Annaly Capital Management, Inc.

Wellington Denahan – Chairman and CEO Kathryn Fagan – CFO

Aaron Siganevich – Evercore Joel Houck – Wells Fargo Securities, Llc Daniel Furtado – Jefferies Mike Widner – KBW

Thank you, Andrew. Welcome everyone to our Q2 2013 earnings call.

Joining me on the call today will be Kathryn Fagan our CFO. This past quarter the free market had to contend with the potential reality of being less than their own to determine the proper risk reward balance, while relying on models that have been processing distorted data.

Nonetheless, I applaud our FED Chairman for attempting to win the financial markets from easy money policy before he heads for the exits himself. And seeking precedent for the rate move over the last quarter, we can look to the extremes of the 80s to our comparable percentage change in rate when the 10-year rose 66% from 9.5% to 15.8% in about 450 days.

The current 66% move took a mere 70 days. As I have mentioned many times in these calls, the pricing distortions caused by Fed policy would be difficult to staff and therefore require caution in managing our portfolio and our business.

Over the last several quarters we have continued to position ourselves to react to the expected uncertainty. We have increased liquidity by operating with lower leverage.

Protected capital by maintaining large interest rate swap positions and we do start overall exposure to the effects of large-scale asset purchases by reallocating capital into less interest-sensitive strategies to our expansion into commercial assets. With this volatility comes opportunity.

Investment spreads have improved market leads. Risk has been more properly priced and demand for high quality collateral in the funding markets remains robust.

Regardless of the economic data, or who is the next Fed Chairman, it seems that Fed needs to reduce its purchases or risk becoming an even greater share of the market as both treasury issuance and mortgage production decreases. As long-term investors in these markets, we welcome the return to a more normalized spread environment and remind investors that over the last 16 years as a public company, the vast majority of the more than 500% return delivered to shareholders has come from spread income.

Before I open it up for questions, I’d like to go over few key data points from the release in our earnings supplement. The change in book value of $2.16 was largely comprised of $1.40 from changes in mark-to-market inclusive of our hedges and $0.66 from mark-to-market loss on pay downs received during the quarter.

During the quarter, we brought leverage down from 6.6 to 6.2 times. Absent changes in mark-to-market the leverage would have been approximately 5.5.

On page six of our earnings supplement, in light of the recent volatility, we provide a simple illustration of how asset collection coupled with leverage impact potential book value moving – moved going forward. And I’ll go to that slide now and just have a discussion.

We present on that slide, just a quick snapshot of 30-year coupon stacks versus 15-year coupon stack and we show the relative price change given rate moves. And you will see that a lot will depend on what you choose in either one of those stacks and the impact that will have on your price change.

Arms are great example of seemingly low duration assets that can also experience some heightened volatility. The next chart that we really – I’d like to highlight is a presentation of the effects that allocating capital into the commercial space will do to the long-term stability and profile of the company.

As we said out early on that we would do our 25% of our assets in other than agency security. This chart just shows as you start that allocation, not only does your overall corporate leverage come down, but the unit of return per unit of the leverage continues to rise.

And with that, I will open it up for questions.

Thanks. You highlighted some, potentially strong returns in the agency market, yet leverage in this pull down, so, it seems you indicate yourself acting somewhat cautiously in this environment.

What would make you feel a little bit more offensive and start to put a little bit more money to work to take advantage of those higher returns?

One thing we would like to see, the Fed has mentioned that it wants to exit the market in some way. And I will qualify that by saying Fed is not going to sell.

Fed is going to stop buying – there is numbers out there that whether it’s $10 billion mortgages each month left that they purchase initially and $10 billion in treasuries. The composition of the market is such that, depending on the assumptions you make on prepayments and what is happening on the physical front that, the impacts of what their exit may not be as dramatic as the last quarter’s sell-off would suggest.

And so we’d like to see them kind of lay out their plan and maybe get a better sense, we have the other big caveat out there that you don’t know whether you have a Bernanke clone or you have a Washington insider as the next Chairman of the Fed. So the nice thing about our leverage position is you can easily leverage back up.

