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Annaly Capital Management (NYSE:NLY)
Q2 2020 Earnings Call
Jul 30, 2020, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Good morning, and welcome to the Annaly Capital Management second-quarter 2020 earnings conference call. [Operator instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Purvi Kamdar.

Please go ahead.

Purvi Kamdar -- Head of Investor Relations

Thank you. Good morning, and welcome to the second-quarter 2020 earnings call for Annaly 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 the 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, Annaly routinely posts important information for investors on the company's website at www.annaly.com. Content referenced in today's call can be found in our second-quarter 2020 investor presentation and second-quarter 2020 financial supplement, both found under the Presentations section of our website. Annaly intends to use their web page as a means of disclosing material, nonpublic information but complying with the company's disclosure obligations under Regulation FD and to post and update investor presentations and similar materials on a regular basis.

Annaly encourages investors, analysts, the media, and other interested parties to monitor the company's website in addition to following Annaly's press releases, SEC filings, public conference calls, presentations, webcasts and other information posted from time to time on its website. Please note, today's event is being recorded. Participants on today's call include David Finkelstein, chief executive officer and chief investment officer; Serena Wolfe, chief financial officer; Mike Fania, head of residential credit; Tim Gallagher, head of commercial real estate; Tim Coffey, chief credit officer; and Ilker Ertas, head of securitized products. And with that, I'll turn the call over to David.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Thank you, Purvi, and good morning, everyone, and thanks for joining us on our second-quarter earnings call. Today, I'd like to highlight a number of current corporate initiatives, provide an update on the market and discuss portfolio activity across our core businesses during the quarter, and finally, provide our outlook for the balance of the year, and then I'll hand it off to Serena to discuss the financials. Of note, while last quarter, each of our credit leaders providing an in-depth look at their respective markets and portfolios to be efficient. I'll provide those updates today.

But as Purvi noted, each of our business heads are here as well to join in Q&A. Now, to begin with, I wanted to touch on a few strategic and corporate actions we've taken as of late. At quarter end, we closed our previously announced internalization transaction, which marks a significant step in the series of measures and only is implemented as an industry leader from a governance standpoint. As an internally managed REIT, we look forward to demonstrating increased transparency and alignment with our shareholders, who will benefit from our ability to be more nimble in the way we do business in order to generate long-term value.

We also announced two leadership changes, Steve Campbell was appointed as chief operating officer, and Glenn Botek will retire from his role as senior advisor at the end of August, while remaining a director on our board. As COO, Steve will expand on the work he has been doing as head of business operations and work closely with the executive team to help oversee Annaly's overall operations and risk management functions. Glenn has been an invaluable part of our leadership team, and we thank him for his numerous contributions over the years and look forward to his continuing service on our board. Additionally, during the second quarter, we utilized our share buyback program and have now repurchased 175 million in common stock year to date.

This underscores our belief that the stock is undervalued relative to our book value and affirms our support of the value of our stock through the various capital allocation tools we have on hand. These initiatives are a testament to our focus on driving shareholder value ensuring that the firm as a whole, our structure, as well as our portfolio is positioned to continue outperforming as our second-quarter results demonstrate. Following one of the most challenging and unforeseen operating environments and Annaly's history, we were pleased with our performance during the second quarter. We delivered an economic return of nearly 15% and achieved core earnings well in excess of our rightsized dividend.

Our measured approach to weathering the crisis served us well, and we feel very good about our positioning as the recovery progresses, as I'll get into in more detail. So the economic slowdown brought on by the pandemic has obviously created considerable uncertainty, and this is a different kind of recession than that which we have experienced in the past, given the unprecedented speed and magnitude of the downturn. Social distancing and mandated shutdowns to damage certain sectors of the economy and the corresponding impact on the labor market has been substantial. There have been some signs that the worst of the economic distress may be behind us, although with the recent surge in cases in some areas of the U.S.

demonstrates the fragile nature of the recovery. Nevertheless, financial conditions have improved considerably. The market dysfunction that occurred amid the initial COVID outbreak in the U.S. has dissipated, and we have seen significant improvement in liquidity and asset pricing.

