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Annaly Capital Management (NYSE:NLY)
Q3 2020 Earnings Call
Oct 29, 2020, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Good morning, and welcome to the Annaly Capital Management third-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, head of investor relations. Please go ahead.

Purvi Kamdar -- Head of Investor Relations

Good morning, and welcome to the third-quarter 2020 earnings call for Annaly Capital Management, Inc. any forward-looking statements made during today's call are subject to certain risks and uncertainties, including with respect to COVID-19 impact, 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, 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 third-quarter 2020 investor presentation and third-quarter 2020 financial supplement, both found under the presentation section of our website. Annaly intends to use our web page as a means of disclosing material, nonpublic 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. 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, webcast, and other information it posts from time to time on its website.

Please also note this event is being recorded. Participants on this morning's call include David Finkelstein, chief executive officer and chief investment officer; Serena Wolfe, chief financial officer; Tim Coffey, chief credit officer; Ilker Ertas, head of securitized products; Mike Fania, head of residential credit; and Michael Quinn, head of commercial investments. And with that, I'll turn the call over to David.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Thank you, Purvi. Good morning, everyone, and thanks for joining us for our third-quarter earnings call. I'll briefly provide an update on the broader market and how we manage our portfolios during the quarter. And before Serena reviews the financials, I'll discuss the factors that underscore our business principles and risk posture and have contributed to our performance.

The U.S. economy rebounded at a faster pace than many had anticipated in the third quarter, best exemplified by the decline in the unemployment rate to 7.9% in September. Household spending rose sharply in certain sectors of the economy, arguably led by housing, have made a substantial improvement with current activity well above pre-COVID levels. However, momentum is slowing as the service sector is unable to fully recover while the virus persists, the extended unemployment benefits supported under the CARES Act, which meaningfully boosted incomes expired in July, although only half of all jobs lost during the pandemic have been restored.

Monetary policy accommodation continues to be critical, especially given challenges on the fiscal front, which is further complicated by the uncertainty around the course of the virus, as well as, the outcome of next week's presidential election. Similar to the second quarter, the Federal Reserve continues to use all available tools to smooth market functioning while signaling they stand ready to provide more support, if needed. Suppressed interest rate volatility remains a positive backdrop for our agency MBS and credit businesses, contributing to our ability to generate a 6.3% economic return during the quarter and core earnings in our dividend by $0.10. Additionally, we achieved these results while reducing our leverage to 6.2 times.

It is important to note that historic volatility we faced in March and a pending risk event in the election are reasons for maintaining a cautious approach. And while we would characterize the third-quarter core earnings as a near-term peak, we do expect to outearn the current dividend again in the fourth quarter, all else equal. Now shifting to portfolio activity and beginning with our agency business. Large-scale fed purchases, now totaling over $700 billion, net of pay down since March and strong nominal carry have offset high levels of supply and elevated prepayment speeds.

While our agency portfolio was largely unchanged in notional terms, we further shifted out of higher coupon pools in favor of lower coupon TBAs. The current attractiveness of TBAs is driven by an improved deliverable resulting from the Fed taking out the most negatively convex pools and implied financing rates that are well below repo rates. And while roll specialness will not last in perpetuity, it contributes to excess returns and serves to mitigate episodes of spread widening, such that we anticipate maintaining our overweight in TBAs while the Fed sustains a heavy presence in the market. Our specified pool holdings do continue to provide considerable value as they offer meaningful call protection, have more accurate model durations, and exhibit better supply and demand dynamics than generic pools.

Prepayments are currently at their cycle highs and we expect speeds will remain elevated given historically low mortgage rates, a strong housing market, and improved uptake in technology, facilitating refinancing efficiencies. The investments we have made in specified pools over the last number of years are paying off in this environment. Our portfolio prepaid at just under 23 CPR in the quarter, more than 10 CPR slower than the GSE universe of 30-year fixed rate MBS, despite a weighted average loan rate on our portfolio that is 17 basis points higher than the universe. And with 96% of our pool holdings characterized by some form of prepayment protection, we are well-positioned to withstand the current environment and we anticipate our speeds will continue to outperform the broader market.

Our outlook for the agency sector remains constructive as recent spread compression is supported by continued Fed support, attractive financing, strong nominal carry, and subdued volatility. Our hedging activity was focused on protecting the portfolio from tail risk as we opportunistically added out-of-the-money swaptions at attractive pricing and also added modestly to our swaps and futures positions. Funding markets are healthy and liquid as capacity remains ample with abundant reserves in the system. Also, financing spreads for credit products, which were elevated through much of the summer have recently contracted and we expect further improvement to come.

