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Annaly Capital Management (NYSE:NLY)
Q1 2021 Earnings Call
Apr 29, 2021, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Good day, and welcome to the Q1 2021 Annaly Capital Management earnings conference call and webcast. [Operator instructions] Please note, this event is being recorded. I would now like to turn the conference call over to Mr. Sean Kensil, vice president, investor relations.

Mr. Kensil, the floor is yours, sir.

Sean Kensil -- Vice President, Investor Relations

Good morning, and welcome to the first-quarter 2021 earnings call for Annaly Capital Management. Any forward-looking statements made during today's call are subject to certain risks and uncertainties, including with respect to COVID-19 impacts, which are outlined in the Risk Factors section in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the disclaimer in our earnings release in addition to our quarterly and annual filings.

Additionally, the content of 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 first-quarter 2021 investor presentation and first-quarter 2021 financial supplement, both found under the Presentations 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 other members of management. And with that, I'll turn the call over to David.

David Finkelstein -- Chief Executive Officer

Good morning, everyone, and thank you for joining us today. Back on our first-quarter 2020 earnings call, I discussed the conceptual three-phase process for how our portfolio strategy would evolve coming out of COVID. To review briefly, the first phase was about preserving capital and shoring up liquidity, which we did successfully as the crisis unfolded, positioning us with the healthiest liquidity and capital position this company has exhibited in years. Phase two characterized the majority of last year, was about deploying capital in the agency sector, which I referred to as the shelter in the storm, while making opportunistic investments within credit, while the Fed and fiscal intervention provided strong support for both our assets and liabilities.

We then outlined phase three, which involves more transformative and strategic reallocation of capital to best position the company in a new environment. We were prepared to utilize our liquidity, benefit from the dislocations across markets and sharpen our strategic focus. Today, I will provide an update on our progress on this third phase which reflects our macro views and the vision for the company going forward. Following changes to the senior leadership team, including my appointment as CEO last March, was an opportune time to reevaluate certain businesses and revisit our expense structure, while also actively building out the necessary infrastructure and personnel to broaden our operational capabilities within residential housing finance.

Now before I go too far down that path, I'll begin with the commentary on the rates market, the price action this past quarter was notable. First quarter was marked by a meaningful sell-off in interest rates as the 10-year note rose over 80 basis points, signifying one of the largest quarterly sell-offs in the past 5 years. The sharp repricing was driven by a meaningful boost in economic growth expectations, best seen in the Federal Reserve's economic forecast for 2021 GDP growth. While FOMC members had forecasted a strong 0.2% growth this year at the December meeting, they revised their projections up to 6.5% by the March meeting.

annual growth would be the strongest in nearly 40 years as the significant progress made on vaccinations appears to be paving the path out of the pandemic. And at the same time, substantial government stimulus, a very healthy consumer balance sheets are also boosting the U.S. economy. Longer-dated rates also reflect the anticipation of higher inflation base effects and consumers' willingness to pay elevated prices given the receipt of stimulus checks are noticeably lifting prices.

Inflation is likely to temporarily rise above the Fed's 2% target in the near term, but it remains uncertain as to whether persist and higher inflation will take hold until we see meaningfully higher wages for consumers. In addition, all the factors that have been associated with lower inflation over the past three decades, changing demographics, automation, and increased globalization to name a few remain in place, which does reduce the risk of a continued sharp sell-off. That being said, volatility in rate markets suggests that investors are not yet efficient in pricing the economic response to consumer enthusiasm. Volatility should, therefore, remain somewhat higher as investors learn how much inflation will rise, how much fiscal support the government will offer and how rapidly the U.S.

exits the pandemic. However, any turbulence should be dampened by a Federal Reserve that continues to signal patients when it comes to its monetary policy decisions despite the strong improvement in the outlook in recent months. Further down the road, the Fed will face difficulties extricating its sizable policy footprint for markets, necessitating any withdrawal to be gradual and well communicated. While we still see strong tailwinds for Agency MBS, which Joe will expand upon following my commentary, the forecasted strong economy and the interest rate landscape tilts the relative value equation modestly in favor of certain pockets of credit.