This is in large part due to the ongoing decisive actions taken by the Federal Reserve, which have been successful in restoring markets and easing credit strains. Liquidity tools have sufficiently supported funding markets. The credit facilities have opened channels to credit for businesses, households and local governments, the temporary adjustments to regulations have somewhat encouraged bank lending, and most impactful to Annaly's portfolio, the asset purchases have supported the smooth functioning of treasury and agency markets. Now, turning specifically to the agency market.

The Fed's purchased an upwards of 850 billion MBS in just over four months has dramatically altered the supply and demand picture for the sector. After a pace of purchases at the height of the volatility that reached nearly 50 billion per day to help stabilize the sector, the Fed has transitioned to a steady run rate of 40 billion per month, net of portfolio runoff, which on a gross basis, equates to roughly 40% current agency issuance. Fed is largely taking delivery of the most negatively convexed MBS, which has resulted in a shift to the TBA deliverable across production coupons to more newly originated pools and as a result, nominal carry on production coupon TBAs has improved dramatically, thereby adding to returns for TBA holders. Given this dynamic, we increased our TBA position in the quarter and gravitated further down in coupon.

The lower coupon holdings are predominantly in TBAs and higher coupons are concentrated in specified pools in light of the meaningful elevation and prepayment speeds in this environment. While our portfolio speeds did experience an increase on the quarter, prepays on our overall portfolio were notably lower than the GSE universe, which paid roughly eight CPR faster despite the higher average coupon of our portfolio relative to universe. And with respect to our hedges, we added to our swap portfolio, primarily in the front end, the short-term swaps with pay rates close to 0%, provide an attractive hedge to our financing. This reduced our pay rate, as well as shortened the maturity of our swap portfolio.

We further reduced the LIBOR footprint of our hedge portfolio with our swap book now 80% in OIS and we reinitiated our treasury future short position that was unwound in the first quarter. We also continue to take advantage of the attractive low levels of volatility to answer the tail risk of a sharp rise in rates in the long end of the yield curve, and as such, we replaced much of our legacy swaption position with additional out of the money payer swaptions. Shifting to residential credit, the sector saw significantly more activity as market dynamics began to improve following the crisis. The housing market remains strong given long-term positive fundamentals, which we believe will help the ultimate recovery.

We're experiencing a meaningful imbalance between supply and demand as the cyclically low number of housing units meets continued strong household formations. An anecdotal evidence suggests that pandemic disruptions have had limited impact on the home buying and refinancing processes. Non-agency securities across legacy, CRT, Jumbo 2.0 and non-QM have seen substantial recovery. Improvement signals that the market currently believes that the majority of forbearance cases, which have stabilized over the past couple of months, will ultimately be resolved.

However, non-agency lending has been somewhat slow to redevelop as credit standards have tightened relative to pre-pandemic underwriting and mortgage originators tend to be focused more on agency originations in light of fewer frictions in a wide primary secondary spread. Our residential portfolio was roughly unchanged quarter over quarter at 2.6 billion as modest purchases and mark-to-market increases largely offset sales and portfolio runoff. Securitization market started to show signs of life in mid-May, and we issued nearly 500 million of expanded prime securities earlier this month, subsequent to quarter end. Aggregate issuance under our OBX shelf has now reached 4.5 billion across 11 transactions since 2018.

As I mentioned last quarter, we expect to see more growth in this segment as markets continue to normalize, and we are encouraged by the steady pace of securitization activity to support our asset generation strategy. In the commercial sector, we are slowly beginning to see activity pick up, but volumes do remain somewhat muted. June, however, did bring about an increase in new refinancing requests with some new acquisition activity at post-COVID purchase prices. And simultaneously, we have seen a significant number of warehouse providers begin to close new loans, although pricing levels have been reset higher.

Cross sectors within commercial, the operating fundamentals remain challenged in hospitality as the average national occupancy rate hovers around 40%. And in retail, the prolonged shutdown and increasing number of retailer bankruptcies is continuing to weigh on that sector. On a more positive note, multifamily remains strong throughout the quarter as the latest data indicates over 90% of renters made a full or partial rent payment as of June. And in the office sector, although new leasing has slowed significantly, office REITs have reported strong rent collections above 90% throughout the back end of the second quarter.