Notwithstanding this liquidity and financing markets, we are cognizant of risks at the horizon and are, therefore, operating with conservative leverage and nearly $9 billion of unencumbered assets, the strongest liquidity position for the firm in years. Now shifting to residential credit. We maintain our positive outlook on the sector considering strong fundamentals and technicals such as stabilizing delinquencies and favorable housing supply dynamics. Less than 6% of the overall housing market is now in forbearance, which is down from 9% in late May.

The pace of improvement in housing has helped return markets to a more normal state and led to firmer asset spreads and a rebound in securitization volume. We completed two securitizations in the third quarter, totaling over $1 billion, which did reduce our overall capital allocation of the sector. However, this decline was partially offset by retained bonds on our new securitizations, as well as, opportunistic investments in NPL and RPL securities. The non-QM loan market also exhibited meaningful spread contraction since the end of the first quarter.

Consequently, credit and convexity evaluation are as critical as ever in this environment, given less cushion in underlying yields. We believe the limited layer risk and delinquencies and convexity profiles of our loans demonstrate our proactive asset selection and focus on borrowers with significant equity. Our belief in this strategy is evidenced by our sizable retained interest in our securitizations, well beyond the mandated 5% risk retention in all securitizations at the time of issuance. Now although non-QM loan originations have been more limited since the first quarter, we are working to rebuild pipelines and source additional supply as non-QM originators reopen operations.

In commercial real estate, while our portfolio was roughly flat quarter over quarter, we have seen a notable uptick in activity with loan and new issue security channels and are selectively evaluating new opportunities. In addition, underlying property sales and leasing activity is beginning to pick up as well. We remain focused on ensuring the health of our current portfolio through an active dialogue with sponsors to closely monitor underlying performance trends and we are comfortable with our current portfolio positioning. It is likely that parts of the commercial real estate landscape will be systemically changed by the pandemic, but it's still too early to judge the full extent.

Despite declining rents and lower net operating margins, broadly characterizing the near-term CRE environment, cap rates should continue near current levels given record low interest rates, ample liquidity in the commercial real estate sector, and the significant amount of capital raised in the sector pre-COVID, all of which could prove to be longer-term tailwinds. Turning to our middle market lending business. As we have spoken about extensively, we have taken a countercyclical approach over the past few years and the economic downturn we're experiencing validates this investment strategy. Our view is that our portfolio is in a sound position, given our financing of nondiscretionary companies, the vast majority of which have been deemed essential operators.

Over diversification has been the downfall of many in late cycles and we have opted instead for concentration among our top sponsors in certain niche industries, as evidenced by the fact that over 50% of our portfolio is predicated on government spending, with the majority of individual assets in excess of $60 million. Regarding portfolio fundamentals, underlying cash flow trends have been encouraging year over year as we've seen EBITDA and revenue growth that has consistently delevered the portfolio of companies. Also to note, last quarter, we highlighted our conservative approach to reserves and CECL adjustments. To illustrate, our middle market lending reserves of $33 million this quarter down from $51 million, which is roughly 1.5% of our $2.1 billion portfolio, as Serena will discuss in further detail.

Now with respect to our outlook for capital allocation, I noted on our last earnings call that our allocation to agency would increase this quarter. However, with tighter agency spreads and our credit exposure at the lower end of the range, we are focused on responsibly increasing our credit portfolios. But as we are still early into this recovery, attractive opportunities are episodic. Now a further note on use of capital, decisions about when to raise or buy back common stock are evaluated as part of our capital allocation framework and similar to how we analyze investment opportunities across our businesses.

It is a dynamic process, consider it of liquidity, time horizon, and relative returns. We've repurchased over $200 million in stock throughout the past six months at times when our evaluation deemed at the most attractive use of capital. And we will consider using the buyback as a tool to generate shareholder return when appropriate to do so. Now an additional topic I want to cover today is related to how we manage our overall business and risk profile.

And specifically, the three different forms of leverage we have available to enhance returns. First, at the corporate level is capital structure leverage, which includes preferred equity and unsecured corporate debt. Second is structural leverage at the asset level, including subordinate securities retained through securitization. And third, traditional balance sheet leverage, primarily in the form of repurchase agreements.

Now beginning with capital structure leverage, as of the end of the quarter, our preferred equity represents just under 15% of our long term capital, which is in line with our average over the past few years. We've been very intentional with the construct of our capital structure by analyzing the relative attractiveness of the complementary financing and capital options. While capital structure leverage can enhance returns during periods of benign volatility that benefit can quickly evaporate when not prudently managed. As the REIT sector witnessed earlier this year, capital structures become -- can become overburdened which is exceedingly difficult to manage when access to common equity is constrained by depressed valuations.

