Annaly Capital Management Q3 2026 Earnings Call Transcript

Annaly Capital Management (NYSE:NLY) reported third-quarter financial results on Wednesday. The transcript from the company’s third-quarter earnings call has been provided below.

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Summary

Annaly Capital Management reported a negative 7.6% economic return for Q3 2026, with earnings available for distribution (EAD) at $0.80 per share, exceeding the dividend of $0.75 per share.

The company redeemed $443 million of Series I preferred stock and issued $757 million in common equity, aiming to maintain a conservative capital structure amidst volatile market conditions.

The agency portfolio decreased to $92 billion, while residential credit remained flat at $10.4 billion, and the MSR portfolio increased to $4.3 billion in market value.

Management highlighted the resilience of the U.S. economy, rising interest rates, and the strategic positioning of Annaly’s portfolios to navigate rate volatility and spread widening.

The future outlook is cautiously optimistic, with substantial liquidity available and a focus on capital preservation and dynamic allocation across agency, residential credit, and MSR businesses.

Full Transcript

OPERATOR

Thank you for standing by and welcome to the Annaly Capital Management third quarter 2026 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question and answer session. If you’d like to ask a question during this time, simply press star followed by the number one on your telephone keypad. If you would like to withdraw your question, again press star one. Thank you.

I’d now like to turn the call over to Shawn Kenzel, Director of Investor Relations. You may begin.

Shawn Kenzel (Director of Investor Relations)

Good morning and welcome to the third quarter 2026 earnings call for Annaly Capital Management. Please note that this call is being recorded. As a reminder, materials for today’s call are available on our website at www.annaly.com. Today’s call may include forward-looking statements which are subject to certain risks and uncertainties that could cause actual results to differ materially and refer to certain non-GAAP measures. Please see the notices in our earnings release for important information regarding forward-looking statements and non-GAAP measures.

Participants on this morning’s call include David Finkelstein, Chief Executive Officer and Co-Chief Investment Officer; Serena Wolfe, Chief Financial Officer; Mike Fannia, Co-Chief Investment Officer and Head of Residential Credit; V.S. Srinivasan, Head of Agency; and Ken Adler, Head of Mortgage Servicing Rights. And with that, I’ll turn the call over to David.

David Finkelstein (Chief Executive Officer & Co-Chief Investment Officer)

Thank you, Shawn. Good morning everyone and thanks for joining our Q3 earnings call. I’ll begin with an overview of the macro environment and our performance during the quarter and discuss each of our three investment businesses, finishing with our outlook. Serena will then provide a more detailed review of our financials, after which we’ll open the call up to Q&A. Now starting with the macro landscape, the U.S. economy remains resilient, supported by heavy AI investment and healthy consumption. The labor market is stable while inflation remains above the Fed’s target, driven in part by higher energy prices. The bond market faced a challenging third quarter with the 10-year Treasury yield rising 82 basis points to multi-decade highs. The sell-off accelerated following the Fed’s first rate hike since 2023, and markets are now pricing nearly three additional 25 basis point hikes through the end of next year.

Higher rates also reflected concerns around government debt, heavy corporate issuance and a repricing of the Fed’s neutral rate. Mortgage rates have accordingly reached 1.5%, a level during this cycle seen only briefly in the fall of 2023, and thus housing activity is likely to stay subdued as affordability challenges persist and the existing borrower lock-in effect continues to constrain turnover. Weaker demand could soften home prices, though supply and demand remain broadly balanced notwithstanding regional disparities, and underlying borrower credit remains fundamentally sound.

As upward pressure on rates intensified during the month of September, rate volatility rose significantly, with implied volatility measures reaching their highest levels since the administration’s initial tariff announcement a year and a half ago. This drove mortgage spreads wider and led to meaningful underperformance in agency MBS. Against this backdrop, our portfolio delivered a negative 7.6% economic return for the quarter. Earnings remained durable, however, with EAD of $0.80 per share again exceeding our dividend, while economic leverage ended Q3 modestly at 5.9 turns.

In capital markets, we announced the redemption of our $443 million Series I floating rate preferred stock during the third quarter, and the redemption helps us maintain a very conservative capital structure. We view balance sheet leverage as more attractive, particularly as repo financing remains readily available and terms for residential credit and MSR warehouse lines continue to improve. Relatedly, we issued $757 million in common equity on the quarter through our ATM program, with proceeds used both to fund the preferred redemption as well as to invest across our portfolios.

Now turning to our investment strategies and beginning with Agency: the sharp sell-off in rates led to meaningful extension across the MBS universe, particularly in the more negatively convex portions of the market. This created duration mismatches and contributed to selling pressure from some more highly levered investors late in the quarter, which exacerbated the volatility-driven MBS spread widening. While we are certainly not immune to mortgage underperformance, we were positioned for rate and spread volatility with conservative duration exposure and historically low leverage.

Heading into the quarter, our Agency portfolio decreased modestly to $92 billion in market value, representing 55% of the firm’s capital. Though we added approximately $2 billion notional in MBS on the quarter, activity focused on deploying a portion of our common equity raised into higher coupon specified pools, primarily five-and-a-halfs and sixes. This past quarter also demonstrated the value of our allocation of high-quality specified pools. On average, our pools are more than three and a half years seasoned and carry loan balances less than half those of new production, providing both call and extension protection.