With respect to our CRE portfolio, specifically, total assets at quarter end of 2.5 billion represented a slight decrease, while economic interest remained essentially flat. The decline in portfolio size was driven by approximately 53 million in loan payoffs, as well as securities sales. On the financing side, our weighted average cost of borrowing decreased by roughly 60 basis points to 2.7%, driven largely by a reduction in LIBOR given Fed cuts. Overall, we feel good about the conservative positioning of the portfolio across sectors and the strength of our relationships with best-in-class sponsors and operating partners to mitigate any further disruption.

Shifting to middle market lending, activity has also picked up as of late as spreads have tightened and sponsors have refinanced transactions that have exhibited improving underlying leverage profiles. New deal activity is primarily relegated to more broadly syndicated loans. However, for context, first lien executions on larger transactions have tightened 75 to 100 basis points over the past quarter. While traditional middle market has shown less movement in pricing.

Unit tranches and second lien loans within middle market are experiencing more notable price discovery than its larger market brethren, and we expect these gaps to remain as traditional middle market participants grapple with their portfolios. Consistent with our communication last quarter, we continue to speak actively with sponsors, borrowers and agents to closely monitor performance. Despite the challenging environment, we are pleased with how the portfolio has performed during the period, ending the quarter essentially unchanged at 2.2 billion in assets. As we gain further clarity around the long-term implications of COVID, we are reassured by the stable and defensive nature of our portfolio and remain confident in its ability to withstand prolonged bounce and market volatility.

We believe our focused industry-specific positioning within nondiscretionary defensive and mission-critical names will generate the outperformance versus peers that will further differentiate our brand in the sector. In fact, some of our industry concentrations have materially benefited from the current environment. For example, government mandates at all levels have created an even greater dependency on technology while also driving demand and behavior in ways that is made once boring annuity businesses into growth sectors. Portfolio construct has been protected against broader sectors that have witnessed demand destruction and we maintain meaningful exposure where pockets of spend remain resilient.

Now, additional note with respect to our direct lending portfolios, we have taken what we believe to be a very conservative approach regarding reserves and CECL adjustments, which Serena will discuss in further detail. And finally, shifting to our outlook. As we think about our capital allocation out of the horizon, we've been focused on preserving flexibility, given uncertainty in the greater economy related to the COVID shutdown. We maintain the view that the agency sector represents the most attractive investment opportunity currently, while also providing strong liquidity.

We have entered a more normalized environment with Fed action serving as a key driver. MBS spreads have retraced much of the widening experienced in March. We do remain positive on the sector, given ample funding availability at low rates, subdued rate volatility and a complete reversal of an inferior technical backdrop that characterized the sector at the outset of this year. While our allocation agency may increase modestly, we do continue to evaluate opportunities to deploy capital across our three credit businesses.

And we are beginning to develop a better lens into how each credit sector is evolving, and we expect to shift to a more offensive posture in the coming months as we gain more clarity on the economic and real estate landscape. We were certainly careful to take prudent steps during the early phase of the market recovery to ensure we are well positioned to capitalize on the opportunities that are sure to arise. And as part of our preparation, we have chosen to be conservative with our leverage, as well as our dividend. Our goal has been to maintain optimal liquidity thresholds and to manage the portfolio within conservative risk parameters to produce the highest level of quality earnings in this smart environment.

Consequently, we reduced leverage during the quarter from 6.8 to 6.4 times and made the prudent decision to set our quarterly dividend at $0.22. The dividend represents a 10.5% yield on our book value, which is in line with our historical average, while being competitive relative to our peers and various fixed income benchmarks. As I mentioned, we outearned the dividend by $0.05 this quarter, and absent another market dislocation or other unforeseen developments, we expect Q3 core earnings to also exceed the dividend. Overall, we maintain a more constructive view of the operating environment and our ability to deliver compelling returns as each of our businesses, respective sectors begins to emerge from the initial volatility and disruption caused by the pandemic.

And now with that, I'll hand it over to Serena to discuss the financials.