Now at the asset level, when we consider structural leverage relative to balance sheet leverage, we focus on synchronizing our financing with the liquidity of our investments. An example of this is our securitization platform, which matches term financing with less liquid residential whole loans. We have been very conservative with respect to repo leverage on top of structural leverage, as evidenced by the relatively low balance sheet leverage applied to our credit businesses, and importantly, certain assets within those businesses. Selection and leverage is a relative value analysis and we have been very careful about not over layering multiple forms leverage, which is not always apparent and reported figures.

And we believe this discipline was very evident in our relative performance this year as markets experienced unprecedented volatility. And finally, I want to touch on transparency and governance as more mortgage-related companies have publicly announced or completed transactions. We welcome a renewed focus on the sector since it will come with it an expanded investor base, increased capital, and greater disclosure. Mortgage investing is the core of our business and we have a differentiated platform that is proven across all market environments.

Importantly, we're a long-term model with an ownership mentality and accountability embedded in how we operate the business. Earlier this month, on the 23rd anniversary of our IPO, we published our inaugural corporate responsibility report, which details our significant corporate governance enhancements, responsible investments, corporate philanthropy initiatives and human capital, diversity, and inclusion commitments. It is available on our website, and I encourage everyone to read it. We published the report during a time of considerable global challenges.

The COVID-19 pandemic, resulting economic and market upheaval and systemic social justice issues continue to have far-reaching impacts. Especially in times like these, we are guided by strong corporate values that enable us to successfully manage risks and take advantage of new business opportunities. Like others around us, we are using this unparalleled moment in history to lead with increased purpose and impact, both societal and economic and we hope others will do the same. And with that, I'll hand it over to Serena.

Serena Wolfe -- Chief Financial Officer

Thank you, David, and good morning, everyone. I will provide brief financial highlights for the quarter ended September 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 suppressed interest rate environment continued Fed support and our active portfolio management has enabled us to do more with less, less leverage that is, as we've generated the best core return per share we've had in five years with 6.2 times leverage.

Our book value per share was $8.70 for the third quarter, a 4% increase from the second quarter, and we generated core earnings per share, excluding PAA, of $0.32, a 19% increase from the prior quarter. Book value increased on GAAP net income of approximately $1 billion or $0.70 per share, which includes a $0.02 benefit related to reversals of CECL and specific reserves that will be addressed in more detail later in my comments, partially offset by common and preferred dividends and lower other comprehensive income of $253 million or $0.18 per share. GAAP net income increased in comparison to the second quarter due to gains on the swap portfolio of $107 million, as well as, higher GAAP net interest income of $447 million, up from $399 million in the prior quarter, primarily due to lower interest expense from lower average repo rates and balances partially offset by lower net unrealized gains on instruments measured at fair value through earnings of $121 million, down from $255 million in the prior quarter. Since the disruption in March, we have recovered a large portion of the decline in the fair value of our portfolio.

We have included a slide in our investor presentation that provides additional color and detail on the assumptions utilized in the evaluation of our CECL reserves. In the current quarter, we have seen a general improvement in market sentiment and the economic models we use in this process. The key macro economic assumptions used in determining our reserves being GDP, unemployment, and commercial real estate values are still projecting unfavorable assumptions comparative to prior years. However, they have improved in comparison to our Q2 assumptions used.

We recorded a modest reversal of reserves associated with our credit businesses of $22 million on funded commitments during the third quarter. Driven by portfolio activity, primarily loan payoffs and the aforementioned improvement in macro assumptions. And now total reserves net of charge-offs, comprised 4.56% of our ACREG and MML portfolios as of September 30, 2020, versus 5.32% as of the prior-quarter end. As always, we do not simply book what the model tells us we should reserve.

And therefore, in conjunction with our investment teams, we spend time analyzing the results of the reserve calculation and ensuring our expectations align with the quality of the portfolio and the performance of the borrowers, which supports the release of reserves. Consistent with prior quarters, we continue to think it critical in the current environment to err on the side of conservatism, given the significant underlying 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 factors quarter over quarter to core earnings, a lower interest expense of $115 million, compared to $186 million in the prior quarter, primarily due to lower average repo rate, lower compensation and G&A expenses as a result of cost savings from the company's internalization, as well as, record high TBA dollar roll income of $113 million in comparison to $96 million in the prior quarter due to higher average balances as we took advantage of specialness in the TBA market and increased concentration in dollar rolls compared to pools. These increases are partially offset by lower coupon income on agency MBS due to lower average balances. Core did benefit from a reduction in financing costs with lower average repo rates down to 44 basis points from 79 basis points in the prior quarter. Combined with lower average balances, down to $67.4 billion from $68.5 billion in the prior quarter, and weighted average days maturity relatively consistent with the prior quarter at 72 days versus 74.

