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spk07: Good morning and welcome to the first quarter 2022 Anna Lee Capital Management Earnings Conference Call. Today, all participants will be in a listen-only mode. Should you need any assistance during today's call, please signal for a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask your question, you may press star then one on your telephone keypad. To withdraw your question, please press star, then two. Please note that today's event is being recorded. Now, I would like to turn the conference over to Sean Kensal, Director, Investor Relations. Please go ahead, sir.
spk05: Good morning, and welcome to the first quarter 2022 earnings call for Annali Capital Management. Any forward-looking statements made during today's call are subject to certain risks and uncertainties, including with respect to COVID-19 impacts. which are outlined in the risk factors section in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the disclaimer in our earnings release in addition to our quarterly and annual filings. Additionally, the content of this conference call may contain time-sensitive information that is accurate only as of the date hereof. We do not undertake and specifically disclaim any obligation to update or revise this information. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our earnings release. As a reminder, Annalie routinely posts important information for investors on the company's website, www.annalie.com. Content referenced in today's call can be found in our first quarter 2022 investor presentation and first quarter 2022 financial supplement, both found under the presentation section of our website. Annalie intends to use our webpage as a means of disclosing material, non-public information, for complying with the company's disclosure obligations under Regulation FD, and to post and update investor presentations and similar materials on a regular basis. Please also note this event is being recorded. Participants on this morning's call include David Finkelstein, President and Chief Executive Officer, Serena Wolf, Chief Financial Officer, Ilker Ertoff, Chief Investment Officer, and Mike Fania, Head of Residential Credit. And with that, I'll turn the call over to David.
spk09: Thank you, Sean. Good morning, everyone, and thanks for joining us on our first quarter earnings call. Today, I'll review the macro backdrop and how it impacted our performance during the quarter, and then I'd like to discuss the sale of our middle market lending portfolio and the transaction's implications for our capital allocation and our broader strategic direction. Ilker will then provide more detailed commentary on our portfolio activity And then Serena will go over our financial results. Although growth slowed in the first quarter relative to last year, the U.S. economy remains robust. The strength in inflation in the labor market has demonstrated that the Federal Reserve needs to remove monetary policy accommodation much faster than previously anticipated. This led to a sharp repricing of fixed income assets, with the aggregate U.S. bond market index facing the worst quarterly performance since 1980. Consistent with the broader market, Annalise Portfolio was vulnerable to the exceptional volatility in this environment, despite our efforts to defensively position our portfolio, experiencing an economic return of negative 12%, with a reduction in total portfolio size of roughly $5 billion, to end the quarter at $84.4 billion in total assets. Returning to the macro landscape, inflation continued to rise during the first quarter, with headline CPI reaching 8.5% in March, driven by a sharp rise in commodity prices. Now, even outside of commodities and food, inflation pressures remain elevated and broad-based, as seen, for example, in the Federal Reserve Bank of Dallas' estimate that only 10% of PCE components are currently witnessing annualized inflation below 2%. The labor market, however, has arguably been the bigger driver of the Fed's hawkish shift. The employment picture has recovered significantly, with the unemployment rate falling 1.1% over six months to 3.6% in March. Consequently, the demand for labor remains extremely strong, creating the risk that employers will have to pay even higher wages to attract workers, which could trigger a wage price spiral. The combination of these two developments, high inflation and tight labor markets, have demonstrated the need for much more aggressive monetary policy tightening, As Fed officials have signaled expeditious rate hikes in coming months, overnight index swaps suggest the Fed will deliver a total of 250 basis points of hikes in 2022, compared to expectations of just three 25 basis point increases back in January. And 100 basis points of hikes are likely to come in the second quarter alone. Now, this repricing of Fed expectations led to a meaningful sell-off in Treasury rates, where two-year yields rose 160 basis points during the quarter, marking the most severe quarterly sell-off in nearly 40 years. The long end of the yield curve fared somewhat better, with 10-year notes rising just over 80 basis points, leading to a substantial yield curve flattening during the quarter. Given the rate sell-off, as well as concerning geopolitical developments that include the Russian invasion of Ukraine, Interest rate volatility, particularly in short and medium term tenors, rose to the highest realized levels since the financial crisis. And as Ilker will discuss in further detail, the volatile rate environment weighed heavily on mortgages, with production coupon nominal spreads widening 40 basis points on the quarter. Agency MBS spreads are now attractive, and we are comfortable maintaining our current agency portfolio at prevailing spread levels. but we remain considerate of heightened interest rate volatility as well as the supply outlook in light of imminent Fed portfolio runoff. Now, specifically with respect to the Fed's balance sheet, the March FOMC meeting minutes provided the market with a general framework for the second iteration of quantitative tightening. For one, runoff will be significantly