest rates go up.

So from a perspective of developments that are going to happen in the market, I would say, our uncertainty is we have more faith in the American markets to recover, economically but we don't see growth spurting out say 3% plus GDP kind of numbers and neither do we expect job growth to be robust going into the election. So I think from a perspective of the way we think about this is that essentially long rates are at risk here to go either down a lot, if we continue to be in deflationary mode which (inaudible) argue and I would say still, the argument has to be disproved, I think is the best way to look at it.

Inflation is definitely creeping in. in terms of services and prices the energy etcetera.

But that's also a capital economy. At $4 a gallon a gas, that's definitely going to suppress consumerism and that's still 70% of GDP that's what they're trying to manage for.

I think we've been clear in the past, I have been clear in the past that I think we hedge the wrong economy who managing. We're probably in more of a business to business economy and when I look at the results of companies like Apple, I look at that, that they are taking market share at the expenses of Nokia and other players in the market, not growing the entire GDP, right, at 2.5%.

This is capitalism at its best. It's eating up market share.

So, how long does that rotate and who are the winners at the end of that? I think you're really not going to be, Apple doesn’t hire the same amount of people that GM does, when they hit their numbers.

So I think we're in a very tentative recovery here. It's very fragile and I agree with Chairman Bernanke on that in that sense that it is very fragile and that he didn’t trust these unemployment numbers that were coming out.

And I think that was actually a pretty good insight into where the Central Bank is thinking. And certainly confirmed the way I'm thinking.

And also to be absolutely clear on how to characterize your leverage. It sounds like the conservative leverage ratio was more of a concern regarding asset price levels than it is regarding pre-payment expectations or is that not a correct….

That is absolutely correct. These prepayment levels are nothing compared to what they were in 2003, which we did manage through, just to remind everybody where you did have significant prepayments coming in, asset prices weren’t nearly as high but you did have to manage in a different way during that period.

Today given rate levels and where we are I think pre-payments are rather subdued.

Yes, I think just to add on that point as you know from 2003 Dan, CPRs went through the ceiling because house price valuations were being mispriced through underwriting, right bid underwriting. At the time there weren’t as many mortgage REITs out there and we literally had a line of investment bankers outside of our conference room here telling us your yield curve is steep.

You guys should be taking as much money as you can here when in fact if you go back and look at our issuance history, the most -GOTO- 26:35 we had as management team was the fact that during that period we actually turned down capital because we didn’t believe the pre-payment rates and felt it was more risk from that perspective. So I think that's a good way to segue into that mindset that you wanted to describe at the beginning is that when you see these things, you have to judge them in the context of what is driving this and against the backdrop of $7 trillion worth of stimulus being put into the economy by a central bank, you still have house prices falling, generally across the country which means that tax revenues are dropping for municipalities, et cetera.

Those things have to weigh on the private sector in some way, shape or form that's GDP driven by the consumer.

Yes, there will be a point probably in the not too distant future where everybody in the mortgage market is wishing their assets would speed up.

Which brings me to the next question if I may and thank you for your time. In an environment where rates start to move higher, really the performance delta of specified tool versus a TBA security should whittle away or is that not the right way to –

Yes, the differential between specified tool pay ups change, it can change dramatically if it's not PBA deliverable, even though you paid two points up for it, you can deliver in to PBA in a sell off you will lose not only that 2.2 paid but you can also be trading back with PBA at that point.

I think that's a good insight Dan.

Yes, I appreciate that.

This discussion around leverages is interesting from a lot of different perspectives. I'm hoping you might be able to shed a little bit of light on the other side of the counter party situation within the repo market specifically, are there any changes or proposed changes that might come about that could alter the demand for repo lending on the part of the large banks whether that be Basil (ph) or this whole discussion around central clearing house and the like, do you see any issues as it relates to where banks would be on the other side of lending in the repo market.

I think the real development said you're going to see out of companies like us. It's going to be on the liability side of the business and I think we've made really good strides here that will be evident over the coming quarters about how we think about the liability side of the business.