Our all-in average cost of funds this quarter was 93 basis points versus 1.29% in the prior quarter. While we continue to benefit from the zero interest rate policy, our treasury department has a keen eye on the market and has renegotiated all debt agreements possible to take advantage of the optimal financing environment. We have opportunistically turned out repo where it has made sense. However, with ample reserves in the system and deliberate forward guidance on the [Inaudible], we're of the opinion that repo rates will be lower for longer.

Therefore, are striking the appropriate balance between shorter-term funding and modestly more expensive longer-term repo agreements. We reduced our leverage and our economic leverage declined to 6.2 times from 6.4 times quarter over quarter, primarily due to lower repo balances of $2.5 billion, higher equity balances of $397 million, due to favorable mark-to-market changes for swaps and instruments measured at fair value through earnings, as well as, realized gains on investments and derivatives, and lower net payables for investments purchased of $254 million, partially offset by higher TBAs of $1.9 billion. In addition, we reduced the balances on our FHLB facility in preparation for the securitizations we closed during the quarter and the upcoming sunset of our FHLB membership. As David had mentioned before, you cannot unsee what we went through in March.

And therefore, we are proud of the strong results for the quarter, achieved with a prudent management of our leverage given lower risk tolerance levels. The portfolio generated 205 basis points of NIM, up from second quarter of 188 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 13.79% for the quarter in comparison to 12.82% for the second quarter. Our core return on average equity, excluding PAA, per unit of leverage improved to 2.22% in Q3 versus 2% in the second quarter.

Again, illustrating the notion of doing more with less. We have started to see the benefits of our internalization with improvements to our efficiency metrics in the third quarter, being 1.32% of equity for the third quarter in comparison to 2.01% in the second quarter of 2020. And 1.73% year-to-date, which is within the range of expected cost savings disclosed in Q1 with our internalization transaction announcement, even with the reduced equity base as a result of the March disruption and our share buyback program. Annaly ended the quarter with an excellent liquidity profile with $8.8 billion of unencumbered assets, an increase of almost $1 billion from the prior quarter, including cash and unencumbered agency MBS of $6.9 billion.

And after Labor Day, we began a hybrid working arrangement with employees voluntarily working from our Manhattan office periodically. While we recognize the benefits to communication and collaboration from being physically together a few days a week, we continue to work seamlessly outside of the office and we'll continue to monitor state and city data in determining future return to office plans. And that concludes our prepared remarks and I'll turn it over to the operator for questions.

Questions & Answers:


Operator

[Operator instructions] The first question today comes from Steven Delaney of JMP Securities. Please go ahead.

Steven Delaney -- JMP Securities -- Analyst

Thanks. Good morning, everyone. A lot of good numbers in this report, but I'd like to just comment that I think from my view, possibly the best number is the 70-basis point drop in expenses to average equity. So we know where that came from and congratulations on the internalization.

Your dividend coverage, obviously, was excellent, strong quarter and 145%. David, we heard your comments that this 3Q may be a little peaky in terms of the near-term cycle. But Serena, I'm wondering if you have available the information to comment on any undistributed retaxable income that Annaly may have had as of September 30.

Serena Wolfe -- Chief Financial Officer

So we are -- there's obviously a lot of differences, Steve, with regards to core versus taxable income.

Steven Delaney -- JMP Securities -- Analyst

Yes.

Serena Wolfe -- Chief Financial Officer

And one of those -- the largest one of those being the amortization of swap losses, which we do over the term of the original hedging instrument versus the gap, we take it all at once and for core we exclude. And so as of the third quarter, we don't have any concerns with not meeting our redistribution requirements for the full year, I would say.

Steven Delaney -- JMP Securities -- Analyst

Understood. So it sounds like there's no -- won't be any tax-driven need to, either increase the dividend or pay a special dividend that you'll make that decision based on other factors as to where the dividend goes, but not taxed mandated.

Serena Wolfe -- Chief Financial Officer

That's the correct assumption, Steve.

Steven Delaney -- JMP Securities -- Analyst

Thank you. And David, just on the RMBS activity, can you comment on -- you do several loan products. Can you comment on the specific loan products that were in those third-quarter transactions? And maybe give us some color on what your actual risk retention is in those deals above the 5% mandated level? Thank you.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure, Steve, and it's good to hear from you. So in terms of the loans and the securitizations, those were from our expanded prime program and largely pre-COVID loans.

Steven Delaney -- JMP Securities -- Analyst

OK.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

And I think if you look at in totality of the securitizations, that we've done which are over $5 billion, I believe we retained roughly 18% of our overall securitization.

Steven Delaney -- JMP Securities -- Analyst

Excellent. And those are nice bonds and I think have the possibility to see ratings upgrades, right, as those loans season.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yes, definitely.