I think the market should understand that we have actively brought it down. We sold $32 billion in the last couple of quarters, yet pulling that income forward in the form of gain, but it was an active decision on our part.

You also still have regulation out there and potential disclosures out there. And so, it’s very easy and I know I’ve said this many times, it’s very easy to purchase after and it’s very easy to bring leverage back up.

Now that, 14% to 18% is new money type returns. I just don’t think that this is the time to go ahead and say, the coast is all clear, let’s go ahead and put on the gas.

Keeping in mind too we, as we ramp the commercial assets, we are looking at a pretty robust pipeline there. We expect to have roughly $2 billion on the books by year end.

We expect to affect our first securitization in the fourth quarter with those assets. And so, that is cash-on-cash return that – they are impacts by interest rate changes are somewhat – not I won’t say immune, but there is more stability associated with that.

Make no mistake about it, the mortgage market is going through a transitional period. And whether Fannie and Freddie’s earnings get them a more permanent seat at the table with position or a lot of these – there is a lot of things that still need to be answered.

Thanks. That’s helpful and on the commercial strategy, I guess, you comment about doing a securitization, you intend to add kind of a level of leverage not additional repo or anything against that.

Do you expect to leverage those investments? And just to be clear, you said 25% of equity or 25% of assets that you feel comfortable with?

No, our charter allows 25% of assets. We have laid out roughly 25% of the equity.

And on the leverage, would you intend to lever up some of this commercial…

You know what, we could lever up between one or two, but again, it’s not our intention to utilize recourse liabilities against those assets. We do originate the entire debt stack and we will securitize and retain the bottom parts.

Understood, thank you.

Sure.

Thanks and good morning.

Hi, Joe.

Appreciate the disclosures again this quarter, it’s very helpful.

Sure.

Can you talk about, July, did you guys take any further action in terms of defensively positioning the portfolio? Obviously, July 5 was very disruptive in terms of price discovery.

Right.

Now things have kind of – at least relative to June 30 are kind of back to where we were. So there has been no change during the month, but there has been a lot about.

So can you talk about what you guys actually did in the month of July?

Once again, it was a blanket statement, I would say as we are actively trying to continue to reduce the overall levered duration of the portfolio and the levered risk of the portfolio. And with that, there are shifts and it shows that simple 30 year and 15 year price volatility chart and so there is shifts that we have done within those asset buckets.

And coupled with that, is leverage and as we continue to bring credit on to the books with commercial assets, you have to strike a balance between the mortgage position which provides tremendous amount of liquidity that other commercial players don’t necessarily have and it allows us to be an incredibly quick mover and responsive on transaction. So, keeping all of that in mind and balancing the two risks, we continue to try and strengthen the durability of the book value that’s allocated to the agency position.

So just bringing lower duration assets on trying to reduce some of the spread duration lengthening some of our swap positions. So you see we do have a large zero to three year bucket that is at above market rates that we extinguish some of that stuff and move it out on the curve.

And so, hopefully, that answers your question.

Yeah, maybe, that’s good, and maybe, Wellington, if you wouldn’t mind talking about – given some historical context in terms of the mortgage spread obviously basis risk of something investors have to live with in these particularly with agency REITs. And also your perspective on the risks of spread widening between now and kind of when we get to the new Fed Chairperson whoever that is.

Yeah, I mean, historically, the relationship has been interest rate drives, spread tighten to the curve. With the distortion, I’ll call it, that the Fed has introduced into the market by their asset purchases, you have a tremendous amount of negative convexity in the market that is a typical.

But the recent activity has rendered the market I think a bit more normalized yet, they haven’t left yet. So, I don’t want to throw a blanket.

When it was just Fannie and Freddie as the big participants, it was a different kind of relationship with the market. They were economically driven and so, you did have a response to spread widening as REITs, really there was a fairly quick response, whereas this time, and we still have to deal with the potential policy impacts from a new FHFA Chairman.

So, I would say there is potentially more spread widening to take place, although I think we’ve seen a fair amount of it.

All right. Thanks for the comments, Wellington.