faster, with the Fed planning to retire up to $95 billion in assets per month, nearly twice the aggregate cap seen during the 2017-19 period. In addition, caps will be phased in more quickly than last time. We currently expect an announcement at the May FOMC meeting next week and fully ramped declines starting three months later. Runoff is likely to last for multiple years as current Federal Reserve security holdings have resulted in excess liquidity within the financial system best seen in the $1.8 trillion of cash pledged to the Fed's reverse repo facility. Using current runoff parameters, the Fed would have to shrink its balance sheet for roughly 18 months before reserves equivalent to these excess cash balances are extinguished. And also to note, although markets continue to discuss the potential for MBS sales, Fed official communication has indicated runoff will be, quote, predictable and running in the background. suggesting that sales will be on the back burner for the next several quarters. While accelerating runoff, MBS sales from the Fed's portfolio would further deteriorate and elevate its supply outlook, risk excessive tightening of financial conditions, and could be difficult to implement effectively. Now, with that said, let's turn to our recent strategic activity. We are pleased to have announced the sale of our middle market lending portfolio to ARIES this past Monday, The $2.4 billion transaction, inclusive of our on-balance sheet portfolio, as well as assets managed for third parties, follows the completion of a highly competitive process that is expected to be accretive to book value and validates the quality of our differentiated corporate credit portfolio. While the middle market lending portfolio has been a source of complimentary returns, it was an opportunistic time to pursue a transaction given the relative valuation ascribed to middle market assets in the current environment. As broader fixed income markets have come under pressure, middle market lending was one of the few areas of the market that commanded a premium while attracting a significant amount of new capital. Accordingly, the sale provided an efficient way to monetize a less liquid non-core business and an attractive valuation and redeploy over a billion dollars in capital into cheaper assets in our core strategies. We expect to close the deal by the end of the second quarter following customary closing conditions. and we believe ARIES is a clear strategic fit for the assets going forward. Finally, turning to our long-term strategy, the MML sale furthers our natural progression towards becoming a dedicated housing finance REIT. Combined with the sale of our commercial real estate business last year, the transaction moves annually closer to the vision we laid out when I stepped into the role of CEO two years ago. As a relative value investor, our permanent capital base allows us to increase our exposure to lower levered, less liquid assets with a premium return, which serves to enhance the durability and quality of our earnings. Accordingly, we expect to expand our capital allocation and non-agency mortgage finance over the long term and solidify our role as a market leader within the MSR and non-agency residential credit sectors. Annaleigh is well positioned to leverage operational synergies across these businesses, which we expect to provide a unique advantage in these high barriers to entry, more operationally intensive businesses. Regarding our MSR business specifically, we expect it will grow to represent a greater steady state capital allocation than the approximately 10% guideline we have discussed in the past. Following the removal of MML's assets from our capital allocation framework, we will be able to devote more capital to MSR while still maintaining our high liquidity and risk management standards. The increased emphasis on MSR is further informed by both the attractiveness of the asset class within our portfolio, as well as the more rapid pace of establishment of our platform in the market. We've grown the asset base by more than five times over the past year and ended the quarter as a top 10 secondary market purchaser of MSR. And as noted on previous calls, the sector remains highly active due to consistent disposition of MSR by the originator community, given reduced profitability, a trend we see likely to persist. Coupled with wider spreads, we expect MSR to remain a vehicle for growth that should improve our overall returns and book value stability over the long term. Additionally, we expect to build on momentum within our residential credit group, which recently surpassed over $1 billion in closed loans through our correspondent channel. With the opportunity to further scale both our securities and whole loan portfolio, we are poised to take advantage of substantial opportunity across residential credit, where private capital is primed to play an even greater role. While the sector grows to post-global financial crisis highs, Annalie continues to broaden its presence, as demonstrated by Onslow Bay becoming the second largest non-bank issuer of Prime Jumbo and expanded credit MBS. As we further increase our products, partnerships, and resources, we're well prepared to capitalize on organic as well as external growth opportunities throughout the marketplace. Now, ultimately, following our MML disposition, Annalia is positioned for its next phase of growth with a scaled and diversified portfolio backed by three distinct but complementary businesses. The power of Annalie's capital allocation framework lies in our ability to calibrate our investments based on where we are in the cycle, as seen through the relative growth of our agency and residential credit assets in recent years. Looking ahead, I'm excited for Annalie's future as we continue to develop our housing finance capabilities, propelled by strong tailwinds within MSR and residential credit, while taking advantage of a more attractive reinvestment landscape for our core agency business. And now with that, I'll hand it over to Ilker to provide a more detailed overview of our portfolio activity for the quarter and outlook for each sector.
