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Annaly Capital Management (NYSE:NLY)
Q4 2020 Earnings Call
Feb 11, 2021, 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 fourth-quarter 2020 earnings conference call. [Operator instructions] Please note, this event is being recorded. I would now like to turn the conference over to Sean Kensil, vice president, investor relations. Please go ahead.

Sean Kensil -- Vice President, Investor Relations

Good morning, and welcome to the fourth-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 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, www.annaly.com. Content referenced in today's call can be found in our fourth-quarter 2020 investor presentation and fourth-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, webcasts, 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; Ilker Ertas, head of securitized products; Tim Coffey, chief credit officer; Mike Fania, head of residential credit; and Tim Gallagher, head of commercial real estate. And with that, I'll turn the call over to David.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Thank you, Sean. Good morning, everyone, and thanks for joining us for our fourth-quarter earnings call. Today, I'll provide an update on the broader market, our capital allocation trends, including credit activity, and our outlook. Ilker Ertas, our head of securitized products will follow-up with specific commentary on our agency and hedging activity, and Serena will review our financial results.

And as Sean noted, our other business heads are also present to provide additional context during Q&A. The primary themes, the dominated markets in the fourth quarter are largely consistent with our third-quarter narrative. The Fed's monetary policy accommodation provided considerable support for risk assets and contained interest rate volatility. This backdrop, coupled with active portfolio management, drove our strong performance to close out the year as we delivered an economic return of 5.1% for the quarter, ensuring a positive return for our shareholders for 2020 which is particularly notable given the historic disruption we all faced in March.

Now turning to the macro environment. The yield curve bears steepened in the fourth quarter in light of optimism about the post-COVID economic recovery which outweighed the negative developments of record virus cases and the resulting lackluster economic growth to end the year. We have seen a continuation of this rate move into 2021 largely due to the results of the January runoff election and democratic control of each branch of government, leading to greater prospects' further stimulus. Furthermore, the Federal Reserve remains committed to monetary accommodation until the U.S.

witnesses a meaningful recovery in labor markets and higher inflation readings. Thus, the Fed is expected to continue purchasing assets at their current pace through 2021 while forward guidance will keep the front end anchored. We do think the shift to higher longer-term rates will be gradual. Nonetheless, it remains prudent to hedge the tail risk of a spike in rates as we'll discuss shortly.

Now to address how this landscape influences our positioning and capital allocation, monetary policy tailwinds maintain agency as the primary vehicle for reinvestment of portfolio runoff. And we remain comfortable with the agency market for reasons Ilker will discuss, but the continued spread tightening does leave us cautious on higher levels of leverage. Fiscal stimulus should ensure healthy consumer spending once the economy reopens more broadly and service consumption can resume which should be a constructive backdrop for credit. Our allocation to credit marginally increased to 22%, as we began the fourth quarter at the lower end of our range.

And targeted opportunities, largely in residential credit and middle market lending modestly tilted the relative value equation back toward certain pockets of credit. It should be noted, however, that risk assets continue to see strong sponsorship and associated spread contraction, given liquidity in the system, and optimism for a cyclical recovery which necessitates a very disciplined approach to asset selection as our investment teams consistently employed. With respect to our residential credit business specifically, we found the unrated NPL and RPL securities sector attractive, as we discussed last quarter which drove much of the $400 million growth in our residential securities portfolio during the quarter. Within the CRT universe, we have rotated our investments up the capital structure with a focus on very short spread duration assets that have strong deleveraging profiles in light of elevated prepayment speeds.

Spreads on our non-agency securities purchased in the fourth quarter have rallied over 100 basis points, given the strength of the market to date this year. Although securities remain an important part of our portfolio as they provide opportunistic relative value, we were encouraged to see volumes once again gained traction within the non-QM loan market. Our expanded prime whole loan effort continues to be a priority and we are focused on new strategic relationships to grow our sourcing capabilities which builds further optionality for us within residential finance. Turning to middle market lending.

Activity picked up in the fourth quarter as liquidity reentered the sector and we were able to grow our portfolio nearly 10% to $2.2 billion. Of the nearly $400 million of gross activity in the quarter, 80% was first lien and included both new and existing borrowers. As discussed on recent earnings calls, our targeted investment strategy continues to differentiate our portfolio relative to our peers, and our middle market lending group's disciplined credit focus has proven itself out through strong fundamentals with underlying borrower LTM EBITDA, increasing by 14% on average since initial close. We continue to maintain an active dialogue with our borrowers and sponsors, and our watch list performance improved by 43% this quarter, underscoring the health of our portfolio.

Our commercial real estate portfolio decreased somewhat quarter over quarter. While we were able to resume origination activity this past fall, volume did not offset the $108 million in pay downs, as well as, an opportunistic sale in our healthcare portfolio. The $150 million sale price for a portion of our skilled nursing facilities which closed in the fourth quarter, resulted in an IRR of 35% for the portfolio and then nearly 2 times equity multiple. Now shifting to the financing of our portfolio which Serena will discuss in greater detail, I would just like to note that borrowing conditions that exist today are the best we've seen during the company's two-plus decade history.

The liquidity in the system has shifted the market advantage to the borrower, much more so than in past periods of monetary accommodation. It's not just the absolute low level of rates, but also the flat term structure of the repo curve which signals the persistence of an ample borrowing capacity and also affords us the ability to fund agency MBS out a year inside of a mere 20 basis points. Additionally, on the financing front, securitization markets have rebounded substantially, resulting in execution inside of pre pandemic levels. This continued momentum provides attractive nonrecourse term financing to bolster our asset generation strategy and diversify funding for our whole loan business.