As mortgage rates increased, pay-ups declined on call-protected pools as expected but increased on extension-protected pools. Given the distribution quality of our collateral, the average pay-up on our portfolio increased modestly over the quarter. Now, early in the fourth quarter, we monetized some of this outperformance, rotating over $2 billion in primarily seasoned pools into higher coupon TBAs, which stand to benefit more from a decline in volatility, something we have begun to see since the end of the third quarter.

On the liability side, as rates moved higher, we responded by adding to our hedge position, primarily in Treasury futures, to keep our overall interest rate exposure contained. We entered the fourth quarter with slightly more rate exposure, however, as current higher yields offer attractive value, and we’re also comfortable carrying somewhat more duration as the rise in rates materially reduced negative convexity in both our portfolio and the broader MBS universe and, as a result, asset durations should be less sensitive to further rate moves in the current environment, reducing the need for hedge rebalancing.

Moving to Residential Credit: our portfolio ended the third quarter roughly flat quarter over quarter at $10.4 billion in market value, representing 23% of the firm’s capital. Residential spreads traded in a tight range for the majority of Q3, with AAA non-QM spreads ending the quarter approximately 10 basis points wider, largely in sympathy with other securitized products. Our Onslow Bay correspondent channel delivered another strong quarter with $7 billion of lock volume and $5.8 billion of fundings, our highest quarterly funding volume since the channel’s inception more than five years ago.

And importantly, growth has not come at the expense of credit discipline, with our current locked pipeline carrying an average FICO of 766 and an average LTV of 67%. Now with respect to securitization, we settled $7.4 billion of transactions in Q3 while pricing an additional $2.2 billion in October. Annaly remains the market’s largest expanded credit sponsor, and we have now priced more than $21 billion securitizations in 2026 across 37 deals. And while the new issue market has experienced margin widening post quarter end, we’re encouraged by the resiliency of the private label market and expect 2026 to be a post-GFC record in transaction volume.

Now to discuss MSR: our portfolio increased to $4.3 billion market value, with our allocation to the sector representing 22% of the firm’s capital. We took a measured approach to purchases during the quarter, settling one bulk package for $140 million in market value, while our flow channel experienced just over $50 million in volume, a new quarterly high, as we continue to gain market share in the co-issue sector. Bulk supply in the market increased quarter over quarter and we expect it to stay robust throughout the balance of the year given current mortgage industry dynamics, as we’ve spoken about extensively over the past year, and this environment should provide ample opportunity to responsibly grow our portfolio here. To date, we remain the largest purchaser of bulk MSR, reflecting the value we bring to the origination community as a strategic partner with a deep permanent capital base.

MSR valuations modestly increased, with our multiple ending the quarter at 6.15 times, largely driven by higher interest rates and wider current coupon MBS spreads. Our prepayment speeds remained very low this past quarter, decreasing to 4.8 CPR, reflecting our portfolio’s low average note rate, seasonal factors and higher mortgage rates. Credit performance remains strong with serious delinquencies below 60 basis points, and along with healthy income from our escrow deposits, these factors support a predictable cash flow profile that continues to be a complement to our other investment strategies and an important contributor to our EAD.

Now turning to our outlook: mindful of uncertainty in the market, we entered the fourth quarter prudently positioned with substantial liquidity, and we remain focused on preserving capital while dynamically allocating across our three businesses as opportunities emerge. Within Agency, we continue to manage call and extension risk proactively as the rate outlook evolves. While current spread levels offer compelling new money returns in the mid to high teens and while elevated volatility persists, the outlook for Agency MBS is constructive as spreads have retraced the widest levels since before the GSEs began more actively increasing their portfolio in mid-2025. At the same time, the technical picture remains favorable with record bond fund inflows and continued support from the GSEs, overseas investors and banks, while supply is limited given seasonals and high primary mortgage rates.

In Residential Credit, our scaled Onslow Bay correspondent platform gives us direct access to high-quality whole loans, greater control over asset selection and supports one of the leading securitization programs across asset-backed finance. As the largest issuer of expanded credit MBS, we’re uniquely positioned to participate in the continued growth in the non-agency market, with non-QM issuance up nearly 60% year to date. The investments we have made across our platform over the past several years have supported expansion, operating efficiency and disciplined credit execution.

And lastly, in MSR, our differentiated portfolio of low note rate, high-quality assets continues to generate durable cash flows supported by our diversified network of servicing and recapture partnerships. And as demonstrated this year, we have the flexibility and capacity to grow the portfolio accretively, further enhancing our earnings and cash flow profile. Now collectively, our three complementary businesses provide multiple avenues to deploy capital efficiently without the burden of a high fixed cost origination model. We remain patient, but we have ample liquidity and balance sheet capacity to put capital to work. We believe the combination of diversified earnings, proprietary asset creation, conservative leverage and capital allocation flexibility positions Annaly well to continue delivering attractive risk-adjusted return.

Now with that, I’ll turn the call over to Serena to discuss our financials.

Serena Wolfe (Chief Financial Officer)

Thank you, David. Today I will briefly review the financial highlights for the quarter ended September 30, 2026. As in prior quarters, our earnings release discloses GAAP and non-GAAP earnings metrics, and my comments will focus on our non-GAAP EAD and related key performance metrics, which exclude PAA. As David noted, the challenging fixed income market environment weighed on book value during the third quarter. Our diversified housing finance platform nevertheless continued to generate solid earnings supported by higher coupon income, continued residential credit securitization activity, and lower operating expenses.