spk04: Thank you, David. As you discussed, the first quarter was characterized by challenging macroeconomic outlook that led to extreme volatility in fixed income markets. Mortgages underperformed significantly given the added headwinds of historically high levels of net supply and speculation about asset sales from the Federal Reserve. Normal spreads widened roughly 40 basis points and the primary mortgage rate increased by over 150 basis points, marking one of the sharpest backups in the history of the mortgage market. With respect to how we managed our portfolio in this environment, We began the year with our leverage at its lowest level since 2014 and maintained a stable notional exposure to MBS throughout the quarter. Within the portfolio, however, we actively managed our hedges and rebalanced our coupon exposure to better position ourselves considering three key market themes. First, there was disparate performance across mortgage stack. Mortgages that were being produced underperformed lower coupons, which were largely locked up in Fed and bank portfolios and therefore more insulated from the consistent selling pressure driven by elevated origination volumes. We used this opportunity to shift up in coupon, selling roughly 7.5 billion lower coupons, predominantly twos and moving into higher coupons. Second, as mortgage rates sharply sold off, prepaid dynamics in the market changed rapidly. With mortgage rates at roughly 5% at quarter end, only a small fraction of borrowers maintain an incentive to refinance their mortgages. At the same time, cash-out activity should remain somewhat elevated due to the recent strong housing market and summer seasonals. As a result, the convexity of our mortgage portfolio improved meaningfully. Speed slowed 22% quarter over quarter, with the aggregate portfolio paying 16.7 CPR in Q1. In addition, we believe our specified portfolio remains well positioned for a discount environment due to around four years of average seasonings, roughly 60% of our pools being low loan balance, and weighted average coupon on our portfolio being 50 basis points higher than the 30-year mortgage universe. Lastly, as production shifted into higher coupons, the TBA deliverable in higher coupons shifted from seasoned, faster-paying pools to new production resulting in collateral scarcity and meaningful growth specialness in these coupons. While this specialness will not last in perpetuity, we expect to continue to shift up in coupon while preferring TBA over pools, given the favorable carry and spread dynamics. In terms of hedges, we entered the quarter conservatively positioned with our portfolio nearly fully hedged. However, as interest rates increased, We added hedges throughout the quarter across treasury futures and interest rate swaps, with most of our activity concentrated in the intermediate part of the curve to help protect against expansion in our portfolio. This contributed to an increase in our hedge ratio with the notional balance of our hedges to the balance of our liabilities, increasing by 14 percentage points to 109%. We ended the quarter with over 70% of our hedges concentrated around 7-10 year point, which has been beneficial as intermediate and long-run rates have continued to rise to start the second quarter. Looking forward, we will remain disciplined managing our duration given the elevated volatility, uncertainty in the macro environment, and tighter financial conditions as FED continues to normalize monetary policy. Turning to MSR. The market was extraordinarily active, with traded volumes nearly reaching levels seen in the full year 2020 in the first quarter alone. We used this opportunity to grow our portfolio through net purchases of over 400 million in market value. Combined with mark-to-market gains, we increased our MSR position by 91% to over 1.2 billion. Mortgage originators continue to be active sellers as operating profitability has come under pressure from rising mortgage rates. We continue to see MSR as a complementary to our agency strategy due to its negative interest rate and mortgage spread duration and attractive unlevered returns which remain in the high single digits. And we expect to continue to grow our allocation to MSR in coming quarters should market conditions remain favorable. In residential credit, our economic portfolio ended the quarter with $4.4 billion of assets with the capital contribution closing at $2.1 billion. The modest decline in the portfolio was primarily driven by our robust securitization activity as we converted whole loans to OBX securities. The residential credit market was not immune to the volatility in the broader rates and credit markets, with key benchmark asset classes establishing their widest levels since the onset of the pandemic two years ago. AAA non-QM spreads widened 75 basis points to 175 to the curve, while investment-grade CRT M2s widened 160 basis points, ending the quarter at 325 basis points. Credit spreads have subsequently tightened post-quarter end with AAA non-QM and CRT M2s 40 and 25 basis points tighter, respectively. Despite the challenging environment, our OBX platform had its most active quarter to date, with 2.5 billion of whole loans securitized across six transactions. Our commitment and discipline to being a programmatic issuer has allowed us to lock in financing on 87% of our whole loan portfolio at an average cost of funds of 2.3%, approximately 240 basis points below the current market cost of funds. The recent sell-off has incentivized originators to expand product offering beyond agency mortgages into alternative credit products, and we expect this to have a positive impact on the development of the non-QM market over time. We continue to dedicate resources to the growth of our correspondent loan channel while also expanding our securitization partners. Also to note, this year's volatility has led to increasing number of smaller originators turning to our correspondent channel given the certainty of execution, which we have ample liquidity to accommodate. Housing fundamentals remain strong with healthy consumer balance sheets, a systematic shortage of single-family housing, low available for sale inventory, and a robust labor market. While there are increasing headwinds, namely around the higher mortgage rates and affordability, we continue to expect to allocate incremental capital to the residential credit sector. While thus far 2022 has proved to be one of the most difficult periods for mortgage investors in recent memory, the outlook for agency and BS has improved significantly. As David alluded to, spreads are materially wider compared to recent historical averages, convexity has improved, funding markets remain robust, and there is more clarity on Fed outlook as they have effectively laid out their plan for the balance sheet reduction. And we believe these dynamics result in an attractive investment environment for Agency MBS. And while Agency MBS is currently a placeholder for capital return through the middle market disposition, looking further out the horizon and as market conditions warrant, we will continue to strategically grow our MSR and residential businesses as we further diversify across housing finance. With that, I will hand it over to Serena to discuss the financials.