Now prevailing financing and securitization dynamics have made both balance sheet and structural leverage more attractive than capital structure leverage in the current environment as evidenced by our recent preferred stock redemption which was prudent from both the capital management and efficiency standpoint and follows a series of transactions since 2017 to reduce our cost of capital and preferred equity. We have differentiated ourselves from others in the REIT sector by growing capital structure leverage more slowly and maintaining a relatively stable amount of total leverage on common equity which is important as we've seen a higher portion of capital structure leverage lead to higher volatility in returns, if not well managed. Annaly is unique in that our size, expense ratio, and liquidity afford us the flexibility to manage our capital exclusively in an accretive fashion. Proactive capital management remains a priority and we renewed our common stock repurchase program authorization following $209 million in repurchases in 2020.

Lastly, despite the attractiveness of balance sheet leverage and funding, we remain disciplined with respect to our overall leverage profile. We've reduced leverage in each quarter since the end of 2019 through last year and maintained leverage at 6.2 times quarter over quarter, the lowest we've had since the first quarter of 2017. We strive to deliver the highest risk-adjusted return for our shareholders and I'm confident our current risk construct is appropriate to yield book value and earnings stability going forward. Now with that, I'll hand it over to Ilker to dive deeper into our agency portfolio activity.

Ilker Ertas -- Head of Securitized Products

Thank you, David. As David mentioned, the agency portfolio had a strong quarter, supported by healthy investor demand, both low in-flight and realized interest rate volatility, and steepening yield curve. Lower coupon TBAs were the strongest performing part of the agency market as they benefited directly from Fed purchases. However, in contrast to prior episodes of QE, specified pools have also demonstrated solid performance.

Given the current elevated prepayment environment, the desire for more cash flow certainty and a strong bid for longer duration mortgage assets, we are seeing the level of pay-ups which stand higher rates and steeper curve experienced over the quarter and into 2021. Apart from Fed, Agency MBS demand remains robust, led by notable appetite from commercial bank community. In the current environment, banks are seeing strong deposit growth while C&I loan growth remains muted. In fact, the loan-to-deposit ratio for the sector is the lowest we have seen in the past 50 years.

With deposits continuing to rise, banks have chosen to grow their securities portfolios which directly benefits MBS valuations and strengthens the specified pool market. Looking at 2020 data, banks [Inaudible] set net bought over $1 trillion MBS in aggregate which was more than twice the available net agency supply last year. Turning to composition of our MBS portfolio. Our lower coupon holdings remain largely in TBAs while our higher coupons are predominantly improved.

This barbell approach maximizes liquidity and benefits from high levels of nominal care in the dollar roll market while providing cash flow stability across diverse interest rate environments from our pools. Approximately, 86% of our pool portfolio consists of higher coupon quality specified pools which provides us with improved convexity and prepayment protection, while the remainder is mainly concentrated in seasoned pools, which are beginning to experience prepayment burnout. The value of our asset selection is evidenced by the prepayment speeds on our portfolio of just under 25 CPR or roughly 10 CPRs slower than the MBS universe over the quarter. In terms of portfolio activity, portfolio runoff was reinvested in lower coupon TBAs and we also rotated out of some of our higher coupon TBAs into specified pools.

On the hedging side, we added to our treasury features and swaption positions, mostly in the 10-year part of the yield curve which benefited from the steepening in the fourth quarter. Hedging costs remain relatively inexpensive in this low rate and low volatility environment. We also want to be positioned for further rising yields under the scenario, where optimism on the economic recovery leads to higher long end interest rates in the medium-term. Given how well risk assets have performed since the second half of 2020, the agency reinvestment landscape is somewhat less attractive than earlier in the year.

However, our outlook for agency MBS remains constructive due to a number of factors. First, the availability of attractive funding in the repo and dollar roll markets. David addressed the repo market. And as for rolls, as we forecasted on the last call, gross specialness has moderated somewhat with market being repopulated with new collateral beyond that, which has been delivered to Fed.

We still achieved a net negative financing cost for our TBAs over the quarter and we expect current production coupon rolls will remain modestly special over the near-term. Secondly, we expect the technical backdrop of strong demand for agency MBS to persist over the course of this year given nominal carry and continued bank demand. And finally, there is a -- there is potential for improved prepayment profile, resulting from steeper yield curve and very early signs of burnout in prepayments. To expand on that point, we observed from recent data that the primary secondary spread is narrowing despite more than 75% of the universe having greater than 50 basis points of refinancing incentive.

In addition, average time to refinance loans has steadily increased from 40 days this past spring to almost 60 days as of late. This suggests that [Inaudible] of easily refinanced target is decreasing for originators, requiring incremental efforts to find eligible borrowers. So for the first time since last spring, the prepayment environment may not be as big of a headwind for higher coupon MBS. As a final point, we note that we cannot look at Agency MBS in isolation.

During previous QEs, other risk assets like the MBS tightening and gave private investors opportunity to rotate into these asset classes. In contrast, during the current QE, nearly all spread products tightened in line, if not more than agency MBS. As a result, we remain constructive on the outlook for agency MBS. Now I will turn the call over to Serena to review our financial results for the quarter.