Steven Delaney -- JMP Securities -- Analyst

OK. Great. Thank you.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

And again, we -- to my earlier point, Steve, about balance sheet leverage, we do apply very minimal leverage to these assets and the return on our last deal was about 12.5% on the balance sheet.

Steven Delaney -- JMP Securities -- Analyst

So nonrecourse. Thank you, both for your comments.

Serena Wolfe -- Chief Financial Officer

Thank you.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Thank you.

Operator

The next question comes from Rick Shane of JP Morgan.

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

Good morning, everybody. Look, in a normal environment, you guys faced binary risk in terms of rate direction, but we're in a period now where the distribution of outcomes is more skewed than it's probably ever been. The other risk you normally face is determining the timing of those rate moves and the Fed is creating an environment through their communications that deliberately diminishes that uncertainty. I think that this creates a setup where there's more -- less uncertainty on a theoretical basis than you guys have ever faced.

I'm curious how you balance being able to maximize profitability in that environment with also managing risk. And there was an interesting comment from Serena related to one place where you're enhancing profitability by staying on maintaining exposure to the shorter end of the repo financing curve. Can you talk about how you look at this going forward?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. So to your point, the rate risk is skewed. It's asymmetric. We don't expect the Fed to go to negative rates and we're at the zero lower bound for the next number of years, and they've been very deliberate with their forward guidance, which has been encouraging.

But that being said, as I mentioned in my prepared remarks, you know there is always that risk that we could see rates out the curve increase and there's a lot of uncertainty around that. So our hedge profile is set up as it has been for the last number of quarters with a modest steepening profile because there could be events that do lead to higher rates out the curve. We're very comfortable at the front end of what the Fed has conveyed to us, but you could see volatility at some point out the curve. And so that's why we've position hedge profile to reflect that and that also is why we've added more swaptions to the hedge portfolio to help us mitigate against that tail risk.

Now with respect to financing and our average days, which I believe was 72 days at the end of the quarter. We do look at our financing profile relative to the cost of hedging short rates with other instruments and we are very comfortable with the level of financing rates out the near-term horizon. The curve is relatively flat from one month to a year, we understand that. But there is an incremental cost of turning everything out to a year when we don't think it's necessary to do so and we can manage those risks and hedge those risks more cheaply with other interest rate instruments, and we do have a fair amount of short-dated swaps that do protect for that.

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

Got it. And so does that strategy makes sense because the swaps -- the cost of swaps are low in a low ball environment. And so that allows you to take the risk on a little more risk on the financing? And again, I don't want to overemphasize the risk because it makes sense, but is that the way you sort of look at it?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. You know there were even periods last quarter where we paid fixed at negative rates. And so it's attractive to do so as opposed to terming out repo from that standpoint, but it's pure relative value.

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

OK. And I do have one last question. I apologize to my peers who are waiting in queue. Just given the volatility we've seen in the equity markets headed into election, can you comment on the volatility that you've seen during that same period in your core asset classes as well?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure, sure, and look, we do have this risk event next week. I think heading into the latter part of last week and this week, there were expectations of stimulus and the potential for a democratic sweep, so we saw an increase in rates, predicated on the possibility for stimulus. That seems to have subsided, given the lack of progress on the stimulus front. But I will say there are a variety of outcomes that could occur with respect to the election and fiscal policy that does have us relatively cautious.

That's why we're hedged well, and that's why our leverage is at the low end of the range over the last number of years. And so we think this conservative approach is appropriate and it also does happen to more than cover the dividend. And so we're pretty comfortable with our operating environment. We have a lot of latitude, particularly, with low leverage right now.

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

Great. Thank you and thank you for letting me get that last question in.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Of course, Rick.

Operator

The next question comes from Kenneth Lee of RBC Capital Markets.

Kenneth Lee -- RBC Capital Markets -- Analyst

Hi, good morning, and thanks for taking my question. Appreciate the discussion of the different types of leverage. Wondering if you could just further expand upon it, perhaps share your appetite for potentially increasing leverage within each of the bucket just given the current attractive environment for investing? Thanks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. So I'll just go through the individual asset classes and what's attractive. What type of leverage is attractive, for example. Just starting with -- you know at the corporate level, I talked about capital structure leverage.

Right now, it's not advantageous to add capital structure leverage, given the pricing associated with pref and that's not something we're looking at, certainly. Now with respect to balance sheet leverage versus structural leverage. Starting with balance sheet leverage, there is obviously an ample amount of reserves in the system given Fed policy. So as a consequence, balance sheet leverage is relatively cheap and that most informs our agency business.