As of September 30, 2026, our book value per share decreased 11.4% from the prior quarter to $17.86, including our quarterly dividend of $0.75 per share. We generated an economic return of negative 7.6% for the quarter. Book value performance primarily reflected wider agency MBS spreads and the impact of elevated rate volatility, including market-driven duration and convexity effects. Gains on our hedging instruments provided meaningful offsets. Earnings available for distribution increased by $0.01 to $0.80 per share, again exceeded our full dividend of $0.75 per share.

The increase was driven primarily by higher coupon interest income on larger average investment securities and residential mortgage loan balances along with lower operating expenses. These benefits more than offset higher interest expense from increased securitization debt and repo balances as well as modestly higher funding rates. Net interest margin declined by 7 basis points to 1.69% while net interest spread declined by 8 basis points to 1.42%. Average asset yields were relatively stable at 5.45%. In comparison, our average economic cost of funds increased 7 basis points to 4.03%, primarily reflecting a greater proportion of securitized debt in our funding mix and slightly higher repo rates. We continue to actively manage the balance sheet through the market volatility.

Economic leverage increased to 5.9 times from 5.6 times, primarily reflecting the decline in equity, while our hedge ratio increased to 100% from 97% as we maintained our defensive positioning. Our weighted average repo rate increased 3 basis points to 3.87%, while weighted average repo days to maturity ended the quarter at 30 days, down three days from the prior quarter. Despite interest rate volatility in the third quarter, the repo funding market continued to function smoothly, ensuring reliable and efficient access to short-term financing for agency MBS. Meanwhile, we continue to maintain ample financing availability for our credit businesses to support their growth, which David highlighted earlier. Total warehouse capacity across our residential credit and MSR businesses remains $8.3 billion, including $2.8 billion of capacity.

We maintain significant available capacity with utilization rates of approximately 57% for residential credit and 50% for MSR. We ended the third quarter with $6.9 billion in unencumbered assets, including $4.2 billion in cash and unencumbered agency MBS. In addition, we had approximately $1.6 billion of MSR collateral pledged and available to support future advances subject to market advance rates. In total, we had approximately $8.5 billion of assets available for financing at quarter end, down approximately $1.1 billion from the prior quarter, primarily reflecting lower equity and reduced unencumbered agency MBS.

This represented approximately 54% of our total equity and continued to provide meaningful liquidity and financial flexibility. Finally, our OPEX to equity ratio decreased 11 basis points to 1.29% for the quarter, while the year-to-date ratio remained 1.34%. As anticipated, expenses moderated from the elevated second quarter level reflecting lower compensation and other G&A expenses. That concludes our remarks. We will now take questions. Thank you, operator.

OPERATOR

Thank you. We will now begin the question and answer session. If you would like to ask a question, please press star one on your telephone keypad. If you would like to withdraw your question, simply press star one again. Your first question comes from Bose George from KBW. Your line is open.

Bose George (Analyst at KBW)

Good morning. Can I start with just get an update on the mark-to-market book value?

David Finkelstein (Chief Executive Officer & Co-Chief Investment Officer)

Sure. Bose. Good morning. As of Friday, excluding the dividend accrual, we were up about 2%. Inclusive of the dividend, closer to 3% in a sideways sense.

Bose George (Analyst at KBW)

Great, thanks. And then just wanted to ask about dividend coverage, you know, just given the expectation for current economic returns, how does that compare, you know, with the required ROE to cover the dividend?

David Finkelstein (Chief Executive Officer & Co-Chief Investment Officer)

Sure. So obviously we outearned in Q3, we expect to outearn in Q4, and we’ll see how 2027 evolves. But as it stands today, we didn’t delever in Q3, notwithstanding the volatility, and the current portfolio delivers the dividend. And as we laid out our projected returns, which are up quarter over quarter, new money gets us there as well, so we’re comfortable with where the dividend is at today.

Bose George (Analyst at KBW)

Great, thanks. Thank you both.

OPERATOR

Your next question comes from the line of Crispin Love from Piper Sandler. Your line is open.

Crispin Love (Analyst at Piper Sandler)

Thank you. Good morning. David, on that last point, the market-level returns, as you showed on slide 7, looks like each strategy a little bit higher than last quarter. Can you discuss some of the dynamics there driving returns a little bit higher, and then also just where you’re most interested in adding incremental capital today in the macro environment? I do appreciate you got three businesses that you want to add, but maybe if you could stack.

Great, thank you.

David Finkelstein (Chief Executive Officer & Co-Chief Investment Officer)

Sure. So I’ll start with the end of your question on capital allocation, then we’ll go through each of the three businesses in terms of how the returns evolved heading into Q4. So in terms of capital allocation, it’s not much different than last quarter. Returns across the three businesses are incrementally higher. And as we did say last quarter, we still want to grow the residential credit business responsibly, considerate of credit. That’s at the margin where we’d like to grow.

And agency returns are ample and certainly compelling, and so that’d be second. And then MSR, we still have room to grow. Obviously those headline returns are a little bit lower than agency and resi, but one point to note is that that position is largely funded with capital, very little leverage. So we do have room to grow and maintain a 20% capital allocation to the sector. So the order is RESI first, close second agency, and then not far behind is MSR.

So let’s just talk about returns in each, and I’ll start with Srini on the agency and then go to Mike, then Ken.

V.S. Srinivasan (Head of Agency)

Sure, David. So basically, agency spreads for the quarter widened about 20 basis. Now when we say spreads widened by 20 basis points, we generally refer to current coupon spreads. And given that only finally six and a half are over par, we really can’t invest in current coupons. So we are slightly below current coupon. Call it five and a half and sixes is our preferred coupon. And for those compared to where current coupon was at the last quarter, spreads are about 10 basis points wider.