spk08: Thank you, Ilka, and good morning, everyone. Today, I'll provide brief financial highlights for the quarter ended March 31, 2022, and discuss select quarter-to-date metrics. Consistent with prior quarters, while our earnings release discloses GAAP and non-GAAP earnings metrics, my comments will focus on our non-GAAP EAD and related key performance metrics, which exclude PAA. As David and Ilka have touched on, Q1 was a challenging quarter for economic return given the extreme volatility in fixed income markets. Notwithstanding this challenging market environment, we continue to deliver solid earnings and ample coverage, approximately 125% of our dividend. To set the stage with some summary information, our book value per share was $6.77 for Q1, and we generated earnings available for distribution per share of 28 cents. Book value decreased by $1.20 for the quarter, primarily due to lower other comprehensive income of $3.4 billion, or $2.34 per share, on higher rates and spread widening, and the related declining valuations on our agency positions, as well as the common and preferred dividend declarations of $349 million, or $0.24 per share, partially offset by GAAP's net income of $2 billion, or $1.37 per share. Consistent with the prior quarter, our multifaceted hedging strategy supported book value, providing a partial offset to the agency declines due to the basis widening mentioned above. with swaps, futures, and MSR valuations contributing $1.98 per share to the book value during the quarter. MSR valuations alone were 12 cents per share higher in the quarter than in Q4 2021. Combining our book value performance with our first quarter dividend of 22 cents, our quarterly economic return was negative 12.3%. Diving deeper into the GAAP results, as I noted above, we generated GAAP net income for Q1 of $2 billion, or $1.37 per common share net of preferred dividends, up from GAAP's net income of $418 million or $0.27 per common share in the prior quarter. The most significant drivers of higher GAAP income for the quarter were the unrealized gains on derivatives of $1.6 billion in comparison to unrealized gains of $135 million in Q4. GAAP net income also benefited from higher net interest income of $581 million compared to $361 million in Q4 2021. primarily due to premium accretion of $25 million compared to premium amortization of $219 million in Q4 2021 due to lower CPR, and higher net servicing income of $31 million compared to $27 million in Q4 2021 on higher average balances of MSRs. As I mentioned earlier, the portfolio generated strong income with EAD per share at $0.28, consistent with Q4 earnings. We have in recent quarters communicated that we anticipate earnings to moderate, which we still foresee, though we continue to expect earnings to sufficiently cover the dividend for the near term, all things equal. Average yields to XPAA remain relatively consistent with prior quarter at 2.62%, down one basis point in comparison to the prior quarter. However, higher dollar roll income continues to contribute significantly to EAD, reaching another record level at 128.4 million. EAD also benefited from higher MSR net servicing income associated with the growth of the MSR portfolio. These increases were offset by higher interest expense of $75 million compared to $62 million in Q4, primarily as a result of higher average securitized debt and repo balances, as well as higher rates, higher net swaps expense of $63 million compared to $59 million in Q4 2021 on higher average notional balances and higher G&A in the first quarter, due to timing of payroll taxes and other compensation items. The portfolio generated 204 basis points of NIMX PIA, up one basis point from Q4, driven by the higher TBA dollar roll income yield that surpassed higher economic interest expense. Net interest spread does not include dollar roll income, and therefore was down 15 basis points and 1.73% compared to 1231.21, due to a higher cost of funds. Now turning to our financing. Funding markets continue to function well with liquidity for agency MBS robust throughout the quarter as ample reserves and strong demand kept overnight levels trading on top of SOFA. Following the Fed's rate list stop in March, markets continue to reprice the increased pace of Fed hikes and the possibility of balance sheet reduction. Considering these factors, we maintained a disciplined approach in our overall liability portfolio, opportunistically extending funding on our agency and non-agency securities this past quarter. where the economics made sense. This positioning increased our weighted average days to maturity for our repo book, ending the quarter at 68 days versus 52 days in the prior quarter. And we will continue to evaluate term premiums in funding markets as we get more clarity from the Fed throughout the year and position our weighted average days to maturity accordingly. The upward trend in interest rates along with higher swap rates impacted our overall cost of funds for the quarter. rising by 14 basis points to 89 basis points in Q1. And our average repo rate for the quarter was 20 basis points compared to 16 basis points in the prior quarter. Our activity in the securitization market also impacted funding costs, increasing the weighting of securitizations on the composition of cost of funds, along with higher effective rates of 2.27% compared to 2.06%, resulting in an increase of seven basis points to cost of funds overall. Finally, swaps had an impact of four basis points to interest expense due to higher swap notionals, partially offset by lower average net rates during the quarter. Additionally, to further enhance the firm's overall liquidity profile, we continue to focus on securing financing facilities and structures for our growing resi loan and MSR businesses, including a new $250 million facility for our residential credit group subsequent to quarter end. Moving now to our operating expenses, efficiency ratios worsen during the quarter due to increased compensation expenses in Q1, one-time items that are not considered run rates, and the impact of degradation and equity on the computation of the ratio. The recently announced disposition of our MML business should have an impact on expenses, as we ought to derive cost savings from this transaction in the long term, and therefore expect to see an improvement in efficiency ratios in future periods. The sale of MML assets is also expected to be executed at a price above the current carrying value. And as such, book value will benefit in the range of two to three cents per share upon the completion of this deal. And in closing, Annalie maintains an abundant liquidity profile with $7.2 billion of unencumbered assets down from the prior quarter at $9.3 billion, including cash and unencumbered agency MBS of approximately $4 billion. Much of the reduction in unencumbered agency securities was due to pressure on valuations and increased leverage on credit assets, partially offset by increased unencumbered MSR. Now that concludes our prepared remarks, and operator, we can now open it up to Q&A.