Serena Wolfe -- Chief Financial Officer

Thank you, David, and good morning, everyone. I will provide brief financial highlights for the quarter ended June 30, 2020, and while our earnings release discloses both GAAP and non-GAAP core results, I will be focusing this morning primarily on our core results and related metrics all excluding PAA. As David mentioned earlier, the stabilizing actions of the Fed, coupled with our active portfolio management, resulted in improved fair value of our agency assets and significant improvement in financial performance. Our book value per share was $8.39 for Q2, a 12% increase from Q1, and we generated core earnings per share, excluding PAA, of $0.27, a 30% increase from the prior quarter.

Book value increased on GAAP net income of 856 million or $0.58 per share, which includes $0.05 related to CECL and specific reserves, and higher other comprehensive income of 721 million or $0.51 per share on improved valuations on agency MBS, resulting from lower market rates. GAAP net income improved this quarter as a result of higher GAAP net interest income of 399 million, primarily due to lower interest expense from reduced repo rates and balances, and we also experienced lower losses on our swap portfolio of $92 million. Last quarter, I noted that most of our assets and liabilities are at fair value. And that our book value decline was not a function of fourth asset sales, but rather unrealized mark-to-market losses with potential full recruitment.

This point was evidenced this quarter with the improvement in fair value measures and resulting improved book value. While financial conditions have stabilized, there is still significant uncertainty around the long-term economic picture. This makes analysis regarding CECL reserves particularly challenging. As a result, we ran numerous scenarios in excess of 20 to determine the appropriate amount of CECL reserves for the quarter and ultimately booked reserves that were considerably more conservative than our base case scenario.

In comparison, our base case scenario resulted in a modest release of reserves, which we felt inappropriate given the continued economic uncertainty centered around the evolving pandemic. We recorded reserves associated with our credit businesses of 68.8 million on funded commitments during the second quarter, consisting of 22 million of additional reserves during the quarter, primarily resulting from the impact of COVID-19 on our borrowers. And more general reserves related to forecasts for a deterioration in economic conditions and market values of 46.8 million. Total reserves now comprise 5.32% of our ACREG and MML loan portfolios as of June 30, 2020.

As a reminder, the impairment model introduced by the new CECL standard is based on expected losses rather than incurred losses, which was the previous measurement for reserve historically. Under the standard, an entity recognizes its estimate of lifetime expected credit losses as an allowance, which the FASB believes will result in more timely recognition of such losses. And while changes in economic scenarios and asset performance in the future will impact CECL reserves in subsequent quarters. Current reserve levels should not be considered as a pervasive credit issue within the portfolio or an indication of what reserves may be recorded in the future.

We have previously discussed our methodology and our thorough and thoughtful approach to CECL reserves. As always, we spent time analyzing the results of the reserve calculations and ensuring our expectations align with the quality of the portfolio and the performance of the borrowers. We continue to think it critical in the current environment to consider the adverse economic scenarios available in this process and to err on the side of conservatism, given the significant uncertainty in the economic and market value scenarios. We remain comfortable with our existing credit portfolios and the associated CECL reserves, and we'll continue to monitor specific asset performance and economic projections as we determine future reserves.

Turning to earnings. The largest factor quarter over quarter to core earnings ex PAA, were lower interest expense of 186 million versus 503 million in the prior quarter. Due to lower average repo rates and balances, as well as higher TBA dollar roll over income of 96 million versus 44 million in the prior quarter. Due to higher average balances, partially offset by higher expense from the net interest component of interest rate swaps of 65 million versus 14 million in the prior quarter on higher average notional balances.

As David touched on, our economic leverage declined to 6.4 times from 6.8 times quarter over quarter, which was mainly due to a decrease in repo balances of 5.4 billion and an increase in our equity base of 1.1 billion. That was partially offset by an increase in TBA contracts of 5.8 billion and an increase in net payables for investments purchased of 1.5 billion. Our treasury function is the best in the business, and their expertise and exemplary market timing was a key component that helped us weather the market dislocation last quarter and our ability to deliver strong core earnings this quarter -- additionally, as noted above, core did benefit from a reduction in financing costs with lower average repo rates down to 79 basis points from 1.77%, combined with lower average repo balances, down to 68.5 billion from $96.8 billion. And we achieved these results while opportunistically extending our repo book term, increasing our weighted average days to maturity by 50% from 48 to 74 days.