Our capital allocation to credit rose from 22% to 27% this past quarter primarily driven by $1.4 billion of gross residential credit investments. I'll also note that the nominal increase in the percentage was in part due to capital optimization decisions for certain credit products made possible by our excess liquidity cushion. Now turning to our strategic activity in the quarter. We announced the sale of our commercial real estate business to Slate Asset Management for a purchase price of $2.33 billion.

And we feel the transaction achieves great execution for our shareholders and is a validation of the quality of the portfolio that has been on balance sheet since 2013 and the experience of our team. The rationale for the transaction is best illustrated by briefly revisiting history. Turning back to the environment when we acquired CreXus, bringing commercial assets onto our balance sheet, the Fed was a few months into QE3, and Agency MBS looked rich on a risk-adjusted basis relative to credit given the first-order impacts of the MBS bond-buying program. Moreover, we were still in the somewhat early stages of the economic cycle and could therefore pick up 200, 300 basis points of excess spread and senior transitional light loans with strong visibility of business plan in top markets.

That relationship has sharply reversed over time as the commercial market has seen strong investor interest and record levels of capital raised, which subsequently eroded the compatibility of the commercial platform with our core Agency strategy. We had embarked upon an evaluation of the optimal size and structure of the commercial business pre-COVID, but the pandemic required CRE participants to confront the fundamental structural changes in the industry that we expect to occur over time. With the unprecedented support injected in the economy, we had certainty the recovery would prevail when the data began to turn, we were well prepared and confident that the sale of our commercial platform would provide the strongest outcome for the company and our shareholders. After a comprehensive exploration and a process to find firms that represent strong fits for the business going forward, we identified a potential buyer to acquire the platform, including its assets in the majority of the people.

In addition to the economics to the buyer, we will maintain a favorable carry profile on the assets until close, mitigating our reinvestment risk. With respect to use of proceeds, while Agency may serve as a placeholder for capital return, considerate of spreads, over time, we will rotate the capital across our other investment strategies as opportunities arise. Given the customary closing conditions and regulatory approvals, we're still multiple months away from receiving the capital back from the sale, which will be approximately $650 million. The transaction will give us additional capacity to further expand our leadership and operational capabilities across all aspects of the residential mortgage finance market, which has been the cornerstone of Annaly's strategy since our founding.

The current environment reaffirms the strength of the housing sector, and we continue to be excited about the growing synergies between our agency and residential credit businesses. Now the first area in which we're expanding our capabilities is the MSR sector. Previously, we owned MSR via a servicer that we acquired in connection with our Hatteras acquisition and later sold. But our portfolio has been in runoff mode for the past year, and therefore, we've employed a multifaceted approach to investing in the asset class today.

We have committed third-party partnerships that we've developed as part of our build-out to own and overseas servicing of MSR in-house, and we have made several key hires with decades of industry experience, lead this effort. Additionally, we've witnessed significant progress with licensing our base subsidiary, established a satellite office, and have begun to grow our portfolio again. We are a complementary strategic partner to originators because of the breadth of products we can acquire from them and the certainty of our capital as a takeout. This has become particularly useful as the primary-secondary spread has contracted, reducing originator profitability, leading to increased secondary MSR volumes.

MSR is highly additive to our prospective returns as a positive yielding hedge to our core agency strategy, while also modestly reducing our agency basis exposure. However, as we have said in the past, in the absence of a severe pricing dislocation, we do not see capital allocated to the sector much above 10% on a run-rate basis given the implied structural leverage and liquidity of the asset. Our view is that MSR is a very attractive ingredient in the portfolio, but the measurements and the recipe require precision in light of potential volatility and risks. Now additionally, we continue to add to our third-party and in-house sourcing capabilities on the residential credit front, which drove the over $450 million of whole loan purchases we saw in the quarter, and our pipeline continues to grow.