So that gets us to 15 to 17 basis points, or 100 basis points increase in prospective returns.

Mike Fania (Co-Chief Investment Officer and Head of Residential Credit)

Sure. Crispin, this is Mike on the RESI side. You know what those returns reflect to 13 to 16% first. It’ll reflect the equity that we’re retaining through our securitization. So call that, you know, 6 to 7 cents of capital on the retained OBX securities using, you know, maybe call it a turn of leverage. So we’ll retain, call it, you know, 10 to 12%. One turn of leverage gets you that 6 to 7 cents of deployment. You know, given spreads have widened, we’ve seen equity bases been able to widen as well.

And given the volatility we’re pricing in incremental premium, we can also earn mid-teens returns on just residential loans putting on non-mark-to-market facilities. Our non-mark-to-market facilities are very accretive in the current environment and, call it, maybe four to five turns of leverage. And this is, you know, non-mark-to-market, you’re calling it, you know, 15, 16%. And lastly, there is an opportunity to buy double-B non-QM bonds. So these are new issue third-party shelves.

Right now they trade, call it, 425 to swaps. You can use 20 to 25% haircuts on those. And the financing there is in the low 100s, so that would actually get you closer to that 16, 17%. So there’s a number of options at which we’d be able to get mid-teens or potentially a little bit above mid-teens.

Ken Adler (Head of Mortgage Servicing Rights)

Yeah. Hi and thanks. This is Ken. On the MSR front, the change in return from the prior quarter is largely driven by all rates, you know, rising and, you know, as capital is deployed that capital earns a higher rate of return. Additionally, with the MSR a bulk of the negative duration, certainly on the lower note rate collateral, is driven by the float income as we manage the borrowers’ escrow account. So as rates rise, we as the servicer earn a higher rate of return on those escrow balances.

And that applies to prospective investments. So those two items are really driving the change in prospective return quarter over quarter. Yeah.

David Finkelstein (Chief Executive Officer & Co-Chief Investment Officer)

And, Crispin, just to add to that point, we entered Q3 with about one and a quarter hikes priced into the market, and we ended the quarter and sit today with about four including the hike that occurred in September. So just that float income increase in income alone gets you a lot more yield.

Crispin Love (Analyst at Piper Sandler)

Great, thank you, that makes sense. And then just one last question for me just on the recent rate vol in the third quarter and then just a little bit of a change in the fourth quarter. Have you made any distinct changes to your hedging strategy in recent months? Recent weeks, especially as rates were rising? You have a little bit of a different environment in October, so just curious on a little bit of the change kind of second half of 3Q into October.

David Finkelstein (Chief Executive Officer & Co-Chief Investment Officer)

Yeah, look, as the market was selling off, we did dynamically hedge and we predominantly used the futures market to achieve that. And we entered Q4 with a relatively higher percentage of futures than we normally operate with. So heading into this quarter, our anticipation will be to find opportunities to convert some of those futures into swaps, which gives us a little bit more yield and keeps a good balance on our hedge profile. But generally speaking, over the last couple of weeks, we’ve been somewhat encouraged by vol subsiding to some extent.

You see it both in realized and implied vols somewhat, and so we’d like to think we’re out of the woods. We’re still very, very vigilant when it comes to our hedge profile and making sure that we’re managing the portfolio responsibly. When we look at the environment today and the level of rates, we understand why rates are higher. Obviously inflation is a big driver and we are in a hiking cycle, as shallow as that may end up being. Heavy debt issuance also. The economy has proven to be able to grow at higher rates and so the neutral rate is higher, and so we feel like the new normal is higher rates and so the floor on rates is, you know, is higher. But we do generally like the rates market.

We’re carrying a little bit of duration here and we think that’s appropriate given the attractiveness of rates, and we’re comfortable with the positioning.

Crispin Love (Analyst at Piper Sandler)

Great. Thanks for all the color, David.

David Finkelstein (Chief Executive Officer & Co-Chief Investment Officer)

Thank you.

OPERATOR

Crispin, your next question comes from the line of Doug Harter from BTIG. Your line is open.

Doug Harter (Analyst at BTIG)

Thanks and good morning. You guys put up a smaller decline in economic return than your peers. Clearly diversification helped that. But I was wondering if you could help us think how the agency portfolio performed this quarter as we try to compare that to peers.

David Finkelstein (Chief Executive Officer & Co-Chief Investment Officer)

Yeah, look, I think I have a Brief understanding of how others performed and I think the agency sector was largely pretty well clustered close to one another for the most part. I think my understanding is that folks were deliberate about managing duration exposure. And I’ll tell you something, Doug, you know, agency, it’s not that easy to differentiate an agency portfolio, which, you know, may not sound too, too attractive to agency monoline peers, but at the end of the day, there’s a lot of correlation amongst agency assets.

You can be up in coupon, down in coupon specs, TBAs, but you know, when the agency market cheapens, it tends to affect the entire sector and performance X, how you manage duration can be somewhat uniform. I think this quarter we were probably somewhat contextual with our agency portfolio. We probably how others perform because I think everybody was pretty responsible about navigating the rates market and hedging.

Doug Harter (Analyst at BTIG)

I appreciate that, David. And then on the residential credit you talked a little bit about some of the spread widening you’ve seen on new issue deals. Can you talk about whether there have been any kind of other structural changes or what the depth of the investor base looks like? You know, kind of as we’ve gone through this market?