Signaling from the Fed on continued low rates, combined with considerable injection of additional reserves in the financial system through repo operations and asset purchases have led to very stable funding conditions with repo markets experiencing no signs of stress through the quarter, even on pivotal month end and quarter end reporting dates. And access to repo financing remains ample. With the improved stability in the financial market, we have been an improvement in lenders appetite to finance credit assets, particularly in the residential space. In anticipation of the expiration of our FHLB membership in February of 2021, we are executing an alternate financing strategy involving committed funding facilities for our residential credit business.

And as David mentioned, we maintain a strong presence in residential securitization market. Consistent with that strategy, since the beginning of the second quarter, we added 1.125 billion of capacity across two new credit facilities for our residential credit group for permanent nonrecourse financing. The portfolio generated 188 basis points of NIM, up from Q1 of 118 basis points, driven primarily by the decrease in cost of funds that I mentioned a moment ago. Annualized core return on average equity, excluding PAA, was 12.82% for the quarter in comparison to 9.27% for Q1.

Our efficiency metrics changed modestly relative to Q1 being 2.01% of equity for the second quarter in comparison to 1.98%. Also, as David mentioned, our internalization transaction closed at the end of the quarter, and we anticipate generating cost savings over the long-term as we embark on being an internally managed company. Annaly ended the quarter with excellent liquidity profile with 7.9 billion of unencumbered assets, an increase of 1 billion from prior quarter, including cash and unencumbered agency MBS of 5.3 billion. And finally, the company has performed exceptionally well given the challenges faced from remote work and market uncertainty.

We continue to be impressed by the resiliency of our workforce and the exemplary service that our IT infrastructure team has provided to every one of us during this time of remote work. Everyone at Annaly contributes to our success, and we are proud of the results that we have reported for the second quarter and expect to continue providing best-in-class results for our shareholders. And with that, I'll turn it over to the operator for questions.

Questions & Answers:


Operator

Thank you. [Operator instructions] Our first question comes from Eric Hagen with KBW. Please go ahead.

Eric Hagen -- KBW -- Analyst

Thanks. Good morning, and nice quarter, guys. How much did TBAs add to your net interest margin for the quarter? Is the specialness reflected in both the asset yield and the cost of funds? And then how big is your TBA balance now versus the end of June?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

So Eric, and thanks for your comments. With respect to the incremental benefit of the TBA position for the second quarter, I'll say, I think the actual dollar contribution or in pennies was about $0.07. And with respect to the NIM contribution, Serena can --

Serena Wolfe -- Chief Financial Officer

Yes. So, the TBA dollar roll provided about 97.5 million toward NIM for the quarter.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

And then our TBA balance is roughly unchanged for the quarter. And with respect to what we expect for the third quarter, it is likely to be in the proximity of where we were at for Q2, maybe a touch higher.

Eric Hagen -- KBW -- Analyst

Right. OK. Just on the TBAs, again, just every mortgage REIT, I feel like kind of accounts for dollar roll specialness a little differently in their NIM. Is it picked up in your asset yield or your funding costs or both?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

In terms of how it's actually reflected in the yield, it's not.

Eric Hagen -- KBW -- Analyst

Right. OK. So, it's reflected in your funding costs?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

No, it is not reflected in the funding cost. We add the incremental dollar roll income to core income. And then, the outcome.

Eric Hagen -- KBW -- Analyst

OK. So, the NIM itself is not reflective of TBAs at all via dollar role?

Serena Wolfe -- Chief Financial Officer

No, no, no, it does. Yes, the NIM will include TBA dollar roll income. Correct.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sorry, I was thinking about it a little bit differently. But yes, that's correct. Total core income is used to drive that, Eric.

Eric Hagen -- KBW -- Analyst

Yes. I think I understand. For the agency derivatives portfolio, I realize you guys maybe don't get asked about this very often, but how much of your cost basis was amortized through core earnings in that portfolio last quarter? And then with rates having coming down, quite a bit. I mean, presumably, some of those assets have cheapened.