Serena Wolfe -- Chief Financial Officer

Thank you, Ilker, and good morning, everyone. Before I get started with the numbers, I just wanted to comment that December 2020 marks my first year with the company as CFO. Over the year, the company performed exceptionally well given the challenges we faced. Our results and performance during 2020 reinforced the reasons I was compelled to join the Annaly team which include our human capital, differentiated risk culture, and robust infrastructure built around the businesses in terms of finance, legal, technology, and other support functions.

During 2020, Annaly demonstrated a 23-year old company's steadfast nature while exhibiting an adept industry leaders agility. So with that as a backdrop, today I'll provide brief financial highlights for the quarter ended December 31st, 2020 and discuss select year-to-date metrics. While our earnings release discloses both GAAP and non-GAAP core results, I'll focus this morning on our core results and related metrics, all excluding PAA. As David mentioned earlier, the primary drivers of performance were an extension of themes from last quarter.

We took advantage of the interest rate and financing environment to generate strong results while prudently managing leverage. To set the stage with some summary information, our book value per share was $8.92 for Q4, a 2.5% increase from Q3. Book value increased on GAAP net income, partially offset by the aggregate common and preferred dividends of $344 million or $0.25 per share and other comprehensive loss of $215 million or $0.16 per share. We generated core earnings per share, excluding PAA, of $0.30, a decrease of 6% or $0.02 per share from the prior quarter.

Our core earnings also represent 140% of our dividend and we saw back-to-back quarters of 13% plus of core ROE. Combining our book value performance for the $0.22 common dividend we declared during Q4, our quarterly economic return was 5.1%. We generated a full-year economic return of 1.76% and a total shareholder return of 2.43%. While down compared to prior years, we are proud of our positive 2020 return given the unprecedented market conditions we faced earlier this year.

Delving deeper into the GAAP results, we generated GAAP net income of $879 million or $0.60 per common share for Q4, down from $1 billion or $0.70 per common share in the prior quarter. GAAP net income decreased primarily due to lower realized gains on investments resulting from fewer agency MBS sales in Q4 versus Q3. However, GAAP net income benefited from higher unrealized gains on interest rate swaps driven by higher rates. Additionally, we recorded higher gains on other derivatives, largely futures, offset by lower gains in fair value option loans and securities, and lower interest expense on lower average repo rate, down to 35 basis points from 44 basis points, and lower average repo balances down to $65.5 billion from $67.5 billion.

Moving on now to CECL reserves. In the current quarter, we continue to see a general improvement in market sentiment and the economic models we use in this process. Total CECL and specific reserves were relatively consistent with prior quarters. As we continue to provide transparent disclosure, we've included a slide in our investor presentation that provides additional color and detail on the assumptions utilized in evaluating our CECL reserves.

We recorded an immaterial increase in reserves, primarily associated with our commercial real estate business of $1.5 million on funded commitments during Q4, driven by an increase in specific reserves, partially offset by a decrease in the general CECL reserve. Total reserves, net of charge-offs, now comprise 4.48% of our ACREG and MML loan portfolios as of December 31st, 2020, versus 4.56% as of the prior-quarter end. We remain comfortable with our existing credit portfolios and the associated CECL reserve, and we'll continue to monitor specific asset performance and economic projections as we determine future reserves. Turning back to earnings.

I wanted to provide more details surrounding the most significant factors that impacted core earnings quarter over quarter. First, consistent with my commentary around GAAP drivers, interest expense of $94 million was lower than $115 million in the prior quarter due to lower average repo rates and balances. TBA dollar roll and CMBS coupon income of $99 million was lower than $114 million for the third quarter due to slightly more modest specialness in the fourth quarter. We had increased expenses related to the net interest component of interest rate swaps of $67 million relative to $63 million in the prior quarter as the swap portfolio reset to lower market receive rates and two high strike receive swaps expired.

And finally, we experienced a continued improvement in G&A expenses. On the financing front, our all-in average cost of funds this quarter was 87 basis points versus 93 basis points in the preceding quarter. The fourth quarter brought the full-year average cost of funds to 1.34% versus 2.25% in the prior year. Our weighted average days to maturity are down, compared with the prior quarter at 64 days versus 72.

Our Q4 weighted average days, slight reduction compared to Q3, results from the natural roll down from our longer-duration repo trades we executed in prior quarters. Our treasury group's view in the latter part of last year was that term curve would continue to flatten. What I can tell you is that we set this view based upon the Fed's forward guidance on remaining at the zero lower bound into 2023, as well as, a meaningful increase in already abundant reserves in the system in 2021 from both continued QE and a drawdown in treasury general account balances. As we've entered the new year, this view has come to fruition as one year bilateral term repo for agency MBS can be locked in, in the upper high-teens currently.

Consequently, we are beginning to add duration to our repo book this quarter. Concerning credit financing, we see further improvement in repo terms for our credit securities with increasingly lower hiccups and tighter spreads. We have also renegotiated our warehouse facilities to support our direct lending businesses proactively and have realized cost savings accordingly. The portfolio generated 198 basis points of NIM, down from 205 basis points as of Q3, driven primarily by the decrease in average asset yields and reduced dollar roll income offset by the decline in the cost of funds that I mentioned a moment ago.