And so as a result, that's the focus in agency is on balance sheet leverage. Now on the credit side, structural leverage is relatively attractive and you see that through our securitization returns. We use more structural leverage on -- in our credit portfolios, but our balance sheet leverage on those portfolios is roughly 1.5 turns. And so we think we've stricken the appropriate balance and not layered structural leverage with balance sheet leverage and we feel good about it.

Now in terms of increasing leverage. Look, assets have to be cheaper for us to increase leverage. We're very comfortable with where we're at right now, 6.2 turns of leverage, gives us a lot of flexibility to see how markets evolve. To the extent assets cheapen, you would see some increase in leverage just through equity degradation, but we would still have dry powder to add assets at cheaper levels if we think the cheapening is transitory.

That's not our expectation that assets will cheapen given the Fed backdrop. But to the extent that did materialize, we could have the opportunity to add assets. Now conversely, if there's continued spread tightening, which brings our leverage down from book value appreciation, it's not the case that we would add assets to maintain leverage. We may even be of the mindset that assets are too rich and even further reduce leverage and sell assets.

So -- so generally speaking, we just have a lot of latitude to do exactly what we think is appropriate, given the market, given asset pricing, and given our current liquidity and leverage profile.

Kenneth Lee -- RBC Capital Markets -- Analyst

Gotcha. That was very helpful color. Just one follow-up, if I may. Just on the equity capital allocation, it sounds like some of the increase toward agencies was due to the securitization transaction.

But I just wanted to get your -- any kind of updated thoughts on where that equity capital allocation could trend in the near-term? Thanks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yeah. Sure. And as I said in the prepared comments, we would like to tick up our allocation of credit, but there's still a lot of uncertainty. We don't know the exact course of the virus.

We don't know how policy is going to shape out on the physical front. We are still learning about how this economy is evolving, so we have to be very methodical about how we add credit assets. Our pipelines are filling up. We're seeing very good opportunities, but again, it is episodic.

And so we'll see how it plays out and we'd like to get a lot more certainty with how the economy shapes up before we make a stronger commitment. But at the margin, I would say we would like to get our allocation and credit marginally higher.

Kenneth Lee -- RBC Capital Markets -- Analyst

Gotcha. Very helpful. Thanks again.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet. Good to hear from you, Ken.

Operator

[Operator instructions] The next question comes from Doug Harter of Credit Suisse.

Doug Harter -- Credit Suisse -- Analyst

Thanks. Can you talk about kind of how book value has performed in October so far?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure, sure, and we're up a few pennies quarter-to-date. Nothing to write home about and we have a long way to go left in the quarter.

Doug Harter -- Credit Suisse -- Analyst

Understood. Can you -- you know, obviously, next week, is kind of a volatility -- potential volatility event. I guess, can you just talk about kind of how the passage of next week, kind of -- how that kind of might influence kind of your actions versus kind of the remaining kind of unknowns out there in the market?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yeah. Well, unfortunately, it's likely the case that the passage of next week may not lead to a resolution in the outcome of the election. And so that's something we're certainly concerned about, but there's different states of the world based on how things evolve. You know if you get a blue wave, for example, then you could see a continuation of that slight sell-off we saw last week and before with the optimism around stimulus.

If you get a split Congress, if the President retains the White House and you have a Democratic Congress that could lead to a moderate stimulus. And if it goes the other way, you potentially, and this is something that concerns us, could see a repeat of what we saw in 2010, where you had austerity coming from Congress from the Senate and the White House in need of stimulus. So there's a variety of circumstances that could prevail. And again, it does come back to taking a cautious approach as we do figure it all out.

Doug Harter -- Credit Suisse -- Analyst

Understood. I appreciate the comment.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet.

Operator

The next question comes from Bose George of KBW.

Bose George -- KBW -- Analyst

Hey, all, good morning. Can you talk about the level of specialness in October versus the last quarter? And then just, how do you think about the level of your net TBA position as a percentage of your total MBS exposure? Could we see that increase if returns remain elevated? Just curious how you're thinking about sizing that?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. No, that's a very good question, Bose. So specialness in October is still quite prevalent. It has moved down in coupon into one and a halves and twos.

But generally speaking, the financing rates -- implied financing rates on those coupons are negative 60 to negative 80 basis points depending on underlying assumptions and that compares almost on part to what we experienced in the third quarter. We generally, on average, rolled our portfolio at south of negative 50 basis points on the quarter. As the market does repopulate with new collateral, you should see specialness dissipate somewhat as time passes and the Fed doesn't take all of the lower coupons out of the market, but it should be here for a little while. Now in terms of how we think about it, this is a carry-driven market.