How are you guys thinking about your footprint in that portfolio?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Well, look, first of all, I'll talk about the footprint and agency derivatives, for example. And what we're talking about here, Eric, is the difference between balance sheet leverage and structural leverage. So, right now, balance sheet leverage, pools of finance through the repo market is more attractive than structural leverage, meaning derivatives who -- when I say structural leverage, I mean an asset whose outcome is dependent on a large asset like derivatives are. So, balance sheet leverage is incredibly inexpensive right now and abundantly available because the reserves and system.

And in the agency space, it's more favorable than structural leverage through derivatives. So, that could change, but derivatives would have to cheapen a little bit, as well as MSR for it to be more attractive. MSR has different structural aspects to it that make it very cheap. But nonetheless, structural leverage is a little bit inferior right now to balance sheet leverage.

Now, in terms of amortization of the cost, I'll give you the MSR, for example, which mimics the derivatives portfolio. There was deprecation in the amount on the balance sheet of MSR, half of which was amortization and the other half of which was the multiple compression. So, I think we had 25 billion of the 277 million of the MSR that started the quarter was actual amortization and derivatives, you might say, would -- on the IO side would mimic that.

Eric Hagen -- KBW -- Analyst

Right. OK. And did you guys say what your book value was through July?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

I didn't in the prepared comments, we've -- it's been relatively calm. We've oscillated around where we've ended -- where we ended the quarter and right now as of last night, it's up roughly 1%.

Eric Hagen -- KBW -- Analyst

Got it. Great. Thank you guys so much.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet.

Operator

Our next question comes from Rick Shane with JP Morgan. Please go ahead.

Rick Shane -- J.P. Morgan -- Analyst

Hey, guys. Thanks for taking the question, and good morning. I wanted to talk a little bit about dividend policy. David, you, in your comments suggested that Q3 earnings, core earnings are on track to exceed the dividend again.

And I'm curious when you guys think about dividend policy, currently, your ROEs are very high. I suspect that one of the things that influences the outlook is reinvestment risk as speeds pick up. I'm curious how you guys are looking at this, and especially in light of having cut the dividend earlier in the year?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

And that's exactly right. Reinvestment is a key criteria here. So, we set the dividend at $0.22 because we believe that to be the sustainable level for the foreseeable future as long as we had a lens into the horizon. Now, core earnings in Q2 were above that dividend, and we expect them to be so in Q3.

A lot of that is driven by the tailwind from the Fed and specialists in TBAs, where our rolling income doubled over the quarter. And it is currently existent today. And if we look at past episodes of QE, it persisted for some time. But when we think about reinvestment into, for example, pools, where we see the levered returns on agency MBS is in the context of 11 to 12% maybe a little bit higher.

And so, as we look at the dividend right now at a 10.5% yield on book value, the reinvestment of agency runoff is perfectly consistent with that longer-term more steady state level, assuming rates in this context. But keep in mind, we do have this near-term tailwind of specialness and some other factors that are beneficial to the portfolio where we're out earning the dividend this quarter. We can't say how long that will persist for. But we do think about this for much more than just the quarter or two where we do have the specialist, and we're trying to get the appropriate level where we know it's sustainable.

And that's how we feel about it. And if we continue to outearn it, that's perfectly OK because we're giving the shareholder of 10.5% dividend yield on their book value.

Rick Shane -- J.P. Morgan -- Analyst

Got it. And actually, as you're answering that question, I'm realizing there's another element of that, which is that some of that additional -- that excess earnings is coming back to shareholders in the form of the repurchase at a discount as well.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Exactly, exactly. And we'll see where we end the year. But we feel good about where everything is.

Rick Shane -- J.P. Morgan -- Analyst

OK. So, is it fair to say that the repurchase will be part of the flex in terms of using that excess earnings in the short term?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

It's all dependent, Rick, on the attractiveness of the repurchase option relative to other options in our capital allocation policy. In the second quarter and beyond, as we mentioned, we bought back 175 million worth of stock. The average price of those shares was, I believe, $6.30, so we're meaningfully above that level now. So, we're very happy that the market picked up the slack and did a lot of that work.