And as a management team, we focus on providing value to our shareholders, including a keen eye on the company's expenses. Having said that, we continue to see improvements in our efficiency ratios, being 1.27% of equity for the fourth quarter in comparison to 1.32% in Q3 of 2020 and 1.62% for the full year, compared to 1.84% for the prior year. The 2020 annual opex results are within the range of expected cost savings disclosed in Q1 with our internalization transaction announcement. And I would reiterate the 1.6% to 1.75% opex target we disclosed last year as an appropriate benchmark.

And to wrap things up, Annaly ended the quarter with an excellent liquidity profile with $8.7 billion of unencumbered assets, consistent with prior quarters of $8.8 billion, including cash and unencumbered agency MBS of $6.3 billion. I'll now turn it back to David for some closing remarks before opening it up for Q&A.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Thanks, Serena. Lastly, before we move on to Q&A, I thought I'd provide broader perspective in two areas. First, there is an abundance of metrics that underscore a growing disconnect between valuations and fundamentals. Broadly, market indices are reaching historical records and consensus calls for them to continue to rise.

The S&P 500 at 40 times earnings, high-yield credit, and the proximity of all-time tight spreads and the $81 billion of SPACs raised last year as liquidity has flowed further out the portfolio balance channel. Annaly, however, continues to be a source of responsible yield in a market where it's increasingly challenging to deploy capital. As I mentioned at the outset, the fundamentals are positive for Annaly investors with a low-cost, stable financing environment, an upward sloping yield curve, low interest rate volatility, and a strong supply and demand backdrop for our assets. We've seen our book value continue to strengthen into 2021 and have outearned our dividend for the past few quarters.

We are delivering a dividend yield of over 10%, in line with our historical average while the S&P 500 earnings yield of 2.5% is the lowest it's been in the past decade. Annaly represents one of few countercyclical or acyclical yield strategies that are less at risk to the pace of economic recovery. Additionally, we provide equity portfolio diversification without sacrificing returns while money market funds are zero and real treasury yields are at near-record lows. As unforeseen events will once again shift investors focused to fundamentals, balance sheet strength and earnings stability will be coveted.

Now secondly, we have talked about leading with purpose this year in response to the trying societal and economic climate that marked 2020. And at Annaly, our mission is to utilize our capital to generate attractive returns and support the American homeowner. To that end, we have kept our focus on the individual needs of our borrowers and supported government policies to extend forbearance periods. We have also used our human capital to meaningfully contribute to the communities where we live and work.

Through our corporate philanthropy initiatives, we have focused on partnerships with high-impact programs that seek to combat homelessness, provide food security, and advance women and underrepresented groups in the workforce. Annaly employees have volunteered their time and energy to serve vulnerable New Yorkers in their hour of need and our culture of responsible investment with respect to where we invest, both our dollars and time is something we're very proud of, and it has undoubtedly yielded considerable impact for our overall stakeholders. And with that, operator, we can open it up to Q&A.

Questions & Answers:


Operator

[Operator instructions] And the first question will come from Steve Delaney with JMP Securities. Please go ahead.

Steve Delaney -- JMP Securities -- Analyst

Good morning, everyone, and thanks for taking my question. David, based on your comments and Ilker's, I would certainly conclude that in the first quarter, we heard the word tightening several times, yields compressing. So it would indicate to me that unless something on the derivative side came into play that your book value for Annaly should have moved higher in the first six weeks of the year and I wondered if you could offer any observation on that.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure, hi, Steve, and good morning. Yeah, our book value has moved up. As of Tuesday, we were up roughly 3.5% on the quarter, partially attributable to your point on spread tightening, but also portfolio positioning in terms of a bias toward a steeper curve, as well as, up in coupon which has outperformed lower coupons thus far this year. So there's still half the quarter left to go, but we feel pretty good about where we're at now.

Steve Delaney -- JMP Securities -- Analyst

Appreciate you sharing that. We'll adjust the comp table immediately. And then just looking over on Page 3 of the deck and looking at the credit book a little bit. You know, it seems like there was growth in virtually every credit bucket that I could determine, especially as you highlighted in the in the residential loan areas.

But CRE at -- CRE debt did decline about $80 million. And is that a trend that we should expect to continue? And if so, what would change you and Tim's outlook for when to -- when to step back into that market? Thanks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. I'll start off and then pass it off to Tim. Look, it's still early in terms of the CRE recovery. We've stressed that on past calls, given the dynamics with respect to the virus and how we're using commercial real estate as a society.

And the notable decrease in the portfolio is attributable to a sale of part of our healthcare facilities, as I mentioned, which we basically took advantage of a very good opportunity to generate a profit on that. We did uh -- we did again, return to the origination front in the fall and did get a couple of deals done, but we also had a little over $100 million in runoffs. So yeah, the decrease largely was opportunistic and with respect to the outlook on CRE, Tim.

Tim Gallagher -- Head of Commercial Real Estate

Yeah, I think that's right. I think this is a one quarter look as to sort of what happened in the fourth quarter with respect to that sale. We're being cautious about where we deploy capital. Like a lot of people in our space, we're focused on industrial and multifamily and to the degree that we can find good opportunities there, we're doing that.

And so I wouldn't read a whole lot into the decrease in one particular quarter, as the market continues to heal, we continue to look at opportunities.

Steve Delaney -- JMP Securities -- Analyst

That's helpful. Thank you, both for your comments.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Steve.