We also continue to believe that a diversified platform beyond residential is a key differentiator for us, including the optionality embedded in our alternative strategies like our middle-market lending platform. Through that business, which has been on balance sheet since 2010, we generate leading returns with cycle agnostic investments. And we'll also retain a $500 million commercial mortgage-backed securities portfolio, which we expect to grow over time depending on pricing and our outlook. And now with that, I'll turn it over to the investment teams to go over our markets and portfolio activity beginning with Ilker to go through the agency sector and hedging activity.

Ilker Ertas -- Head of Securitized Products

Thank you, David. The portfolio delivered another solid quarter despite a very volatile interest rate environment, characterized by sharp sell-off in the intermediate and long end of the curve. MBS performance was mixed with lower coupon price performance lagging higher coupons due to extension of the cash flows and resulting delta hedging costs. However, spreads generally continued their trend tighter as investor demand outpaced issuance, which remains near-record levels.

Most notably, the bank demand we discussed last quarter remained robust, as expansionary and fiscal policies continue to drive the level of deposits higher, while commercial and industrial loan growth has been muted. The size of our agency portfolio remained stable as we reinvested runoff primarily into TBAs, which benefited from negative implied financing rates over the quarter. Within our TBA position, we shifted exposure into two and a halfs and threes, while we reduced lower coupons as we expect Fed and bank purchases to migrate hiring coupons following the rise in rates. In specified pools, our average portfolio payout declined by approximately three-quarters at a point due to higher rates.

However, their good prepayment and resulting profile contributed to specified pools outperforming both TBA and duration hedges over the quarter. While the sell-off brought mortgage rates above 3%, we remain in high prepayment environment due to technological latencies and increased capacity in the originator community. And therefore, we expect protection to continue to prove valuable part in higher coupon specified pools. Now shifting to our hedges.

We were well-positioned for the steepening of the yield. As we mentioned on our Q4 call, we added additional treasury futures and swaption positions during Q3 and Q4 of last year. These lower-cost duration hedges, especially on the longer end of the curve, proved instrumental to our portfolio performance as yields rose sharply on the back of fiscally induced inflation fears. In particular, the options that we bought throughout 2020 at lower levels of implied volatility and lower float rates proved to be an excellent convection duration hedge against the extended duration in Agency MBS assets.

Although we actively rebalanced our portfolio through the rising yields this quarter, due to our prior positioning, delta hedging needs were minimal compared to the size and momentum of the sell-off. These hedges were primarily in treasury and interest rate swaps and all swaps were executed with floating retails benchmark as we continue to decrease our LIBOR footprint. Finally, as yields stabilize at the of the quarter, we took the opportunity to add protection against a rally as we were able to purchase receiver options at attractive levels with the market commanding higher price protection against the sell-off. We expect to grow this position in coming quarters as it complements our planned growth in our MSR portfolio.

After the performance in Q1, spread tightening potential for MBS looks somewhat limited. But the framework we have been operating still holds. tailwinds such as Fed and bank demand are likely to persist, financing rates remain extremely attractive and nearly all other asset classes are trading to tight valuations. So looking ahead, we anticipate maintaining our conservative leverage posture, while our existing core portfolio provides a solid income and enables us to grow our higher-margin businesses that David talked about.

Now I turn the call over to Mike Fania to cover our residential credit portfolio.

Mike Fania -- Head of Residential Credit

Thank you, Ilker. Turning to our residential credit business. We continue to remain bullish on both consumer and housing fundamentals given considerable government stimulus monetary policy in addition to a systemic undersupply of one to four single-family homes. The majority of U.S.

consumers have been able to successfully navigate the COVID pandemic with household net worth at all-time highs personal savings rates in excess of 10%, household debt to income at historical lows, and year-over-year declines in credit card and auto delinquencies. The health and resurgence of the consumer has also benefited the residential credit market with outstanding forbearance plans declining to 4.4% of the total market as of mid-April, down from 5.2% as of year end and first-lien delinquencies down over a hundred basis points on the quarter coming in at five spot zero two percent. The housing market continues to exhibit strong momentum regarding both construction and home price appreciation as a result of low mortgage rates, limited available inventory for sale, strong household formation, and changing homeowner preferences regarding both location and the desire for space. National home prices were up 12% on a year-over-year basis in most recent release, and will most likely continue to see outsized depreciation as the supply/demand imbalance is a long-term structural issue that will not be resolved at the current pace of housing completions.