In the third quarter, we had about $4.8 billion in portfolio runoff. In the agency portfolio, about half of that was allocated to TBAs to grow the TBA position with the other half more early on allocated to pools. Now we're at a point where specified pools have gotten to a point where they're pretty fully valued. And so the way we're thinking about it currently is runoff in the fourth quarter will more than, on average, go into TBAs.

But we are certainly considerate of what the portfolio looks like and we have to manage the portfolio, not just for near-term carry but we have to think about a variety of scenarios as to how markets can evolve. And our specified pool portfolio is the core of our business and those cash flows -- long-term cash flows that we put on the balance sheet are going to remain the core. So to make a long story short, we'll probably grow the TBA portfolio modestly in the fourth quarter. But we do remain focused on our full portfolio and we think it's performed quite well, as I talked about in the prepared comments with respect to portfolio speeds.

Bose George -- KBW -- Analyst

OK. Great. That's helpful. Thanks and then, just in terms of the difference -- incrementals of the difference in the TBA returns versus the spec pools.

Can you just cite that as well?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. I would say pools are in the high single-digits in the very low double-digits in TBAs.

Bose George -- KBW -- Analyst

OK. Great. Thanks. And actually, just one clarification.

The -- youi know the cost of funds that you guys reported, the 93 basis points, does that include the implied funding benefit of the TBAs? Or that's just the balance?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

No. No. That's a subjective assessment because you'd have to incorporate a prepayment assumption. So when we give you our cost of funds, it's entirely objective data.

Bose George -- KBW -- Analyst

OK. OK. Great. Thanks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Bose.

Operator

The next question comes from Brock Vandervliet of UBS.

Brock Vandervliet -- UBS -- Analyst

Hey, good morning, everyone.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Hey, Brock.

Brock Vandervliet -- UBS -- Analyst

Hey, David. On the CPR speeds, you remarked we are kind of in an unusual environment here with low rates for looking like a very long time, but seasonally, there should be a bit of a decel in activity. Help us kind of get our head around the forward look on CPR. And also with respect to the available pool of mortgages that pencil for refinancing and where that is now versus a couple of months ago?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. So let's start with the available pool of refinanceable mortgages. As of today, roughly 80% of the universe is 50 basis points in the money or more. So it's dropped a little bit and that's largely because the market has been repopulated with heavy issuance and lower loan rate loans.

But nonetheless, the vast majority of the market is in the money. So how we think speeds will evolve over the near-term? Speeds will be faster in the fourth quarter but not by too much, we think roughly 5% to 7% faster. Now to your point about seasonality, one thing to note is that originators are operating at full capacity and they're adding a lot of capacity. And so when you're at full capacity and supposing we do have lower housing turnover in the winter, which drives that seasonality, you're going to see us shift the resources over to the refinancing side of the spectrum and originators.

And so we don't think that seasonality will be a significant lead or a significant decline in prepayments in Q1, which is typically when you see it most. If anything, it will be flat to up.

Brock Vandervliet -- UBS -- Analyst

OK. Got it.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Brock.

Brock Vandervliet -- UBS -- Analyst

And on, uh -- with respect to funding costs, big drop this quarter, how much more room do you sense you may have there or is this kind of it?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Well, look, I think when we look at repo rates on the agency side from overnight out to a year, we're talking 13 basis points so thereabouts out to an upwards of 30. And so as the portfolio does roll, we will be resetting the agency portfolio at lower rates. As of today, our average rate is 36 basis points, so where our current repo rates are today. So that's -- that's a decline to some extent, we'll see as more repo rolls.

Brock Vandervliet -- UBS -- Analyst

Got it. OK. Gets room. All right.

Thank you.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Brock.

Operator

The next question comes from Mark DeVries of Barclays.

Mark DeVries -- Barclays -- Analyst

Yeah. Thanks. You mentioned looking to start to reallocate back toward credit investments, but the opportunities you're seeing are episodic here. Could you just talk about where you're seeing the most attractive relative value and where we should expect you to kind of reallocate capital?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. So we can go around the room here. We do have the full room of all our business heads. And again, opportunities are episodic.

We have started to rebuild our residential whole loan pipeline and we're seeing our other businesses pick up in activity in terms of, at least looking at a lot of opportunities. But again, we do have to take the backdrop of what the uncertainty entails with respect to the economy and how credit could evolve. So we're certainly cautious, but let's just start with Mike Fania on the resi side.

Mike Fania -- Managing Director

Sure. Thanks, David. I would say within residential credit, we do think non-QM securitizations have levered IRRs in the low mid double-digits to mid double-digits. And I think to your point, a lot of it is just -- there is a certain element of scarcity of supply.