Mike Fania (Co-Chief Investment Officer and Head of Residential Credit)

Doug, this is Mike. I would say at the top of the capital stack, you know we ended Q2, call it 130 over the curve. That’s the Treasuries. At the end of Q3 we’re probably 10 basis points wider. Call it 140. We just priced our latest deal, our latest transaction post quarter end non-QM 16 that was done at 150. We have seen other AAA sponsors and other shelves, you know, probably price, call it, 5 to 15 basis points. I do think reflecting the strength of the OBX name, you know, the programmatic nature of the platform and then also the performance as well.

So I do think we’re still firmly in that kind of tier one category and we’re benefiting from that. In terms of structural changes, you know what we have seen, it’s been fairly modest, right? So the deals that have been coming maybe low 7% gross WAC, low to mid 7% gross WAC. The current coupon within non-QM right now, the 102.5 rate, is probably closer to 8%. So these deals are modestly out of the money. What the market has really demanded as a concession to be able to move the risk is that the AAA bond, which traditionally is pro rata with the AA and the single A, has turned into a full sequential.

So it’s a fairly modest change. The BBB down, the M1 and down, has always been a sequential pay. So you’re really changing the structure, the waterfall, of two bonds, and then what you’re seeing is those AA and those single A bonds, because instead of being pro rata and factoring down, they become sequential pay in the initial period before the call. So very modest changes. But I would say that the market is still healthy. The market is very resilient. We’ve seen 95 billion of non-QM issuance this year. Last year the entire year was 80 billion. You know, 45% of all issuance we’ve seen in non-agency has been within the non-QM market. So haven’t really seen any change in terms of investor depth and it’s a slight structural change to be able to absorb modestly out of the money transactions.

Doug Harter (Analyst at BTIG)

Great, appreciate that, Mike.

Mike Fania (Co-Chief Investment Officer and Head of Residential Credit)

Thank you, Doug.

OPERATOR

Your next question comes from a line of Jason Stewart from Compass Point. Your line is open.

Jason Stewart (Analyst at Compass Point)

Hey, good morning. We noticed a decent uptick in home equity securitization volume. Just maybe if you could talk, Mike, about the two sides there, how you’re approaching sizing that as an asset and then how the market is pricing those liabilities today.

Mike Fania (Co-Chief Investment Officer and Head of Residential Credit)

Sure, thanks. Thanks, Jason. So I mean, you know, home equity, we’ll classify that as both, you know, HELOCs and closed-end seconds. We’ve seen in terms of total issuance, right in, you know, the size of the market, you know, we’ve seen about 220 billion of issuance within the non-agency market. About 15% of that has been closed-end seconds and HELOCs, it’s around 33 billion. In terms of our production and what we really focus on, you know, it’s probably, call it, 5 to 6% of our production that we see through the correspondent. You know, we are active predominantly in, you know, full documentation HELOCs and closed-end seconds. We’ve talked about that before. There’s a small kind of niche market within the alternative doc, but really the focus continues to be on non-QM and DSCR. A lot of it is scalability, a lot of it is our competitive advantages are within non-QM and DSCR.

Those seconds and HELOCs, they trade at very large premiums. Even to be able to aggregate them through a correspondent, you need to be willing to pay 106, 107 type dollar prices. So that is something where we’ve been a little bit more conservative than the rest of the market. But in terms of the distribution securitization market, you know, similar to non-QM, it’s very healthy. It’s not the same size but I will say that it’s, you know, we continue to see transactions, we continue to see deals.

If you call AAA non-QM right now for tier 1 issuers, if we call that 150 to 155, I would say for tier 1 closed-end second issuers, it’s probably 5 to 10 basis points inside of non-QM. And part of that is that the market does believe it’s a better convexity profile. But in terms of our strategy, we’ll continue to buy those assets but I think we’re probably a little bit more conservative in terms of our scenario analysis analytics and our willing to pay premiums.

But market is open, it’s healthy and I would say maybe call it 5 to 10 basis points inside the non-QM AAA market right now. Okay, that’s helpful.

Jason Stewart (Analyst at Compass Point)

Thank you.

Mike Fania (Co-Chief Investment Officer and Head of Residential Credit)

Thanks, Jason.

OPERATOR

Your next question comes from a line of Marissa Lobo from UBS. Your line is open.

Marissa Lobo (Analyst at UBS)

Thanks and good morning. Just on MSRs, historically, you know, MSRs have provided you a natural offset to the negative convexity in agency MBS. But as we’re seeing that mortgage universe become more fully extended and the convexity profile improving, how are you thinking about the role of MSRs in the portfolio today? And should we think about them more as a standalone return opportunity or do they continue to provide more diversification across rate scenarios?

Ken Adler (Head of Mortgage Servicing Rights)

Hey, this is Ken. Thanks for the question. I would answer as both. The standalone return is certainly ample and, you know, we talked about that earlier. In terms of the hedging properties beyond the gamma, the convexity sort of hedging, there’s another form of hedging that’s going on and that’s model hedging. You know, we use prepayment models to measure our duration, convexities and other risk measures. To the extent prepayment speeds for some other reason come in faster or slower than the model, you know, MSR provides a direct hedge to the portfolio.

Consider if speeds come in slower than expected, that’s always good for MSR and that’s in today’s market, with the mortgage universe at a discount, just not good for the agency MBS portfolio. So there’s this model error that’s being hedged through the MSR.