Operator

And the next question will come from Rick Shane with J.P. Morgan. Please go ahead.

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

Hey, guys. Good morning, and thanks for taking my question. Look, I think that there are lots and lots of silver linings here. But David, you said something that was kind of interesting in terms of reducing or staying at the lower end of leverage.

We're in an environment now where rates are exceedingly low, yields are exceedingly low, and that has a historical precedent of not necessarily ending particularly well because it sucks so much liquidity into the system. I'm curious to sort of hear your touch of gray theory on lower leverage and how you'll be defensive through this period.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yeah. It's a great question, Rick, and yes, we are at the lower end of our leverage. We do feel like we still have in 2021 a fair amount of runway for carry in agency MBS to dominate the day. But again, asset spreads across sectors are tight and we have to be very mindful of yields and spreads, and to the extent that there is some local shakeup in terms of spreads or any market volatility.

We want to be prepared for that eventuality. Now that's not to say we would keep leverage at these low levels, but we are a ways away from spread widening that would suggest we'd increase it and we just think it's the right approach to maintain. We're still generating a double-digit yield. It is providing the income for the shareholder and we're able to do more with less, and we're perfectly content to maintain that posture for the time being.

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

Got it. And it is interesting because the last couple of quarters, you've talked about very clearly a path to outearning the dividend at this point. You didn't make that comment this quarter. How do you feel in context of running with a lower leverage in some of the spreads tightening?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. And so for the first quarter, we do expect to outearn the dividend, but not to the extent we have in the last quarter. But we still feel very good about where core earnings are coming in at over the near-term.

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

Terrific. Thanks. I apologize for the puppy yearning in the background. We expect it now.

Thanks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Rick.

Operator

The next question is from Eric Hagen with BTIG. Please go ahead.

Eric Hagen -- BTIG -- Analyst

Hey, good morning, guys. I hope you're well. A couple of questions here. Lots of numbers getting offered out there suggesting.

I think you said in your opening remarks, 75% of the market, I've heard upwards of 90% of the overall market and the money to refi. That feels aggressive considering how much turnover there already was last year. Can you weigh in on that? And maybe just rationalize how strong you think the incentive is, including for various cohorts of specified pools? And then on the portfolio, can you talk about where in the coupon stack you see the carry being strongest right now and which cohorts of specified pools you think offer the strongest value? Thanks.

Ilker Ertas -- Head of Securitized Products

Sure. In terms of like refi incentive, what people use and we also use the similar thing is like we just look at the gross coupon of the pools and as long as it's like 75 basis points in the money, we called it like 50 basis points. As long as 50 basis points in the money, we call it 50 basis points in the money. For example, if you take the primary rate as 275, clearly, that's the best borrowers are getting.

Right now, you can say that around 77% of the universe is in the money. But you pointed out perfectly that not all guys get this 275 and a lot of these guys have like, problem with the refinancing. In fact, like we said in our prepared remarks that we are seeing some signs of burnout because everybody is not getting this. In terms of like specified pools, we are still finding opportunities in higher coupon, higher coupon meaning to in our sense, threes in this case.

Loan balance pools with some other characteristics, for example, non owner-occupied and all that kind of stuff. So, yes, there are still pockets of opportunities. But unlike the previous QEs, where only Fed was buying and specified pools who are reasonably attractive, this time around, banks are also buying and that will make specified pools tighten in line, but there are still opportunities, as I said, loan balance like some other characteristics.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Does that help, Eric?

Eric Hagen -- BTIG -- Analyst

Yeah. Thank you guys very much.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Thanks, Eric.

Operator

The next question will be from Bose George with KBW. Please go ahead.

Bose George -- KBW -- Analyst

Hey, guys, good morning. So just actually wanted to follow up a little bit there on just -- on the returns, incremental returns. In terms of specialness, I think Ilker, you said you expect modest specialness. Can you just quantify that a little bit and then just incremental ROEs that you're seeing on the specified pools? And then if you just add it all up, can you get a double-digit return now in the market on incremental capital?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Hi, Bose, it's David. So yeah, to Ilker's earlier comments, getting a double-digit yield is difficult. It was certainly achievable in TBAs in the latter half of 2020, but specialness has dissipated somewhat. We do expect it to remain prevalent, certainly while the Fed's in.

But I'd say we're talking very high single-digits on TBAs and in that context on pools we're buying.

Bose George -- KBW -- Analyst

OK. Great. That's helpful. And then actually just switching over to the returns you're seeing in NPLs and RPLs.

You know when you look at the recent deals they're selling at par, can you just help us walk through the returns that you're seeing from those assets?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. I'll start and then hand it over to Mike and this is something Mike talked about on our last earnings call in terms of that being a part of the resi sector that we've taken advantage of. And throughout the fourth quarter, I think Mike was very active in acquiring RPL 8 2s and at spreads that were meaningfully wider than where they are today. So the trade is not quite as attractive now, but we certainly took advantage of it in Q4 and into Q1.

Bose George -- KBW -- Analyst

Sure. Thanks.

Mike Fania -- Head of Residential Credit

Yeah, I would say, in terms of kind of the unrated NPL/RPL space, we still think that you're able to achieve high single-digit levered ROEs and that's on a prudent amount of recourse leverage. I would say the assets that we added throughout Q4, we think are probably closer to low mid-double-digits, very low-teens. And to kind of frame that market right now, 8 1s are probably at 2.25% yield, so that's 190, 195 [Inaudible]. And then RPL 8 2s which has been more of a focus, not so much on the NPL 8 2s, call that 375 to 400 to the curve.