spk07: We will now begin the question and answer session. As a reminder, to ask a question, you may press star, then one on your telephone keypad. If you are using a speakerphone, please pick up your handset before pressing the keys. If you would like to withdraw your question, please press star, then two. At this time, we will pause momentarily to assemble our roster. Today's first question comes from Rick Shane with JP Morgan. Please proceed.
spk11: Hey, guys. Thanks for taking my question this morning. And now that you're selling the middle market business, I'm not necessarily sure I have that much to ask. That seems to be my routine question. I do want to delve a little into Serena's comment related to, dividend coverage in the near term. That's helpful context. I'd love to get your thoughts longer term about what the opportunity is and your confidence around the dividend. When we look at things, obviously we're looking at the margin expansion opportunity, but the trade-off there being potentially less specialists on the roles. And I'm just curious if you roll out further how you think about dividend coverage.
spk09: Sure. Good morning, Rick. So look, as we've said in the past, you know, we set the dividend. based on what we think is an appropriate level, consistent with our historical yield, and competitive in the market. And we always look at it with our board quarter by quarter. We have out-earned the dividend really since the second quarter of 2020 post-COVID. I think we've ranged between 27 and 30 cents in terms of earnings available for distribution. Coming into this year, we did think that EAD would be a touch lower in the first quarter. but with dollar roll income increasing and a couple of other areas that benefited earnings, we matched that last quarter. You know, 28 cents going forward, we continue to think that it's going to moderate towards the dividend this coming quarter. We're going to well cover it, although 28 is certainly ambitious. And how we think about it over the long run is we have to assess what the returns are across the businesses, what the capital allocation is, and determine what we think to be a level that we can consistently earn out the horizon. Right now, we feel good about our dividend. The returns on agencies, as both Ilker and I discussed, have increased a fair amount. We're in the low to mid teens in terms of levered returns on agencies, and so we feel good about that. But the Fed is raising rates out the horizon. It's a little bit difficult to predict exactly how earnings are going to evolve, but we feel good about it right now. Great.
spk11: So, and again, just to sort of be clear about this, there's no implication about some specific concern. It's just a reflection of the uncertainty you're willing to sort of make a near-term call, but given the what's sort of an unprecedented environment, less certain further out.
spk09: Yeah. Yeah. And you're speaking with respect to the fact that we're out earning the dividend, um, right now and what our intention is, why we're being conservative with the dividend. Is that your question?
spk11: That's exactly it.
spk09: Yeah. And look, I think, as I've said, we do think that the, that earnings available for distribution will moderate towards the dividend, uh, but we're comfortable that we're going to out earn it, you know, in Q2, for example. But, uh, We do think that when we look at the forwards, EAD will moderate. Great. Terrific. Thank you, guys. You bet, Rick.
spk07: The next question comes from Bose George with KBW. Please proceed.
spk06: Just in terms of returns, so you mentioned low to mid-teens on agencies. Can you just talk about how that compares to credit and And also just in the returns on the MSR, you know, what's the returns on the invested capital there?
spk04: Sure. So, yeah, agencies are, as we said, close to the mid-teens, low to mid-teens, as David said. And, in fact, like if you look at the headline numbers, it will be higher than that. But, like, this is an environment that you need to be hedging a little bit more and then you need to pay more hedging costs. So let's call it low to mid-teens on agencies. And on the residential credit, it will be very similar, low to mid-teens, because it also widened. And in terms of MSR, as you know, we always evaluate MSR on an unlevered basis. And unlevered returns are very high singles right now.