As we look at the buyback policy, it's not a point in time estimate, everything changes on a daily basis because asset prices changes and the relative attractiveness of buying back stock, versus putting that capital to work in the portfolio changes. And if you just think about the immediate accretion of the stock buyback in terms of book value versus the longer-term earnings of the portfolio, there is a trade-off there, certainly. And yes, we generated 25% accretion from the buyback thus far. But when you look at the portfolio and the economic return of the portfolio in the quarter, that was 15%, and that persists, we think.

So, it's not an apples-to-apples comparison. We have to look at how attractive assets are and then put that in the context of where the stock price is and make a buyback decision based on that.

Rick Shane -- J.P. Morgan -- Analyst

Great. I appreciate that. And everything you've said, the two words that stood out, everything changes. I think that's probably the best description of what we've all been through this year.

So, thank you guys.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yeah, you bet, Rick. Thank you.

Operator

Our next question comes from Kenneth Lee with RBC Capital Markets. Please go ahead.

Kenneth Lee -- RBC Capital Markets -- Analyst

Hi. Good morning. Thanks for taking my question. Wondering if you could just provide a bit more color on your prepared remarks on the potential to increase agency allocation.

Do you expect any meaningful shift in terms of equity capital allocation going forward?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure, Ken, you bet. And what I meant by that is that the increase in agency could occur over the very short-term as credit markets are still redeveloping, and we do have some runoff, and that capital will be reallocated to agency over the very near term. And when we say that, I mean a very small percentage. We don't anticipate increasing agency meaningfully but we do recognize that these credit markets are a little bit slow to redevelop.

We don't have complete clarity on the economy, and some of that runoff could go into the agency sector. Now, that being said, we are starting to get through this Phase 2, as I mentioned last quarter, where it's really about recalibrating each portfolio in the business and making sure we're optimizing each of the businesses. And we're starting to get a better look at how things are going to unfold, and we're seeing opportunities in credit. And we're very constructive on it.

It just may take a little bit of time to make sure we have the right approach, and we have complete clarity on how things are going to play out. So, we don't expect a meaningful increase in agency, but over the near term, you could see a small uptick.

Kenneth Lee -- RBC Capital Markets -- Analyst

Great. Very helpful. And one quick follow-up, if I may. You mentioned in terms of the agency funding composition, extending out the repo financing terms wondering going forward, would you expect to either further lengthen the repo financing terms or maintain what you've been doing?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yes. It depends on the shape of the curve, like over the last couple of months, the term structure of repo has flattened pretty considerably, which has enabled us to extend out the curve at very attractive rates. So, we'd like to see it flatten a little bit further. And we think it should, given the posture of the Fed.

And when you look at the last set of economic projections, lift off, not likely to occur for the next couple of years. You could see some further flattening in the turn curve, but we're we're watching it, and we're making incremental steps to term out our repo.

Kenneth Lee -- RBC Capital Markets -- Analyst

Great. Very helpful. Thanks again.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Ken.

Operator

[Operator instructions] Our next question comes from George Bahamondes with Deutsche Bank. Please go ahead.

George Bahamondes -- Deutsche Bank -- Analyst

Hi. Good morning. Just one, congrats on a soft quarter. A really favorable backdrop, funding costs, attractive specialist TBA market.

Just out of curiosity, kind of what are some things that you're concerned about are really looking closely at kind of in the near intermediate term things do look, I think, positive generally, but just wondering how you may think about downside risk from here.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yes. I think prepaid is kind of an obvious one. So, maybe outside of that. Sure, sure.

So, look, with respect to the agency market, we are in an environment where funding is abundantly available and will be for some time given the reserves in the system. Volatility is low and the Fed is specifically directing volatility lower, and they also happen to be a huge tailwind in terms of purchases of agency MBS. So, the technicals are very favorable. And to your point, it does appear to be a very good backdrop for the foreseeable agency.

And prepay is obviously being the uncertainty and the risk, which we -- I don't think you've heard a lot about, I'm sure, this quarter. And I think we manage prepay risk, as well as anybody. 96% of the group portfolio is in specified pools, and we've built that portfolio up over a number of years. And we used the -- took the opportunity in March to reduce the pool holdings that we didn't find as attractive and what we're left with is a portfolio that is very high quality.