Regarding our rental credit portfolio, consistent with our comments on our last earnings call surrounding attractive residential credit spreads and net interest margin, we were active in deploying capital by purchasing approximately $910 million of residential credit securities and settling $467 million of predominantly expanded credit residential whole loans. The residential credit portfolio ended the quarter at $3.4 billion of economic risk, excluding our committed loan pipeline. Leverage across the residential credit portfolio has remained conservative with financial recourse leverage at one spot zero debt equity, with resi ending the quarter comprising $1.8 billion of the firm's capital. Within securities, greater than 95% of our purchases were concentrated in the unrated MPL, RPL, and seasoned CRT subsectors.

In the beginning of the year, both of these products displayed attractive ROEs per unit of spread duration and have benefited from continued improvement in the financing market. The shorter duration par priced assets should yield high single digits to low double-digit lifetime ROEs and serve as an excellent accretive hedge to our longer-dated CMBS portfolio. Moving to residential whole loans. We continue to be proactive in sourcing accretive assets and had a robust pipeline of $410 million that we anticipate will settle over the next few months.

We continue to see opportunities in the non-QM market and have started to capitalize on opportunities in the agency investor market given recent changes to the GSE's preferred stock purchase agreements. Turning to our resi securitization platform. In March, we securitized $257 million of expanded credit hold loans in a non-QM transaction, generating $15 million of term-funded subordinate securities with an expected low mid-double-digit ROE with minimal recourse leverage. We also priced our inaugural prime jumbo securitization earlier this week, a $354 million transaction where we retained all of the subordinate securities, approximately $14 million in market value.

The organic creation of nonrecourse term funded assets through our whole loan strategy, allowing us to control asset acquisitions, overseas diligence, and the selection of our preferred subservicers with the ability to control loss mitigation remains our team's primary focus. With the reopening of the economy on the horizon, a healthy consumer, and the housing market poised for strength in 2021, the residential credit market should see continued positive performance. I will now turn it over to Tim to talk about the MML portfolio.

Tim Coffey -- Chief Credit Officer

Thanks, Mike. Q1 of the middle market lending group was influenced by a combination of our portfolio success through the pandemic as exhibited by the year-end watch list decreasing by 41% versus the prior year, followed by a very intense refi driven market in the absence of any meaningful new issue M&A throughout Q1. This resulted in the portfolio modestly declining from $2.39 billion at year end to $2.07 billion at quarter end $331 million. Returns, both economic and core increased meaningfully in the quarter versus year end as the team remains disciplined about new investment activity and we'll protect the existing portfolio selectively.

As in 2020, we are very pleased with underlying portfolio performance with continuation of zero nonaccrual credits versus the Water Direct Lending index average of 2.9% and and a watch list presenting less than 4% of the Annaly middle market total portfolio size. In addition, the portfolio continues to migrate toward a first lien -- moving three full percentage points from 66% at year end to 69% at 331. As we have reiterated over the past 10 years, Annaly middle-market significant outputs during periods of intense turbulence is a function of staying true to the industries in which we want to invest, the forecastability of underlying credits to survive tumult, and partnering with private equity owners that exhibit like-mindedness and track records consistent with our own inside the very industries in which we want to be active. Consistent with our behavior since joining in 2010 we have historically countered market periods dominated by refinancing with pipelines weighted alongside sponsors that acquire businesses differently.

We anticipate 2021 will be no different in that respect. and investing in concert with freshly contributed equity from sponsors, will continue to dominate our thinking when putting money to work. Reignited convergence in the fixed income market and more specifically the loan markets makes us wary of leverage multiples more so than pricing. With refi-driven markets coming out of the pandemic, the broad array of issuers capturing contracting spreads for last year's performance seems to be an acute contradiction, but nonetheless, our reality.