David Finkelstein (Chief Executive Officer & Co-Chief Investment Officer)

One more point, Marissa, I’ll say is, in following up on Ken’s point, that to the extent that the mortgage market’s at a reasonable discount like it is, and turnover is actually lower than natural turnover or what should be the case, then the MSR portfolio is going to hedge that as well. And as I talked about a moment ago, in terms of float income, it’s a hedge for short rates. Higher short rates increase the float income and MSR benefits from that as well.

So there’s still a very productive balancing component to the MSR portfolio in the current environment. I would also add that away from models and all of that, MBS has been trading directionally with rates. So when rates sell off, MBS spreads have been under pressure. And what we have observed over the last three years is when rates sell off, MSR actually trades very, very well, so from a pure mark-to-market trading perspective, it does provide cushioning on book value moves.

Marissa Lobo (Analyst at UBS)

Okay, great, thank you. And then just shifting to residential credit and thinking about home price appreciation, you know, can you talk to your home price outlook and is flat HPA manageable? And, you know, what are the assumptions that are underlying that 13 to 16% residential credit return?

Mike Fania (Co-Chief Investment Officer and Head of Residential Credit)

So thanks, Marissa. I’ll address the second part of it, the 13 to 16%. Again, that’s mostly the OBX platform. It’s non-QM and DSCR. I will say that, you know, that’s modeled to, call it, maybe a 20% lifetime speed, which is generally where non-QM has come in. In terms of cumulative losses, that probably represents close to 75 basis points of cumulative loss in terms of what our projections are. So there’s significant room for upside. If you look at the totality of our securitization program, we’ve issued I think close to 67 billion life to date.

The actual amount of realized losses we have taken inside the trust is around 6 million. So it’s been less than 1 basis point. So one of the areas where we’ve outperformed our initial expectations has been within credit modeling. We do expect to take, you know, more losses, and lifetime losses on a lot of non-QM, DSCR maybe closer to 10 to 15 basis points as they season. But it just shows you that there is a level of conservatism in terms of those projections.

In terms of, you know, the housing market, you know, a lot of it will depend upon what mortgage rates do and where mortgage rates ultimately settle. If we stay at 7 and 3/8 to 7.5% for an extended period of time, we do believe, you know, housing can go negative. It can go negative by, you know, a couple points nationally. So a lot of it is dependent upon, you know, mortgage rates. You know, in terms of, you know, where we sit today, what we would say, you know, the modestly bullish case for housing is still positive.

You know, September was up 8 basis points month over month. It’s up 1% year over year. If you look at, you know, zip code level, 77% have positive year-over-year increases. There’s a significant amount of homeowner equity, you know, call it 35 to 40 trillion, depending upon what you think the size of the market is. The average borrower is locked into a 4.65% rate. Inventory is still 15% below, you know, 2019 and new listings, which is reflecting that mortgage rate, they haven’t really increased.

It’s only up 1 to 2%. You know the caution, and this is what a lot of people are seeing now, and you know we do have a level of conservatism in terms of just not only our purchase assumptions but also the quality of the portfolio. As Dave mentioned, the Southeast is very weak. Texas, Florida, you see the public builders talking about competing with resale. Months’ supply is at a ten-year high and a 7 and 3/8 mortgage payment. That mortgage payment is up 6 to 7% just over the last quarter relative to Q3.

And everyone knows the, you know, the affordability issues that we have. Right. So if we stay at these rates, yeah, we do think it could go down, you know, 2 to 3, you know, 3 to 4%.

Marissa Lobo (Analyst at UBS)

But manageable within the—yes, yeah, I guess within the equity cushion that you’ve—

Mike Fania (Co-Chief Investment Officer and Head of Residential Credit)

Yeah, it’s very manageable. Dave mentioned in the script, you know our average borrower has close to 400k of equity. It’s a 64 mark-to-market LTV. And our portfolio, the D60+ of our portfolio right now is 160 basis points. And we are predominantly targeting upper middle class borrowers. Right. So it is not necessarily, you know, this first-time homebuyer, it is not necessarily the borrower who has been challenged with their discretionary income in this inflationary environment.

So I think from that perspective we feel pretty good about the strategy.

David Finkelstein (Chief Executive Officer & Co-Chief Investment Officer)

And Marissa, there’s also very little layered risk in the portfolio so we can manage and wouldn’t even mind seeing HPA, home prices, come down a little bit to increase the affordability equation and get turnover up.

Marissa Lobo (Analyst at UBS)

Thank you very much.

OPERATOR

Your next question comes from Rick Shane from JPMorgan. Your line is open.

Rick Shane (Analyst at JPMorgan)

Good morning everybody and thanks for taking my questions. There’ve been a lot of great questions this morning. So just wanted to talk a little bit. I mean empirically it’s one thing to understand what’s going on in MSR, but there are, I would describe, a lot of exogenous factors that are impacting, potentially impacting valuation, you know, mortgage volumes, industry capacity, potentially the impact of AI affecting speeds. I am curious when we think about again sort of your empirical models and then overlay all of these different structural things that are happening in mortgage right now.

How is that impacting value, pricing, demand and you know where you see attractive opportunity within MSR.

David Finkelstein (Chief Executive Officer & Co-Chief Investment Officer)

Thanks for the question. And those are certainly things we’re thinking about actually all night. Look, I mean the mortgage industry is in a place because of consolidation, because of technology, you know, where people are operating much more efficiently and are operating at much lower profit margin. So because the efficiency that’s priced in, because there’s overcapacity, because there’s technology, because there’s consolidation, it’s tough to decouple.