And again, probably right now, very high single-digits levered ROEs. In terms of CRT, we have been active, it's mostly been seasoned pre-COVID M2s. So these assets are -- have unlevered spreads of 180 to 200. But they have a number of redeeming credit characteristics, their one to two-year late average life assets, very high-gross WACs, and you're seeing significant deleveraging of those assets.

And I would say for both of these products, there's been ample liquidity and balance sheet in terms of P&L. We've continued to see terms tighten in given the landscape, so not as attractive as what we saw last quarter, but we still think that there are pockets of opportunity.

Bose George -- KBW -- Analyst

OK. Good. That's helpful. Thanks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Bose.

Operator

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

Doug Harter -- Credit Suisse -- Analyst

Thanks. Acknowledging that we haven't even hit the kind of the one-year anniversary of the volatility, but I guess, how do you think about your liquidity position today and kind of over the long-term as markets continue to heal. Kind of what the right level for liquidity holdings in a normalized environment?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yeah. It's a great question, Doug. And we have talked about this a fair amount over the past. Look, we can't -- as I've said, we can't unsee what we saw in March and all of these episodes of volatility does have to inform your business model on a go-forward basis.

So in light of this, we do think that the steady-state level of leverage is lower than it was. You know, the Fed is not always going to be there and liquidity is paramount. We put ourselves in a very good position coming out of March, and we've maintained that. And it's not just about having reserves on the balance sheet to manage through volatility, it's also about having opportunities to do things that others without the capital base of the liquidity that we have that others can't quite do.

And when it comes to investing, for example, in Mike's residential effort and being able to provide certainty of execution for originators with our liquidity, that's confidence inspiring to our partners and they look at our balance sheet. They know that we're in a place of strength and so there's a lot of other benefits beyond just simply being able to manage through volatility. The same is the case on middle market lending, where Tim's got a very unique business where he does have the liquidity of the REIT. That conveys to sponsors that we can do things that other lenders aren't in a position to do.

And as a consequence, he can accomplish some pretty significant things in that business. So -- so there's both a conservative aspect coming out of March, but there's also an opportunistic aspect as we look forward in terms of just being able to do things with our liquidity and having that strong foundation that we feel good about and we think it will remain the case for the foreseeable future.

Doug Harter -- Credit Suisse -- Analyst

Thanks. And then also just on the capital structure, I guess just how are you thinking about that going forward? Any other kind of changes that you would -- that you would envision kind of in the coming year?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. And I talked about the call of our preferred which we certainly feel very good about our overall capital structure, where 11% of our capital is in preferred with the rest entirely in common. And it's important to note with our existing preferred, where we issued that, the post reset spreads that will prevail are between 417 basis points and 490 basis points. And when you look at the forwards, when those preferreds do reset, we're talking about a preferred cost of capital in the context of 5%.

So the existing preferreds that we currently own, we feel good about, particularly, with respect to that low cost of capital. But now how we look at our overall capital structure is, as we said last quarter, there's three forms of leverage. There's, first and foremost, balance sheet leverage, then there's structural leverage within the portfolio, and then there's capital structure leverage. Currently, right now, the best form of leverage is balance sheet leverage and that's a function of just the incredible amount of reserves in the system.

And as a consequence, that's what we're taking advantage of and that's what we feel good about. Now with respect to structural leverage, it's important to note that just the ample amount of balance sheet available in the system, it hasn't just affected agency MBS, but it's also had an impact on other products that also use leverage, mainly very high credit quality assets like AAAs and as a consequence, for example, AAA spreads across our businesses are very tight. So the way we look at that is, for example, in our resi business and securitization, we can take advantage of the availability of balance sheet by selling AAAs and then retaining that structural leverage and we get a benefit from that, but it all starts with the balance sheet leverage that's available in the system. And with respect to preferreds and the capital structure leverage, you know, we're not at a point in terms of where yields are on preferreds where we would issue.

We need a much greater spread between where we can invest. For example, agency MBS versus the cost of prep in the market. And so at these current spreads, we don't have an intention of increasing our structural leverage right now or I'm sorry, our capital structure leverage.

Doug Harter -- Credit Suisse -- Analyst

Great. Thank you.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet.

Operator

The next question is from Kevin Barker with Piper Sandler. Please go ahead.

Kevin Barker -- Piper Sandler -- Analyst

Thank you. Good morning. Could you perhaps just give us a view on your appetite for acquisitions and what the market currently looks like? Just given a lot of activity that's going on in the capital markets, combined with a bunch of disruption in various other lending categories, just love to hear your view on what's happening within M&A.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure, Kevin. Look, we have been acquisitive in the past. The way I look at it is there's three catalysts for acquisition. Number one is assets, number two is price, number three is the strategic fit.

Now there has been a couple of combinations that we've seen in the recent past, and candidly, they've traded at prices that I wouldn't characterize as compelling. For us to acquire a company, provide liquidity, we got to get paid for our time, operational risk of onboarding a portfolio, and we got to make sure that the assets fit what we want to do going forward. And so, you know, I will say it's not as attractive today, just given the pricing. But to the extent where there's a disconnect between where we're trading versus where somebody else may be trading and there's a need for our liquidity and we can do so profitably, we'll absolutely consider the opportunity.