spk06: Okay, great. Thanks. And then can you just give an update on your book value quarter to date?
spk09: Sure, sure. So it's been a little bit of a volatile start to the quarter. Rates are up 30 to 50 basis points across the curve, and mortgages are about 10 to 12 wider. I'm a little hesitant to put an exact pin in inches, given that things are moving around, but it's off roughly, you know, mid to upper single digits on the quarter thus far. But things, mortgages have found their footing, it seems like, this week, and we've got two months left to go in the quarter.
spk06: Okay, great. Thanks a lot.
spk09: You bet, Boze.
spk07: The next question comes from Eric Hagan with BTIG. Please proceed.
spk01: Hey, thanks. Good morning. Maybe just one on the market to start. How much connectivity do you guys see between higher Fed funds and mortgage spreads? In other words, we know that there's this tight connection between the Fed securities portfolio and mortgage spreads, but do you see a strong linkage between Fed funds and spreads, or is there anything specific in this tightening cycle that could change that relationship.
spk04: Hi, Eric. That's an excellent question. So the way that we look at it, it's not the level of Fed funds, but how fast it's raising, namely the velocity of the Fed funds. So this velocity affects the yield curve and overall monetary tightness in the system. And these two channels, it has indirect but very strong effect on MBS valuations and MBS spreads. Having said that, when we look at the market today, curve is inverted in the forward space, and mortgage spreads are close to the historical whites with the exception of like a funding problem days. So one would think that most of these things have been priced in, and that's what we believe right now. But that's a very good observation. So this time around, It's how fast it's raising, but it seems like market is already prepared for, for example, coming 50 and another 50. So most of that velocity has been priced in.
spk09: Eric, I'll just add one thing to note. Really, since the onset of COVID and the intervention by the Fed, markets have been very fast at pricing in the eventual policy into markets. And you saw that in the first quarter. The yield curve is inverted one year forward between twos and tens. We're like negative 15 basis points, and mortgage spreads are obviously quite a bit wider, so it does feel like the market's done an effective job of pricing in a considerable amount of policy tightening.
spk01: That's really helpful, guys. Thank you. One on the portfolio, just what kind of ratio – I think you mentioned this in your prepared remarks, but maybe some more color. The ratio that you see yourselves being comfortable with between pass-throughs financed with repo and then TBA is financed with the role. And then when you reinvest the capital from the middle market portfolio, if nothing else changes, where do you see yourselves kind of leaning with respect to that breakdown?
spk04: Yeah, again, Eric, as you know, we have been like elevated on TBA levels and we think in the short run, we will still be a little bit elevated on the TBA levels because the production coupon TBAs are very, very special. But you can see us going more into pulls down the road. But we will still be maintaining, let's call it 20% TBA type thing. We are getting the more long-run average on that. But in the short term, we will be a little bit heavier on the TBA side.
spk09: Yeah. And Eric, we're not constrained by, you know, limits on TBAs versus pools in light of the fact that there's ample liquidity in the market and financing while the Fed is tightening policy still remains quite ample. And so, you know, really it's a pure relative value play between TBAs and pools and whatever offers the best value. There's always limits with respect to being a REIT and the like, but we have ample latitude within those two buckets. And then on your question on overall capital allocation post-MML, in my prepared remarks, I did discuss the fact that we will expect to increase our MSR position over time. And, you know, the way we look at it with the three buckets, three verticals between agency, resi credit, and MSR, we would like to get better balance over the long term into residential credit and MSR and reduce our exposure to agency. But we're not in a hurry to do that by any stretch. In fact, if you fast forward this quarter, you will see the capital allocation to agency modestly higher with the return of that capital. Agency serves as a good placeholder. And then episodically, we'll reallocate into both the MSR and residential credit. But we're in no rush. We'll be patient and we'll invest as we see it appropriate.
spk01: That's helpful. Thank you guys very much. Good talking to you, Eric.
spk07: The next question comes from Kenneth Lee with RBC Capital Markets. please proceed.
spk12: Hi, good morning, and thanks for taking my question. Wondering if you could just share with us your thoughts about how funding costs are trending in the near term and consequently implications for investment spreads.
spk09: Sure, I'll start. And Serena, feel free to jump in here. But in spite of the volatility in short rates, funding costs on a spread basis have actually been rather stable. So if you look out the curve and, you know, in the front end of the curve, out to three months versus OIS, you can term for, you know, two to four basis points or thereabouts on top of OIS, and then it spreads out to about five to seven basis points on top of OIS out the curve. So there's still a considerable amount of liquidity in financing markets. Rates are volatile, but spreads have been reasonably consistent. And Ilker, did you have anything to add there?
spk04: Actually, David, as you said, funding is available. It spreads to the software curve and OS curve at very attractive levels. And this was our point, as you and I have been discussing. That's why MBS looks very, very attractive right now. These kind of MBS valuations only happens when there's extreme stress in the funding markets and lack of balance sheet. When funding markets are this stable, I have never seen MBS this wide in nominal spreads.