Inside of Annaly, middle-market lending is very aware of the current credit risk versus interest rate risk equation. And with today's yield curve, we are comfortable with middle markets current allocation. As always, middle markets growth or contraction for the balance of the year will remain subject to the underlying credit and our perception of adequate unlevered compensation for the risk, both absolute and relative. With that, I turn it over to Serena.

Serena Wolfe -- Chief Financial Officer

Thank you, Tim, and good morning, everyone. This morning, I'll provide brief financial highlights for the quarter ended March 31, 2021. Consistent with prior quarters, while our earnings release discloses both GAAP and non-GAAP core results, my comments will focus on our non-GAAP core results and related metrics, all excluding PAA. We continue to generate strong core results from the portfolio for the first quarter of 2021, benefiting from the continued low interest rates in the funding market and sustained specialness in dollar to set the stage with some summary information, our book value per share was $8.95 for Q1, a slight increase from Q4 2020.

Book value increased on GAAP net income of $1.75 billion or $1.25 per share, partially offset by the common and preferred dividends of $335 million or $0.24 per share and lower other comprehensive income of $1.7 billion or $0.98 per share. A significant impact to GAAP net income and therefore, book value for the quarter was the held-for-sale accounting entries recorded in association with the announcement of the sale of our commercial real estate platform, particularly the impairment of goodwill of $71.8 million or $0.05 per share. I will expand on the details of these entries later in my prepared remarks. We generated core earnings per share, excluding PAA, of $0.29, a decrease of 3% or $0.01 per share from the prior quarter.

Combining our book value performance with the $0.22 common dividend we declared during Q1, our quarterly economic return was 2.8%. As I noted earlier, our book value increase reflected a $0.05 impairment of goodwill. Excluding this impairment, our tangible economic return for the quarter was 3.6%. Economic return and tangible economic return for Q4 were 5.1% and 5.2%, respectively.

Taking a closer look at the GAAP we generated GAAP net income of $1.8 billion or $1.23 per common share, up from $879 million or $0.60 per common share in the quarter. GAAP net income increased primarily on higher unrealized gains on our interest rate swaps and derivatives portfolio. Specifically, GAAP net income benefited from rising interest rates reflected in unrealized gains on interest rate swaps of $772 million, which was $258 million in the prior quarter; other derivatives led by futures of $517 million, which was $12 million of unrealized losses in the prior quarter, and swaptions of $306 million, which was $4 million of unrealized losses in the prior quarter. GAAP net income also benefited from lower interest expense on lower average repo rates and slightly lower average repo balances at roughly $65 billion.

I will cover more details on interest expense later on. Now to provide more color on the impact to book of the commercial real estate divestiture. As David mentioned in his remarks, during Q1, we issued a press release stating attention to exit the commercial real estate business, including selling substantially all of the commercial real estate business to slate asset management. The transaction is expected to close in the second or third quarter, following receipt of customary consents and approvals from regulators and joint venture partners.

As a result, as of March 31, 2021, we met the criteria for held-for-sale accounting, including the small number of commercial real estate assets excluded from the transaction, given our intent to exit those positions. The held-for-sale criteria require all assets in the disposal group to be recorded at the lower of cost or fair value. Therefore, under held for sale accounting, assets are written down, but not up with gains recognized at closing. This evaluation resulted in recognition of valuation allowances and impairments of approximately $157.4 million on loans, real estate, and securities offset by annualized gains on CMBS available for sale of $16.8 million.

As the various closings of the traction occur, we will realize gains that more than offset the net valuation allowances and impairments recorded on the portfolio. As the portfolio is now held for sale, it is no longer in the scope of CECL. And in Q1, we reversed the previously recorded reserves of $135 million through earnings. In aggregate, the divestitures of our commercial real estate platform through the sale to Slate Asset Management and our opportunistic sale of a portion of our skilled nursing facilities in the fourth quarter of 2020 will result in a $0.02 portfolio benefit to tangible book value at closing, which will be fully recognized over time due to GAAP accounting.