Now the third point is strategic fit, as a third catalyst. If there is something out there that can accommodate our businesses, we would certainly look at it. But right now, we feel we're well equipped across all of our businesses to do what we need to do organically and to the extent that changes and there's something out there, we'll certainly look at it. But we feel very good about how our businesses are performing right now and we're in a good place.

Kevin Barker -- Piper Sandler -- Analyst

Sure. I mean would you categorize the M&A opportunities or the amount of flow that you're seeing to be equal or better than what you were seeing pre-pandemic levels just given the state of the market today?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You know, it's episodic. That's a hard question to answer, candidly. We do expect there to be more M&A activity in this sector and a lot of it does have to do with what occurred early last year in terms of depletion of capital across firms. And so you get to a point where firms can really be inefficient because operating expenses relative to what type of returns can be generated are just -- they're just not of scale and so I would expect there to be more activity in 2021.

And again, to the extent it would work for Annaly, we would certainly look at it, but we're not out there chasing companies to buy. But yeah, you should expect more activity going forward.

Kevin Barker -- Piper Sandler -- Analyst

Thank you very much.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Kevin.

Operator

The next question will be from Vilas Abraham with UBS. Please go ahead.

Vilas Abraham -- UBS -- Analyst

Hey, guys. How are you? An interesting commentary on the commercial bank bid for agency MBS. Just curious, how material do you think that is to where spreads are now and just how does that play out over the course of the year? And I guess, maybe also tying that into what you guys are thinking about the Fed taper and then on the back of those kinds of events, where it could leverage go? Could it go higher as those events transpire? Thanks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. You bet, Vilas. So look, with respect to commercial banks, it has been a very strong bid in the market. In 2020, commercial banks were flushed with deposits and there weren't a lot of lending activity or there wasn't a lot of lending activity to take advantage of.

And so banks had really the -- the direction they took was to buy securities. And between treasuries and agency MBS, they added over $750 billion in those sectors in 2020. Now you compare that to prior episodes of QE and net securities growth for banks, for example, in QE3 was roughly flat, even, I think, slightly negative, if memory serves me correctly. And so the point being is that banks have been a very strong bid for the agency sector in the fourth quarter alone at about $200 billion.

January, we just got data, another $75 billion in agency MBS and so they've been a strong contributor to the spread tightening and we do expect that to continue. Now with respect to taper, and that's obviously gained a lot of conversation in the market over the -- not to -- over the recent past. Now I'll say this is a very different environment in 2021 than what we experienced in 2013 with the taper tantrum and the Fed is in a very different place and the market's in a very different place. Now the Fed learned a lot from the taper tantrum.

And as a consequence, you see much greater transparency, better forward guidance, and they fully intend to prepare the market for a cessation or drop-off in purchases of securities. So we feel good about how the Fed is going to message to the market and the signaling we've got is that QE will exist in its current form through 2021. And we may get reason to think they'll change that guidance depending on how the economy plays out, but we do think we're a ways off from that from that eventuality. Now another point to note is the market is in a much different place in 2021 than it was in 2013.

You know, in 2013, it was almost as if the market felt like it had a put option because of the Fed's position. And obviously, that turned out not to be the case. Here, in 2021, I think the market is much more conservative and defensively positioned and you see it in a lot of the data. For example, if you look at some of the statistics about short positions on the CFTC, the market appears hedged.

Also J.P. Morgan puts out a survey about long versus short and the market appears short from that standpoint or at least hedged. And then when you look at option pricing, the price of puts, the price of portfolio insurance and fixed income is meaningfully higher than the price of calls and so it does feel like the market is a little bit positioned for higher rates. And another point to note is the convexity profile, and the convexity in the market is better today.

And it's not just about the actual convexity in the instruments, but also who holds the agency MBS in the market and that did contribute to a lot of the sell-off and spread widening in 2013. At the time, the Fed and banks owned roughly 50% of agency MBS in 2013 with the rest of the market owning the rest and a lot of the rest was hedged. REITs were more levered and so there had to be more activity with the sell-off at that point. Today, banks and the Fed owns 63% of the universe at year-end.

Now if we fast forward to how this year should play out, if bank demand is consistent with what it was last year, and the Fed maintains its pace, then that number will go -- grow to 70% of the agency MBS in the market. And again, that doesn't hedge convexity and banks hedge very little of it and so we feel like the market is better prepared. Fed is doing a much better job of messaging and we're in a much better place, but we're always going to be watchful. We have our portfolio of pretty much fully hedged from a duration standpoint and we have optionality where roughly 40% of the convexity profile of the agency portfolios hedged with swaptions and so we feel good about that.

But we're going to be vigilant and we're going to make sure we stay on top of any rate moves. Does that help?

Vilas Abraham -- UBS -- Analyst

That's very helpful. Thank you. And just quickly on prepay speeds, it sounds like you guys are getting incrementally more positive there. Can you just talk about what you see the cadence of CPR is being, like do we get to a normalized level there anytime soon? Or is it still going to be pretty elevated for a while, just maybe a little bit less elevated than you previously may have thought? Thanks.

Ilker Ertas -- Head of Securitized Products

Sure. Ilker here. Yes, it is very elevated and in the near-term, it may stay elevated. And biggest reason for that one is, obviously, because of the COVID, they made it so easy to refinance.