Sure.

Good morning Wellington. Kathryn.

Thank you. Hi, thanks for the opportunity.

I just had a couple kind of maybe, slightly outside the strike zone questions here. The first is, I am kind of surprised with the diversification plan, we haven’t seen any non-agency RMBS come on the balance sheet.

Can you just talk around your strategy there in terms of, maybe you just not find this an attractive market or waiting for prices to settle or just kind of a higher level strategy there.

Yeah, no, I mean, it’s – we have an interesting situation where we do have a large public company that does participate directly in that market. And they have been active participants in that market.

If there are things outside of what they can do, we certainly have the wherewithal to go ahead and take advantage of that. And I’ll leave it at that.

Understood, thank you. And then, my favorite conspiracy theory surrounding FIDCA of Shannon Funding.

I am just curious, are you originating home loans out of Shannon during the second quarter?

We have not, but we have the ability to.

And eventually your plan to do so, is that how to think about that opportunity?

Yes.

Okay, and then if I may, just one more on that. Would this be predominantly a conforming or a jumbo type of strategy?

It would probably primarily a jumbo strategy.

Understood, thank you for the opportunity, Wellington.

Thanks, Dan.

Hey guys. Thanks for taking my questions this morning.

How are you doing Rick?

I’d love to sort of talk through two things here following up on Joel’s question, but also relating it to capital allocation. You guys have basically made the comment that OA assets normalized but I think implicit in your comment is that even though basically that reflects rational expectation as the taper begins, that’s already reflected in pricing, you think that you could see some additional spread widening.

Is your decision to shrink the balance sheet, but not to buy back stock during the quarter basically, positioning you for a view that spreads are going to widen over the next three to six months and you are going to have the opportunity to put that capital to work?

Yes, yes.

Okay, and so that’s really why you guys, because if I look at it on a pure – where you are trading versus book, where you are in terms of leverage, what the near term ROE is, it would have made of sense to buy back stock this quarter.

It would make some, I mean, I think, it’s a delicate issue not only with liquidity but also with the original program that we put out there as we wanted to reduce our exposure to the impacts of Fed policy and not having the commercial option on the balance sheet and not having great options in the agency space, the best thing to do at that time was to reduce our overall exposure to the market. With the markets becoming much more attractive at the prospects of not only the Fed exiting, potentially exiting the scene, but also with the commercials coming on and having seen the impacts of the flexibility of our balance sheet and its ability to deliver for borrowers that the best option is not necessarily to buy back stock.

Okay. Hey, Wellington, there is actually something really interesting occurred to me as you were saying that, which is that, is this service say that your expectation of how long QE3 was going to last has compressed significantly since you announced the buyback.

Not necessarily. No, not necessarily.

I think, the buyback was – we hadn’t had the CreXus on the table. And, the long-term impacts of adding assets at the levels that were in the market and the risks associated with it warranted reducing the size of the company.

I would say, it’s nice to see that the market understands that it’s not just a one way market anymore. And the Fed, I would remind you, the Fed hasn’t done anything yet.

Yet we had a significant repricing from the lows and yields. That’s not to say we won’t go back there, but it’s nice to see that you can get a more disciplined approach by mortgage investors in the market.

Okay, great. Thank you very much.

Did answer your question Rick?

It did and I guess in some ways when I think – in concluding this, and I know, that you guys were concerned how the exit would – how long it would take to see an exit and how that would play out and I think the conclusion is that it is better than feared.

Yeah, I mean, I agree, I do think though, if you just take the economic data for example, it wouldn’t necessarily and there are thresholds in particular whether it’s unemployment or inflation. It wouldn’t necessarily warrant a hasty exit from policy.

I think, with them laying it out as agile and not a lever would suggest that they understand and want to communicate. But they are also concerned about the relative position on the normal functioning of the market and I think they’ve been fairly verbal and clear about that.

And I agree with them. Yet, even as they tape, their impacts will still be fairly large.

So, I know I invoke the 80s here, but I don’t think you are going to see anything like that.

Fair enough. I’m sadly enough to remember the 80s as well.