In conjunction with the acquisition of CreXus in 2013, we recognized an intangible asset of Given our intention to exit the commercial real estate business, we have impaired the carrying value of the goodwill, again, $71.8 million or $0.05 per share in Q1. Moving on now to CECL reserves. Consistent with the prior quarter, we continue to see a general improvement in market sentiment and the economic models we use in this process. And given the commercial real estate disposition, The CECL reserve now relate solely to our middle-market lending assets.

We recorded a decrease in reserves of $6.2 million on funded commitments during Q1, driven by a reduction in the portfolio and improved macroeconomic assumptions. Total reserves net of charge-offs comprised 1.58% of our MML loan portfolio as of March 31, 2021. We expect that CECL reserves will be an immaterial part of our financial statements in the future. Turning back to earnings.

I wanted to provide more detail surrounding the most significant factors that impacted core earnings quarter over quarter. First, consistent with my commentary around GAAP drivers, interest expense of $76 million was lower than $94 million in the prior quarter due to lower average repo rates and balances. We had increased expenses related to the net interest component of interest rate swaps of $80 million relative to $67 million in the prior quarter as the swap portfolio position increased by $5.5 billion. Finally, We had lower interest income primarily driven by lower average agency balances and a reduction in average agency yield.

And while the amount is consistent with Q4 at $97 million, dollar roll income contributed meaningfully to core for the quarter, given continued record levels. Our treasury group's view on the funding markets came to fruition in Q1, with continued tightening of rates and flattening in term curves. Today, we see overnight rates in the low single digits and term market north of six months at 12 to 14 basis points in the bilateral market. As a result, we successfully executed our strategy to add duration to our repo book, with our weighted average days to maturity up compared to prior quarter at 88 days versus 64.

Providing further color regarding our reduced interest expense for the quarter, while overall cost of funds is consistent with the prior quarter at 87 basis points, the composition differs from Q4, with repo interest expense lower, the cost of funds associated with hedges increasing due to the increase in added. Our average REPO rate for the quarter was 26 basis points compared to 35 basis points in the prior quarter. And we ended March with a repo rate of 20 basis points, down from 32 basis points at the end of December 2020. We continue to actively manage our repo book and look for further opportunities to reduce our cost of funds and improve liquidity.

For instance, we experienced lower haircuts across the board for our agency book. And considering our liquidity profile, we selected to fund the most liquid credit assets and utilize capital to The portfolio generated 191 bps of NIM, down from 198 bps as of Q4, driven primarily by the decrease in asset yields. Moving now to our efficiency ratios. Previously, we've provided a range of OPEX targets associated with potential cost savings from our internalization of 1.6% to 1.75%.

And in the prior year, we incurred G&A costs for an annual OPEX ratio in this range of 1.62%. We expect to realize cost savings due to the disposition of our commercial real estate business, and began to see these in Q1 with an OPEX to equity ratio of 1.4%. Giving consideration to the pivot in our strategy in commercial real estate to resi credit MSR and our MML business, we believe that a revised estimated range For OPEX to equity for 2021 would be 1.45% to 1.6%. And to wrap things up, Annaly ended the quarter with an excellent liquidity profile with $8.9 billion of unencumbered assets, slightly up from prior quarters of $8.7 billion, including cash and unencumbered Agency MBS of $6.2 billion.

Now with that, that concludes our prepared remarks. And, operator, we can now open it up to Q&A.

Questions & Answers:


Operator

Yes, ma'am. [Operator instructions] And the first question we have will come from Steve Delaney of JMP Securities. Please go ahead.

Steve Delaney -- JMP Securities -- Analyst

Good morning. Thank you. Good morning, I guess my first question, I'd address to Mike Fania. Mike, on the resi side, about two-thirds of the new investment was in RMBS and the other third in whole loans.

Explain that logic and were there -- was that simply expedient and that obviously securities transactions can be executed more quickly. And that balance between securities and whole loans going forward, how should we think about that?

Mike Fania -- Head of Residential Credit

Sure, Steve. Thanks for the question. I think that we've always designed our platform to have the ability to buy and purchase both securities and whole loans. We've never wanted to enter into the resi credit market as a monoline entity.