spk08: And Ken, thanks for your question. When we're looking forward with regards to cost of funds and agency repo rates, our expectations are that agency repo rates will be about 20 basis points higher for the second quarter. So you should think about that when you think about our cost of funds as well.
spk12: Great, very helpful there. And one follow-up, if I may, just wondering if you could just talk a little bit more about some of the growth opportunities around the Prime Jumbo expanded credit MBS assets.
spk00: Sure, thanks, Ken. You know, Prime Jumbo, I'll say that we have a number of strategic partners that we've utilized over the past year, year and a half. We don't necessarily take balance sheet risk with Prime Jumbo. A lot of that is that our cost of capital and our cost of funds is inferior to banks, and we don't really feel as if we have any real competitive advantage. However, we're a very active and large buyer of the subordinate securities, and we do have a fee structure in place that makes economic sense for us to issue those deals with our partners. On the expanded credit non-QM side, we feel very strongly that that market will continue to have solid origination activity. I think if you look at the top four banks, they're down 30% origination volume in Q1. We do think non-QM will be more stable in terms of origination volumes. About 60% of that market is purchase money. About 25% of the market is cash out. So 85% of non-QM originations in 2021 We're not with rate and term refi. If you look at the agency market, that's closer to 40% in terms of purchase. And Dave and Elker both mentioned this in their scripts, but we have also seen a number of the non-bank community start to originate and start to roll out non-QM platforms and underwriting guidelines and products. And this has been very beneficial in terms of bringing supply. So this year to date, we've locked over $800 million in through our correspondent channel of non-QM. And I'll say in Q1, we locked $520 million. It was our highest quarter to date. So there's fierce competition on the agency side. Origination volumes are down. Margins are down. And you have seen originators come to the non-QM market to fill that gap.
spk12: Gotcha. Very helpful. Thanks again.
spk09: Thanks, Ken.
spk07: The next question comes from Doug Harter with Credit Suisse. Please proceed.
spk03: Thanks. Mike, I was wondering if you see opportunities kind of on the bulk purchase side in non-QM, you know, especially in light of the middle market sale, you know, and kind of having additional capital to deploy?
spk00: Yeah, sure, Doug. You know, what I'll say in terms of transaction activity is In January, in the bulk market, we saw $2 billion of flow and available for us to bid. In March, that number was $750 million. And a lot of what's transpired is origination volumes are down, but you're also seeing these smaller non-bank originators and some of the larger non-bank originators move away from the bulk market to delivering best efforts and wanting to deliver through our correspondent channels. So we certainly have seen a number of opportunities. I think the challenge that the market is going through, and it's more on the originator side, is non-QM rates have increased so fast that originators have been caught off guard, not necessarily having appropriate hedging strategies, and they continue to sell discount loans. So since the end of the year, we've seen non-QM rates go from $4.25. We think the $1.02 rate walking in here today is $6.75. And unfortunately for a lot of these originators, they've been trying to sell that bulk through the market, but it continues to be out of the money. So we've evaluated. Our preference is for at-the-money collateral and not necessarily continuing to buy discount pools on the way up. But I'll say that the bulk market, you have seen less supply, and you are seeing more originators willing to engage and lock best efforts given the dynamics and given the hedging practices of those originators.
spk09: And Doug, just to add to that, the silver lining in the volatility we experienced year to date is the fact that we have a deep capital base and can provide a lot of liquidity. And so when you look at bulk versus flow and originators not wanting to warehouse loans, rather opting for that certainty of execution, You know, we've been open for business and it's helped build Mike's Correspondent Channel. We're very happy about that.
spk03: Great. And David, you talked about, you know, being willing to take MSR, you know, kind of beyond the 10%, you know, any way to dimension, you know, kind of how much beyond 10% you're willing to go on that?
spk09: Sure. So, you know, looking at the less liquid bucket, obviously middle market lending off balance sheet, that was roughly 10% of capital. And I would think about it, MSR over time could make up that balance and get to an upwards of 20% of capital over time. Great.
spk07: Thanks for the answers. Thanks, Doug. The next question comes from Kevin Barker with Piper Sandler. Please proceed.
spk10: Good morning. Thank you for taking my questions. I just wanted to follow up on the proceeds from the middle market portfolio you touched on earlier. Could you talk to us about how you weigh the differences between reallocating that capital between MSRs, agency mortgage backs, or maybe even look at other sources, whether it's M&A or other things that are out there as potential proceeds from the middle market?
