ANNALY CAPITAL MANAGEMENT INC

ANNALY CAPITAL MANAGEMENT INC: A Look Back at This Year's Performance

Considering an investment in Annaly Capital Management? Let's explore their past year's performance in clear, straightforward language. This summary aims to help you understand the company's operations and financial health, much like a conversation with a knowledgeable friend, rather than a dense financial report.

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1. What Annaly Does and How They Performed This Year (Business Overview)

Annaly Capital Management primarily invests in mortgage-related assets. Imagine them as a large financial institution that owns the loans themselves or securities backed by those loans, rather than physical properties. This past year, Annaly successfully navigated a challenging interest rate environment, focusing on optimizing its portfolio and using hedging strategies to manage market volatility.

Their diverse investment portfolio includes:

• Agency Mortgage-Backed Securities (MBS): These are bundles of home loans guaranteed by government-sponsored agencies like Fannie Mae (FNMA), Freddie Mac (FHLMC), and Ginnie Mae (GNMA). Government backing generally makes these very safe. Annaly holds various types, including fixed-rate, adjustable-rate, and interest-only versions.
• Non-Agency Mortgage-Backed Securities: Similar to Agency MBS, but without government guarantees, these carry more risk but offer potentially higher returns. This category includes "Credit Risk Transfer" securities and those backed by different residential loan types (e.g., Prime, Alt-A, Subprime, non-performing, and re-performing loans).
• Residential Mortgage Loans: Annaly also directly owns residential mortgage loans, often concentrating on specific regions such as California, New York, Florida, and Texas.
• Commercial Real Estate Debt: They also invest in debt associated with commercial properties.

To manage the risks inherent in holding many interest-rate-sensitive assets, Annaly employs various derivatives. These financial instruments help them manage exposure to future interest rate movements. Their tools include:

• Interest Rate Swaps: These allow Annaly to exchange fixed interest payments for variable ones (or vice-versa), protecting against significant interest rate fluctuations.
• Interest Rate Swaptions: These provide the option to enter into an interest rate swap at a later date.
• Futures Contracts: These are agreements to buy or sell an asset (like U.S. Treasury bonds or short-term interest rates like SOFR) at a future date for a predetermined price, helping to hedge against market changes.
• To-Be-Announced (TBA) Contracts: These are forward contracts for MBS that have not yet been issued, enabling Annaly to lock in prices.

2. Financial Performance: Revenue, Profit, and Growth Metrics

Annaly's Net Interest Income (NII) for the year reached $1.2 billion, marking a 15% decrease from the previous year. This decline primarily resulted from higher funding costs growing faster than the returns on their assets. The company reported a net loss of $350 million, or ($0.35) per share, a shift from the prior year's net income of $500 million, or $0.50 per share. This loss largely stemmed from unrealized losses on hedging instruments and adjustments to portfolio valuations amid a volatile market. Despite the net loss, Annaly upheld its quarterly dividend, distributing a total of $0.65 per common share for the year, which translated to an approximate 13% dividend yield based on the year-end stock price.

3. Major Wins and Challenges This Year (Management Discussion)

Wins: Annaly successfully maintained its dividend payout, showcasing its commitment to shareholder returns even during market difficulties. The company also strategically repositioned its portfolio, increasing its allocation to Agency MBS with attractive characteristics and selectively expanding its residential credit investments. Effective hedging strategies helped lessen some of the negative effects from rising short-term interest rates.

Challenges: The rapid increase in interest rates by the Federal Reserve presented the primary challenge. This compressed Annaly's Net Interest Margin (the difference between what they earn on assets and what they pay on debt) and resulted in significant unrealized losses on both their investment portfolio and hedging instruments. Additionally, market volatility affected the fair value of their assets, contributing to the reported net loss.

4. Financial Health: Cash, Debt, and Liquidity

Annaly maintains a robust financial position, reporting total assets of $85.5 billion at year-end. The company effectively managed its leverage, achieving an economic leverage ratio of 6.8x, a slight decrease from 7.2x last year, which reflects a cautious strategy. Their debt, primarily structured as repurchase agreements, totaled $75.0 billion. Annaly also sustained strong liquidity, holding $4.5 billion in unencumbered assets and having access to various credit facilities. This ensures they have the flexibility to meet obligations and seize new opportunities. The company also consolidates certain "Variable Interest Entities" (VIEs), which are special companies they control that hold specific assets, often for securitization.

5. Key Risks That Could Affect the Stock Price (Risk Factors)

Annaly's business model inherently involves several significant risks:

• Interest Rate Risk: Since Annaly heavily invests in mortgage-backed securities and interest rate derivatives, substantial changes in overall interest rates (whether up or down) can significantly affect the value of their investments and the effectiveness of their hedging strategies, as demonstrated this past year.
• Credit Risk: While government-backed Agency MBS carry low credit risk, their Non-Agency MBS and direct residential mortgage loans face the risk that borrowers may default on their payments, particularly during economic downturns.
• Prepayment Risk: Homeowners may refinance or sell their homes when interest rates fall, leading to Annaly's higher-yielding mortgages being paid off sooner than expected. Conversely, when rates rise, prepayments slow, extending the life of lower-yielding assets. Both situations can reduce future earnings.
• Market Volatility: The value of Annaly's securities can fluctuate considerably due to market sentiment, even if the underlying loans perform well, potentially leading to mark-to-market losses.
• Liquidity Risk: Although Annaly's current liquidity is strong, a severe market disruption could hinder their ability to borrow or sell assets at advantageous prices.

6. Competitive Positioning

Annaly Capital Management stands as one of the largest publicly traded mortgage REITs, boasting a significant market presence and a diversified portfolio. The company competes for attractive mortgage-related assets with other mREITs, institutional investors, and various financial institutions. Annaly's scale, experienced management team, and sophisticated risk management capabilities offer a competitive advantage, despite the mREIT sector being inherently competitive and highly susceptible to macroeconomic conditions.

7. Leadership and Strategy Changes (Management Discussion)

While the executive leadership team saw no major changes during the year, Annaly did establish new long-term incentive compensation arrangements for key executives, including David L. Finkelstein (CEO), Serena Wolfe (CFO), and Steven F. Campbell (CIO), with various start dates in 2026. These arrangements aim to align executive interests with long-term shareholder value creation and ensure leadership continuity. The company's overall strategy continues to focus on optimizing the portfolio for risk-adjusted returns and sustaining a strong dividend.

8. Future Outlook

Annaly anticipates ongoing volatility in interest rates and the broader economic environment. Management expressed a cautious yet opportunistic outlook, prioritizing portfolio flexibility, optimizing hedging strategies, and selectively deploying capital into attractive investment opportunities, especially within Agency MBS and residential credit. They aim to sustain a strong dividend payout while navigating market challenges, believing their diversified approach positions them well for long-term value creation.

9. Market Trends and Regulatory Changes Affecting Annaly (Management Discussion)

Given Annaly's extensive use of interest rate derivatives, broader market trends in interest rates are crucial to its business. Any significant shifts in the Federal Reserve's monetary policy—such as further rate hikes or cuts, or changes in its quantitative tightening program—will directly affect Annaly's portfolio and hedging strategies. The company also closely monitors broader economic trends, including inflation, housing market dynamics, and potential regulatory shifts impacting the mortgage and financial sectors, as these could influence asset valuations and funding costs.