Thanks guys.

Thank you.

Hey, good morning. Most of my questions have been answered already.

But, I guess, just the broad question, the environmental volatility is probably here for a while and I guess, a few questions are, one of the reasons you guys had kind of run fairly defensively in low leverage kind of all along was, your anticipation that the market was sort was in an unnatural place because of the Fed, but – so, when kind of some of that started to unwind, I guess, some of us just started to hope that your defensiveness would result in the performance of book value holding up somewhat better. And so, I guess, maybe the broad question is, are you surprised by, not only what happened but, how difficult that was to sort of protect against both through a combination of hedges which you took up as well as leverage which you took down.

And how much confidence do you have that, given that what we just went through was a little bit of a learning experience. But it was unpleasant for book, but I mean, do you have any more confidence that you can hedge better if things or protect book better I should say, if things continue along this path, which as maybe rates go up another 100 basis points or maybe they come down 100 basis points.

All right. No, I mean, as a mortgage investor for a long time, I am not surprised by any of this and I’ve said, year in year to – on these calls and to investors individually that mortgages start somewhat of a pan in the – to deal with, and quite frankly that’s the way it is.

One thing I will say or – if I just look at our book value move over the last two quarters, relative to moves of everyone else in the space, our move comes in lower than the average for the stake. So, leverage does matter.

And the flexibility that it provides you from a number of fronts whether from your creditor, from regulators looking at it. It’s just, there is a number of things that has to go into trying to protect book.

The other thing I would say is, there is no perfect mix of protection and if you overly protect book, you don’t have any earnings. And so, trying to strike a balance between the two is really the ongoing challenge of mortgage investors.

So, I look back on the earnings of the company and what we delivered to shareholders and if you pull up the chart, you see most of it if not all of it has generally come from spread income and so, if you protect book and you – or you actually have a gain in book and the REIT you pay it out. And so, your biggest long-term commitment to shareholders is that dividend.

And trying to make sure that, book doesn’t deteriorate to the point where you can’t provide that dividend going forward, but also you have to allow for a certain amount of flexibility and volatility in book as a mortgage investor.

No, that certainly makes sense, yeah both as an analyst and I am sure as a portfolio manager, I agree with the fact that mortgages can be attained in the end as you put it. I guess my other question related to that is I go to the table on page 19 in your presentation, you show the interest rate sensitivity.

Right.

I know all the caveats and sure, we all know all the caveats that a pair of a shift in all that. But, as I look at the 75 – the bottom-line of the table, the 75 basis point move, it suggests that book value is, I don’t know, I mean, roughly about the same exposures we had before.

So, I guess I am just struggling with, we’ve heard different comments from different REITs over the past month or so. Some are really taking it more defensive and kind of getting negative or zero duration gaps and then certainly from this it would imply that, that’s not where you are heading.

Well, the thing is, one thing I will say is, you don’t get anywhere without giving up something. And so, we are actively trying – this is a snapshot as of June 30.

There is no question we are actively trying to reduce our exposure to further volatility keeping in mind the technical and fundamental backdrop that we are dealing with. I think the market was contending with this idea that they are not going to have this long-term participant and the Fed is going to get serious irrespective of economic data about introducing a tapering.

So, you saw a lot of the impacts of that. We will actively try and reduce this risk as we continue to rebound the portfolio.

There is no question that, this is a snapshot at period end and this what we are showing the market, but we are actively trying to bring these exposures down while balancing your ability to earn a dividend.

Thanks. I definitely appreciate the comments and yeah, absolutely a difficult market with historically high volatility and trying to hedge out mortgage.

Yeah, like I say, there is so many of them and every market is different. So, it’s not like you can say this is like ‘94, this is like 2003, they are all different.

Yeah, by 2013, can you assume now we’ll be talking about that?

Exactly.

All right, thank you very much.

Thank you. If there is no further questions, Andrew, we’ll wrap up the call and I just want to say, thanks to the team here at Annaly who has done a tremendous job during a very volatile time and we look forward to speaking to you on the third quarter earnings call.

Thank you.