spk09: Yeah, so with respect to the actual billion in capital, You know, as I mentioned, the placeholder is agency MBS, but we will look to redeploy it episodically in RESI and or MSR over time. And ultimately, the longer-term objective is to get those two non-agency and MSR buckets up to a higher percentage of capital. But we're perfectly comfortable with agency, you know, taking on that responsibility of redeployment over the near term. And then in terms of, you know, other opportunities out the horizon, we're always looking at everything, whether it's M&A or new sectors. We're consistently evaluating different opportunities in the market. And we, you know, Serena mentioned in terms of liquidity on the balance sheet, cash and agency MBS, $4 billion, you know, another billion coming in. You know, we can engage in a lot of potential strategies should the opportunity materialize. M&A has been tough over the past couple of years after some pretty high price points in the sector. We're not actively seeking to buy another company, but it's always something we look at.
spk10: When you think about the opportunity set for other companies, you indicate a pretty broad range of different things you're looking at. Is there anything in particular or any sectors that you know, screen as particularly attractive, just given your raw strategy today?
spk09: Yeah, it's, you know, hopefully it fits within, you know, the three verticals that we're looking at. With agency, you know, you're looking largely at price. With MSR, you know, it's potentially in the realm of other portfolio companies or an origination, which we do not need. We've been very successful in with respect to partnerships with large originators. So we're not looking at the origination market right now. And then in the resi credit space, you know, we have looked at smaller originators in the past, but the development of the correspondent channel and actually partnering with originators as opposed to competing with originators has worked out quite well. And again, we're relied on for that certainty of execution. So to, you know, paint a broad picture, If there is a need for liquidity in the mortgage REIT space and it's at the right price and it presents a strategic fit, we'll certainly evaluate it and we have the liquidity to execute on it. But outside of the portfolio management sector, we don't have aspirations to do anything at this time.
spk10: Thank you for taking my questions.
spk07: Thank you. You bet, Kevin. As a reminder, if you do have a question, please press star then one on your telephone keypad. Our next question comes from Mark DeVries with Barclays. Please proceed.
spk02: Thank you. David, Analy's been on quite the journey over the years, you know, building out its businesses, creating the most diversified mortgagery platform, and then kind of under your leadership, narrowing that focus back to residential mortgage. So can you just talk more about kind of the strategic benefits you expect to realize from this more narrow focus?
spk09: You bet. So, look, I've known Annalie really since the beginning, well before I came to work here. And Annalie has always been residential housing finance and has always been a market leader in it that I've known. And that's my background. And as I laid out two years ago in terms of the strategic direction, that we are going, it is refocusing on the roots of the company, but being broader within housing finance and creating a platform whereby we don't just invest in securities, we invest across the loan, whether it's the rate and convexity component of the loan in agency MBS, the credit component in residential credit, or the IO and MSR, we want to look at the loan and allocate capital across the cheapest component of the loan. And there's considerable synergies across these three functions. As we've talked about in the past, whether it's MSR hedging, agency, or residential credit having less correlated returns with both MSR and agency. And we think it leads to the best risk-adjusted returns for for this company. Now, the question is, those are the ingredients, but making sure you get the measurements appropriate so that you're liquid and that you're generating the best risk-adjusted return. And so longer term, agency is always going to be the anchor of the company and the mothership, but increasing these other two ingredients, we think, will create a better balance in the overall portfolio, better risk-adjusted returns. lower leverage, and actually more liquidity because of these lower leveraged sectors. And we think that's the optimal direction for the company. Does that help?
spk02: Okay. Yeah, that's helpful. And then with agencies kind of near their wides, what's the greatest risk that's keeping you from levering up more? Is it just concern that the Fed may need to tighten conditions even more than currently expected? And and become a seller as opposed to just letting the portfolio run off? And do you see kind of risk of that at least as great as tightening here?
spk09: Yeah, we don't see that risk in 2022. And I think, look, you know, the feds talked about the possibility of selling mortgages, although they, you know, recently said until QT is well underway, they don't want to sell mortgages. They've never sold mortgages in the past other than test trades. And it's not an optimal approach. They would love to just let the portfolio run off naturally. But nonetheless, it could be an eventuality out the horizon. We just don't think it's in 2022. The other risk in the market, and Neil can expand on this, is that there is still volatility in the rates markets. And that gives us a little bit of hesitation. We got pretty meaningful risks in the system, whether it's geopolitical or economic uncertainty. And so we're waiting for, you know, a little bit more calmness to prevail. But, you know, the other point to note is that, you know, with agency spreads where they're at, you don't need to add a lot of leverage to really get ample returns. And we will certainly benefit from spread tightening. But, you know, between the volatility in the market and the supply picture, we're, you know, we're comfortable.
spk02: Got it.
spk09: Thank you. You bet. Thanks, Mark.
spk07: At this time, there are no further questioners in the queue, and this concludes our question and answer session. I would now like to turn the conference back over to David Finkelstein, President and Chief Executive Officer, for any closing remarks.
spk09: Well, thank you, everybody, and we will talk to you in the summer.
spk07: The conference has now concluded. Thank you for attending today's presentation, and you may now disconnect.
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