Supply has been relatively nascent. Agency pipelines are full high gross margins and you also had a reduction of programs going in April. So we like the sector. We continue to build back up our originator network and our strategic alliances and I think another area of the market that we find attractive is the unrated NPL or RPL security sector.

We see A1 senior securities, 3.8% to 3.25% unlevered yields and we see the senior support securities, 5.25% to 5.50% unlevered yields. And we think levered IRRs within that space are high single-digits on the senior securities. And low mid double-digits to mid double-digits on the senior support.

Michael Quinn -- Head of Commercial Investments

Hey, Mark, this is Mike Quinn. So on the commercial side, I would say, the most attractive things that we're seeing today are in the transitional whole loan space and I think that's for a couple of reasons. One, obviously, we're being cautious just given the uncertainty going forward. But assets have repriced and I think we're seeing opportunities where we're able to lend to borrowers at lower levels today than we saw, you know call it, 12 months ago.

In addition, spreads are quite a bit wider today than they were. I think all-in coupons are probably pretty similar, maybe a little bit higher, but the credit quality of those loans is quite a bit better. So we are seeing opportunities to make new investments on the whole loan side.

Tim Coffey -- Chief Credit Officer -- Analyst

Mark, it's Tim Coffey. I think on the middle market side, we will just continue the pattern of what we've been able to accomplish to date. The portfolio remains very clean and so we expect to see continued tack on acquisition activity on our existing book. You'll see it in the number of issuers that we've been able to maintain, if it continues to be at 50 on the head.

And so I think the benefit of having a clean portfolio is that those names have the ability to go out and execute with tack on acquisition activity, thus, resulting in financing needs to which we can obviously leverage our past success. So the bulk will be coming from what we've done today and continue to increase our exposures on our existing stable of names.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

And Mark, we do also have Ilker Ertas here on the agency side, but it looks as though I've already stolen all this thunder in prior comments. I think where we stand on that front.

Mark DeVries -- Barclays -- Analyst

OK. Great. That's very helpful. Could you just provide us an update on kind of the efforts to manage, whether retroactively on existing portfolio perspective in a new underwriting kind of COVID exposure in the commercial and middle market lending?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. Mike can start --

Michael Quinn -- Head of Commercial Investments

Yeah. So, hey, Mark, this is Mike Quinn again. I think the COVID exposure in the commercial portfolio, I think hits us most in two places, one is the hotel space and two is in retail. So first, on the hotel side, we've really got five positions in the hotel space and in every one of those positions, sponsors are contributing capital to those deals to support those assets.

And four out of our five hotel positions are currently paying. In the retail side, I think we've been hit as well. I think similar themes in that space in that -- the positions we have, sponsors are supporting those deals and infusing capital. I think in some instances, those loans will need to be extended in order to get through this kind of low liquidity period.

But we like our basis in those assets and we feel comfortable with the outcomes going forward.

Tim Coffey -- Chief Credit Officer -- Analyst

Mark, and on the MML side, I think it's pretty clear to us that we've been ironically, a pretty big beneficiary in our portfolio of what's going on with COVID. And certainly, we don't like to say that too loudly, but the portfolio has certainly been able to take advantage of the last six or seven months. So I think [Inaudible] to a lot of things that have been going on with our peers. Our portfolio has actually been able to witness a fundamental improvement across the portfolio name by name.

And I would also tell you, to the extent that we have seen, a select narrow group of names see softness over the past six or seven months. I can also tell you that just in the last couple of months, those names that did see softness in the initial phases of COVID has seen substantial progression in the last few months as they may have been the first -- they may have witnessed the first order effects of COVID, but they've certainly seen the second order of return of firmness. So again, we feel pretty good about how the portfolio stands after the latest sort of volatility in the general market.

Mark DeVries -- Barclays -- Analyst

OK. That's very helpful. Thanks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet. Thanks, Mark.

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

Thank you, Elissa, and thanks to everybody for joining us. We hope everybody's staying healthy in these times. And in line with my earlier commentary around purpose and impact in this environment, irrespective of your political affiliation, I just want to conclude by reminding everyone to get out and vote next week if you haven't already, and we'll talk to you soon. Thanks.

Operator

[Operator signoff]

Duration: 53 minutes

Call participants:

Purvi Kamdar -- Head of Investor Relations

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Serena Wolfe -- Chief Financial Officer

Steven Delaney -- JMP Securities -- Analyst

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

Kenneth Lee -- RBC Capital Markets -- Analyst

Doug Harter -- Credit Suisse -- Analyst

Bose George -- KBW -- Analyst

Brock Vandervliet -- UBS -- Analyst

Mark DeVries -- Barclays -- Analyst

Mike Fania -- Managing Director

Michael Quinn -- Head of Commercial Investments

Tim Coffey -- Chief Credit Officer -- Analyst

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