Currently there is, let's just throw out the most argued about thing, let's talk about money market funds and the tri-party system which is under assault by the regulators, that keeps on coming up in newsletter items now that the Central Bank, the SEC are all concerned about how money market funds don’t break the buck and how they report and whether or not those issues are disclosed and how the collateral is held and actually how that collateral is now gone from a very diverse system. I can remember where there was six clearing banks that banks could use.

You're really down to two, Bony (ph) and JPM who have formidable balance sheets but there's a lot of concentration risk similar to what happened in 2008. That concentration risk that grew in AIG can be very damaging in terms of business decisions, et cetera.

So a lot of that money that turns around in the money market funds today goes into the repo markets, certainly we're at the long end of the liability curve but think about every small bank in the United States that has demand deposits that are earning zero right or maybe 10 basis points or 1 basis point, whatever they are paying you and they might lose their ability to transfer that capital into a tri-party. So now that's even going to grow into a larger base of too big to fail and clearing.

So I think that all of this regulation is kind of hung up in the political discussion about how to move the economy forward but I would say in the discussions that we've had with policy makers and regulators, the very least that you can think about is more disclosure and we think that there's plenty of that that's going to be asked for across the board from every company, this whole argument about how general GAAP accounting works versus non-GAAP account et cetera. That's focused in on your bank, how do you account for a debt that you had outstanding that today because it's been downgraded you could buy it back and as to your company's profits, those kinds of questions are all part of this group by regulators to try to use one measuring stick for entirely different sectors, whether it's mortgage rates or banks or securities deals et cetera, and I think that a lot of that is hung up right now because of the political situation and the gridlock in Washington but as soon as that starts to clear, either be dealt with or it will become clearer to the markets how it will be dealt with.

Certainly if a large bank in Europe blows up they are all linked. We are still a globally financial robust system in today's world but only because central banks are defending it.

Can you elaborate on any of the developments that you are expecting to see from Annaly on that is it relates to that corner?

I would say that you will see us develop the liability side of our balance sheet pretty strongly over the next couple of quarters and that’s where I'd like to leave that.

And then you remain very close to Washington in your comments about policy decisions that could basically have implications for the mortgage market? Are you inclined to think that they may do something around kind of some mass (inaudible) or something that would be kind of I guess struck like that by the market or are you look at it from the perspective of principle forgiveness and trying to accelerate that side of that sit.

Where do you think there is more likely move on the policy side?

Who's going to get the most votes.

Yes, how about if you are a student and we just keep your interest rates at 0%, just if you're 18 make sure you vote. There is definitely a mood of gridlock where the house is not going to pass anything that makes them look un accountable for the budget and I think that the administration is making it clear that they are going to try to keep the cookie jar open for everybody when at the end of the day all its done is continue to have this slow drain of a price deflation continuing to hit the markets which eventually shows up in the bank's balance sheets and I think the banks are definitely arguing that very strongly.

If you want to look at what's going on in the FHA, they are increasing fees, they are increasing insurance, but they're still underwriting loans in a 3% to 5% range, 10% range. Those kinds of underwriting standards on the residential side are only going to continue to make people maybe who should be renting go out and become buyers when they shouldn’t be buyers because they have long term interest for not they own house.

So we still have to get all that supply off and then demographically I think this is a very important thing to understand is that the baby boomers are going to be selling 30 million houses over the next few years, let's say the next 10 years as they consolidate and move into multi families or bank with their kids or have their kids move in with them and our population is only going to create 12 million new household formations. So you have that weighing on it as well as the price stagnation in housing.

All of that doesn’t add up to I think much of the policy action by Washington that can direct all of those different issues.

Well thank you very much. Thank you for joining us here today and I'd just like on a personal note, we'd like to thank all of the hundreds of people, literally I can't back to all of you, who have sent me such kind words, kept me in your thoughts and prayers.

I'm really grateful for that, my family is really grateful for it. We look forward to seeing you in the next quarter.