All the reasons the profitability of the origination part of the business is very low. And the value of a newly created MSR today is somewhere depending on the loan type, between, you know, a point and a point and a half. And the profitability of the mortgage industry, you know, is substantially lower than that. And on average, when you look at the MBA numbers is, you know, in the 20 basis point range now. And since they’ve been measuring it, on average is in the 40 basis point range.

So originators are just forced to sell MSR going forward, in our view. So if loan production picks up, they have to sell MSR because they’re not making as much money. Historically, when volumes picked up, margins picked up and they picked up because of the shortage of capacity that occurred. We think because of technology that won’t occur anymore. So as a result, there’ll be lots of MSR selling if volumes pick up because the profitability will not increase on a per unit basis, allowing more MSR retention.

And then we think if origination volumes don’t pick up, what we’re seeing is capitulation, consolidation, needs for liquidity to keep the platforms going until profitability might increase. And that’s creating MSR selling as well. So we just see a continual restructuring of how the industry worked. Folks without a cost of capital like ours or better are not really going to be able to hold MSR and they’re still holding a lot of legacy MSR and then, go forward, the new MSR, we have a tough time seeing how they’ll be able to retain that. And I think when you look at the MSR transfer data that’s public, you’ll see who the sellers are, the bulk sellers are, and you’ll see this thesis kind of playing out already.

V.S. Srinivasan (Head of Agency)

Yeah, Rick, I’ll jump in here and just talk about the demand side and valuation. The market, the bid for MSR is somewhat bifurcated. You have folks like us, capital participants in the market that have obviously accumulated a lot of MSR. And you also have banks, which, particularly given the likelihood of MSR not being a constraint when it comes to the Basel III proposal, which we expect to get out the final within the next couple of months, banks have been a strong source of demand, particularly in lower loan balance type MSR that carry a lot of escrow balances relative to the capital committed.

And so they’ve been a significant bid. As we talked about last quarter, we sold into the bank bid at levels that we thought were quite attractive. And then folks like us, you know, we benefited from all the liquidity that’s been generated with the activity in the MSR market and have traded quite a bit of MSR and we still have a fair amount of appetite to add MSR and as do other … our portfolio companies. So we understand the market pricing. We still think it’s fair. When there’s a rich bid out there, we’ll sell MSRs, as we’ve evidenced very recently.

And I think from a portfolio standpoint, we’re positioned conservatively and our pricing on our portfolio is probably the most conservative in the industry.

Rick Shane (Analyst at JPMorgan)

Well, look, I appreciate the answer and it’s an interesting thing. I think 25 years ago we wrote something that said the pro cyclicality of margins would start to erode because of technology. And it feels like we’re finally on the cusp of that. And I do think that there’s probably no industry that’s financial services industry that’s going to be more transformed by AI than mortgage. So it’s a really interesting time and I do appreciate your insights.

David Finkelstein (Chief Executive Officer & Co-Chief Investment Officer)

Thank you. Rick.

OPERATOR

Your next question comes from Jason Weaver from JonesTrading. Your line is open.

Jason Weaver (Analyst at JonesTrading)

Good morning. Thanks for taking my question. So first, hey Dave, since the beginning of the year, we’ve thought of the GSEs as showing a stabilizing bid behind the MBS spreads. And I don’t think we’ve seen any data since August. But do you have any sense as to the extent they’ve been involved or stepped away from purchases over the past several weeks?

David Finkelstein (Chief Executive Officer & Co-Chief Investment Officer)

Yeah, look, everything’s anecdotal subsequent to August because we don’t have that data either. It did appear as though the activity was a little bit slow in the summer. But anecdotally, you know, we have heard that they have been involved in the market and I think, you know, you even got a tweet out of the FHFA Director in September talking about the GSEs buying and some adjective to describe a considerable quantity of MSR. So our understanding is that they probably are, they still do have a fair amount of dry powder.

I think at last look at the end of August, total capacity under the PSPA caps for loans and MBS was like 140 billion. They do still have to keep a lot of dry powder for loan buyouts and things like that, but our understanding is that they still have some ammunition left.

Jason Weaver (Analyst at JonesTrading)

Got it. Thanks for that. And second, I think you mentioned layering into some higher coupon TBAs in your prepared remarks and I wonder if you could talk just a bit about how you see the risk reward in current coupon production where, you know, a sharp uptick in prepayments could occur under a flight to quality.

V.S. Srinivasan (Head of Agency)

Sure. I mean before we go there, I just want to define where higher coupon is. We refer to Fannie 5.5s and 6s as higher coupon. Now 6.5 float is quite small. We’re going to start getting more issuance in 6.5 in the coming months. Higher LLBs and 6s are preferred to TBA right now and at this point the only coupon that’s trading at a premium dollar price is 6.5. So most of the TBAs we bought were 5.5s and 6s. In terms of prepayments we think TBA, particularly in production coupon, continues to deteriorate at an accelerating pace because more and more collateral is being carved out into specified pools and so what is left for TBA is significantly more negatively convex. So after coupon stack we generally don’t like being in TBA for very long. We obviously, when we want to add mortgage exposure we typically do it in TBA and then over time swap it into pools.

So right now we’re not worried about our TBAs in five and a halves and sixes mainly because they’re discounts. But at some point, particularly for 6s, we will swap them into specified pools.

Jason Weaver (Analyst at JonesTrading)

Got it. That’s great color, Srini. I appreciate it. Thanks guys.