For example, electronic form of like signing some documents and all that kind of stuff and recent IPOs, all these nonbank originators becoming extremely efficient. These are all well known but also like what happened is, we rallied very sharply. So they were like a really good collateral. 2018, 3s and 4s and for example, are like prime borrowers at that point because that was the current coupon rate and 3s of 2019, likewise and 2022 announced.

So brand-new issued collateral at that point become in the money so quickly and these guys are recently refinanced guys, they know how to refinance, and they are getting costs from brokers. And also like refinance happens like in two channels: borrower cost to refinance or lender or broker reaches the borrower to refinance. So we do not expect a burnout on this second channel that I'm mentioning and the reason is that recent IPOs and very high profitability of the refinancing. But we are seeing burnout and we will expect to see more burnout on the first channels which means that borrower makes the outgoing cost.

Because if you haven't called by now and you have been in the money more than like 100 basis points in the money for over a year, it's a good bet that you will not be calling soon. So in the first channel that I mentioned, we'll be seeing some burnout and this burnout will show itself in the more seasoned collateral and like a more loan balance collateral. As for the overall burnout that we were accustomed to, it will take a little bit longer time, probably end of the year that we will see on the brand-new collateral for getting the burnout. Does it help?

Vilas Abraham -- UBS -- Analyst

Yeah. Thank you, guys.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Vilas.

Operator

[Operator instructions] Next question is from Kenneth Lee with RBC Capital Markets. Please go ahead.

Kenneth Lee -- RBC Capital Markets -- Analyst

Hi, thanks for taking my questions. Wondering if you could further expand upon your prepared remarks about potentially seeing some benefit from a steepening yield curve. I wonder if you could share some thoughts on any potential impact to returns or net investment spreads going forward. Thanks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. There's a couple of components, Ken. I will say, from a positioning standpoint, as I said, we do have a modest steepener on. We added roughly $10 billion in hedges in the fourth quarter at the longer end of the yield curve and we also actually added a little bit very early in the first quarter of this year, and so we feel good about the positioning.

We're right around five years, average duration of our hedge profile and our mortgage portfolio is roughly half of that. And so -- and so from that standpoint, just a pure steepening of the yield curve with spreads unchanged, we would benefit modestly from that, we think. Now it is somewhat of a double-edged sword because the steeper the yield curve, the more expensive it is to hedge. Your pay rate on new hedges goes up, while your receive rate stays very low as the front end is anchored.

Another point to note is that your hedges do roll down the curve and they roll down at a much quicker pace than agency assets do. So as that roll-down occurs, there is some mark-to-market deterioration as a consequence of that. But nonetheless, a steeper curve would probably -- would modestly benefit us. And if Ilker --

Ilker Ertas -- Head of Securitized Products

Yeah. Those are very good points, David, and also like steeper curve helps the option cost a lot on these mortgages. And we were talking about burnout, but steeper curve helps the prepayments a lot and also market segmentation can be really beneficial. As curve steepens, there will be more opportunities on the coupon swaps, and because of the option costs and there will be also opportunities on the derivatives execution.

So steeper curve is most mortgage investors want and we are looking for that. But we are -- we should be very cognizant of the hedging consequences that David mentioned. So as long as we can manage those steeper curve is like very nice welcome for the mortgage investors.

Kenneth Lee -- RBC Capital Markets -- Analyst

Great. That's very helpful. And just one follow-up, if I may. I think in the prepared remarks, you mentioned that you were adding a little bit of duration to the repo book.

Wondering if that's primarily an opportunistic just taking advantage of the current costs. Or is there any kind of longer-term view toward, either extending out the financial maturities or things of that nature? Thanks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure, Ken. So we have added duration of the repo book. We are now just over three months and that is attributable to taking advantage of, as I've talked about in the prepared comments, of one year rates, for example, inside of 20 basis points. We don't expect to see a negative rate environment.

And as a consequence, to the extent we can lock in funding costs for a year, that close to the zero lower bound, shame on us if we don't take advantage of it. And so that's just simply a function of the fact that rates out the term are incredibly low. And as Serena talked about, we did let the repo book run down in terms of average days in the fourth quarter and that was just simply a function of the desk's view that with more and more liquidity entering the system and the actual need to lock up cash with collateral, we've seen a willingness for participants to term it out. Just to lock up that collateral at rates above overnight, even though we're 10 basis points or less between overnight and term, and there's just demand for collateral in the market that we've taken advantage of.

Kenneth Lee -- RBC Capital Markets -- Analyst

Great. That's very helpful. Thanks again.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Ken.

Operator

Ladies and gentlemen, 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, and thank you, everybody, for joining us today. We hope everybody stays safe, and we'll talk to you soon.

Operator

[Operator signoff]

Duration: 63 minutes

Call participants:

Sean Kensil -- Vice President, Investor Relations

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Ilker Ertas -- Head of Securitized Products

Serena Wolfe -- Chief Financial Officer

Steve Delaney -- JMP Securities -- Analyst

Tim Gallagher -- Head of Commercial Real Estate

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

Eric Hagen -- BTIG -- Analyst

Bose George -- KBW -- Analyst

Mike Fania -- Head of Residential Credit

Doug Harter -- Credit Suisse -- Analyst

Kevin Barker -- Piper Sandler -- Analyst

Vilas Abraham -- UBS -- Analyst

Kenneth Lee -- RBC Capital Markets -- Analyst

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