And as a consequence of that portfolio, we did see a fair amount of appreciation in those pools in the second quarter as markets stabilized. And that is one of the risks, I think, going forward. Beyond just prepays is what happens to pool pricing over the next quarter or two. We feel good about where pools are at.

The reason why they appreciate it is because they're worth it. They provide a much better convexity profile and lower prepayment characteristics than the market. But generally speaking, pool pricing can be variable, and so that's probably the risk in agency. In credit, as we've said, we like our portfolio.

We've appropriately conservatively reserved for any -- what we think to be any eventuality down the horizon. But there's idiosyncratic risk in every credit asset. And so, we feel good about it, but there could be one-off disruptions. And so, that's something we're looking at as well.

So, broadly speaking, in agency, it's probably pool pricing and in credit. There could be unforeseen events given the economy that could disrupt individual assets.

George Bahamondes -- Deutsche Bank -- Analyst

Got it. That's helpful color. And my other questions have been asked and answered. Thanks again

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet. Thanks, George.

Operator

Our next question comes from Doug Harter with Credit Suisse. Please go ahead.

Josh Bolton -- Credit Suisse -- Analyst

Hey, guys. This is actually Josh Bolton on for Doug. Was wondering if you could talk a little bit more about the thought process around the hedge repositioning in the quarter, adding more hedges on the short end of the curve. And then, I guess, should we expect more options hedging going forward? I know you mentioned some of the tail risks? And just any more additional comments on the hedge position would be great.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure, you bet, Josh. So, first of all, with respect to the repositioning, what we experienced in the quarter was initially a pretty significant steepening of the curve, which we anticipated. I think -- got to roughly 20, 25 basis points higher than it was now. At the time, we started the quarter with a swap portfolio of about nine odd years, I believe.

Now, given how long that portfolio is in duration, as we mentioned last quarter, it provides multiples of interest rate protection relative to the assets, which are much shorter in duration. So, given the slope of the curve, given the significant decrease in front-end OIS rates to zero roughly. We took the opportunity to add hedges and move down the curve and better balance out the hedge profile to bring the average life to about half what it was at the end of the first quarter. And it's still about twice the duration, maybe a little bit more than twice the duration of the asset portfolio currently.

But at 40% hedge ratio being more -- a little bit over twice the duration, you get to roughly 80 to 90%, maybe a little bit more of interest rate protection, assuming a parallel shift in the curve, with a still slight steepening bias, which we think is the appropriate approach. But nonetheless, it's a more balanced hedge profile now with a slight steepening bias, and we took advantage of near zero rates at the front end of the curve, which we think has very limited downside potential. In terms of those hedges losing money because it's not our view that we end up in a negative rate scenario, negative policy rate scenario that is, and so we feel good about it. Now, with respect to options, we did reinvest a lot of the runoff in our swaption portfolio back into out of the money swaptions.

And I'll tell you, going forward, that will be a function of the level of implied volatility. When I look this morning, three-month, 10-year swaption ball was about 53 basis points. It did get below that level in early 2019 to about 49 basis points. And then, the last time prior to that was 2017.

And before that, it was pre crisis. So, implied volatility is very low, and that's by design, on the part of the Fed. And to the extent it continues to decline, it will be a more attractive hedge to our agency portfolio. And I would say that at current levels, you should expect it to be a critical component of the portfolio going forward.

Does that answer your question?

Josh Bolton -- Credit Suisse -- Analyst

Yep. That's great thanks David. Appreciate the comments.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Josh. Good to hear from you.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to David Finkelstein for any closing remarks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

OK. Thanks, Brendan, for your help, and we hope everybody stays safe. Thanks for joining us today, and we'll talk to you soon.

Operator

[Operator signoff]

Duration: 47 minutes

Call participants:

Purvi Kamdar -- Head of Investor Relations

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Serena Wolfe -- Chief Financial Officer

Eric Hagen -- KBW -- Analyst

Rick Shane -- J.P. Morgan -- Analyst

Kenneth Lee -- RBC Capital Markets -- Analyst

George Bahamondes -- Deutsche Bank -- Analyst

Josh Bolton -- Credit Suisse -- Analyst

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