V.S. Srinivasan (Head of Agency)

You bet. Thank you.

OPERATOR

Your next question comes from Kenneth Lee from RBC Capital Markets. Your line is open.

Kenneth Lee (Analyst at RBC Capital Markets)

Hey, good morning and thanks for taking my question. Just at a higher level, curious as to how you would characterize your overall risk appetite just given the current rate outlook and the potential trade-off between market volume and return opportunities as you see across the various asset categories. Thanks.

David Finkelstein (Chief Executive Officer & Co-Chief Investment Officer)

Yeah, thanks Ken. Good question. So look, we’re reasonably optimistic on the outlook here. Rates are higher. We do think there’s somewhat of a ceiling to rates. I think when you look at the level of interest rates, it’s obviously being driven by strong growth and inflation and there’s some real costs associated with these high rate levels. Obviously the AI sector is continuing to borrow and continuing to invest, but the rest of the economy to some extent is being crowded out. That’s households, corporates, and it’s becoming more expensive for government to issue debt.

So we feel like there’s limit how high rates can go. But there’s also a new floor on the level of rates given we are, as I spoke about, in this new normal environment. So what that says to us or suggests to us is that vol should come down. And it has to some extent. As we started the fourth quarter, we’ve reset and our view is that things are going to stabilize or continue to stabilize and you will see implied vols coming down because realized vols are a little bit lower.

So that gives us a little more optimism in terms of our appetite for risk. And I think the position is to a large extent reflecting that we let our leverage organically increase this past quarter. We didn’t delever. We did delever the capital structure a little bit on the pref side. And I’ll just tell you a little bit about that because that was really about capital structure and leverage optimization. You know, when we issued pref a year ago, we issued it at 8.7% and agency spreads were 18% to 19% or thereabouts. So the spread on that was about 1,000 basis points.

And then you fast forward to when we made the decision to reduce our structural leverage, which was right after earnings I believe. And at that time we had floating rate pref outstanding and we’d gone from two cuts priced into the market over the prior year to four hikes. And so the cost of that increased to around 10%. Meanwhile, agency spreads were relatively tight at that time and levered returns, as we spoke about on the last call, were as low as 14% to 15%.

So that spread compressed quite a bit. We reduced capital structure leverage and we felt good about it. And then you fast forward and the market cheapened again obviously to get closer to the higher teens return. So here we are again and things look pretty appealing from that standpoint. And we’re comfortable with our leverage. We have a little capacity to increase it tactically but we’re generating the returns we need with current leverage. And should spreads tighten, I think we show in our spread shocks for 25 basis point tightening, it’s just over 10% return from that. So we’re in a position where we like to be and we’re comfortable with the risk in the market. We think vol will continue to come down and we’ll be back in business like we were prior to the episode of vol in the late summer.

Kenneth Lee (Analyst at RBC Capital Markets)

Great. Very helpful color there. That’s all I had. Thanks again.

David Finkelstein (Chief Executive Officer & Co-Chief Investment Officer)

Thank you, Ken.

OPERATOR

Your final question comes from Trevor Cranston from Citizens JMP. Your line is open.

Trevor Cranston (Analyst at Citizens JMP)

Thanks. Question on the non-QM market, obviously it’s less rate sensitive in general than the conventional space. But curious your outlook on how, you know, the increase in rates, particularly if mortgage rates hold up here, how that impacts the non-QM space and what your outlook is for origination volumes there going forward compared to where they’ve been the last couple of quarters. Thanks.

Mike Fania (Co-Chief Investment Officer and Head of Residential Credit)

Thanks for the question, Trevor. In terms of non-QM origination this year, we still think it’s probably going to be, call it, 150 to 175 billion. I would say it’s probably leaning toward the higher end of that range. In terms of total mortgage origination, maybe we’ll call it 1.9 trillion to 2 trillion. So we do think it’ll continue to be around, call it, 8% to 9% of the entire market. The reason that non-QM is still an elevated percentage of originations — a lot of it is just because mortgage rates are elevated.

It is a purchase market, right. And non-QM is targeting a lot of investors, right? So over 50% of this market is investor. Investors right now are about 20% of all real estate purchases, which is a higher share. So we are getting a higher percentage of the end borrower at this point. And also, to your point, self-employed borrowers are a little bit more inelastic at these levels of rates. So I don’t know if the share itself will grow. I think a lot of what you’ve seen over the last number of years has been maturation, but originators at this point pretty much to a T have rolled out the product. It’s still higher gross margins than the conforming market, than the government market. And it’s a product that originators need to have to be able to serve their brokers or serve their LOs on the retail side.

So I would expect it to continue to be 8% to 9% of originations at this point. If the market rallies and the mortgage rate is at six, six and a quarter, that percentage is going to shrink exponentially because you’re going to see a lot of rate-and-term refinance of government and conventional. So the share is outsized a lot just because it is a purchase market. This market does target the purchase borrower, high investor share. And, you know, there’s not a lot of rate-and-term and cash-out at this point.

Trevor Cranston (Analyst at Citizens JMP)

Yeah. Okay. That’s helpful. Thank you.

OPERATOR

Thank you, Trevor. And that concludes our question and answer session. I will now turn the call back over to CEO David Finkelstein for closing remarks.

David Finkelstein (Chief Executive Officer & Co-Chief Investment Officer)

Thank you. And thank you, everybody, for joining us. We’ll talk to you soon.

OPERATOR

This concludes today’s conference call. Thank you for your participation. You may now disconnect.

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