And I think this quarter shows that we do have the ability to flex into products to the securities are showing high ROEs per unit of spread duration per unit of leverage spread duration. And then we do have an operating platform as well that allows us to express a view in the organic creation of those assets. So I would say when we see the ability to have attractive NIM, we can deploy capital in both securities and whole loans. And we were able to be successful in doing that.

Steve Delaney -- JMP Securities -- Analyst

It looked like -- please, David. I'm sorry. Go ahead.

David Finkelstein -- Chief Executive Officer

I would just add that as of quarter end or after quarter end, the whole loan acquisition part of the business has accelerated. I think we're over a billion year to date either loan settled or loans in the pipeline. So we're enthusiastic about the growth of the loan business as well.

Steve Delaney -- JMP Securities -- Analyst

Got it. And it looked like on the NQM deal, you maybe retained about 7% on the prime deal or a little bit less. And the math is not -- I don't have the exact math. I'm just curious, do you consider when you're doing a deal, and I know these new issue RMBS are extremely well bid and overbid, if you will.

But do you look at the economics of retaining some bonds further up the stack as well as the sort of the minimum amount, and obviously, some of those I know you can put a little bit of leverage on.

Mike Fania -- Head of Residential Credit

Yes. That's a good point, Steve. So we've always been aligned with our investors in that we normally take greater than 5% of the risk retention. So I think we usually target 6% to 8% of capital deployment per each securitization, and that will include some nominal amount of recourse leverage as well.

And I would say, historically, we've retained about 10% to 15% of the market value of our assets. So the answer to your question is yes. We've been very active in terms of retaining more risk than some of our peers, and we do think that the delevering of the asset upgrades and improvements in financing makes that a logical choice for us.

Steve Delaney -- JMP Securities -- Analyst

Thanks for the comments, and congrats on the quarter.

David Finkelstein -- Chief Executive Officer

Thanks, Steve.

Operator

And next, we have Bose George of KBW.

Bose George -- KBW -- Analyst

Hey, everyone. Can you talk about where you see incremental returns on pools and on TBAs? And then on the credit side, I think you gave some color on the RPLs like where the returns were. Can you just reiterate that and just talk about how that compares to what you're seeing on the agency side?

Ilker Ertas -- Head of Securitized Products

They should. On the agency, the new investments on the TBA side, given -- if you add some specialness of the roll, you are getting very low double digits, especially on some higher coupons. And for the higher coupon so you can expect high single digit. For the rest of the like mid to high single digits and for the credit, Mike, you want to take that?

Mike Fania -- Head of Residential Credit

Sure. Thanks, Ilker. So on the NPL/RPL purchases, I would say, in Q1, we thought that they were high single digits, very low double digits. I would say if you fast forward to the market, we have seen a good amount of tightening, probably 40 basis points on the quarter in terms of A1, which are the seniors close to zero basis points of tightening on the A2, which are the senior subordinates.

So we think levered returns on the seniors now are probably mid-high single digits on the subordinates, it's still probably very low double digits. But I don't think you'll see the growth of that portfolio on a go-forward given the tightening in the NIM.

David Finkelstein -- Chief Executive Officer

Yes. And, Bose, just to add, this is David. Mike has been talking about that sector for the last couple of quarters, if you recall, beginning last fall, and we've slowly accumulated our position, and we've gotten to a point where it's not more attractive than agency currently. But I think if you look back to last fall, we started by even prior to that, and then there was a substitution away from agency marginally toward that sector.

Bose George -- KBW -- Analyst

OK. Great. And then actually, I don't know if you gave that what's the book value quarter to date?

David Finkelstein -- Chief Executive Officer

Sure. As of yesterday, we're just about flat within a penny of where we ended the quarter.

Bose George -- KBW -- Analyst

OK. Great. Thanks a lot.

Operator

And next, we have Rick Shane of J.P. Morgan.

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

Hey, guys. Thanks for taking my questions this morning. David, I did have one strategic question for you. I understand the decision to exit the commercial mortgage book.

But then you made the comment about continuing to invest in CMBS. And when we think about it, the loans, the mortgages themselves, bespoke risk versus sort of more commoditized risk in the CMBS book. And we think back about either recent history or really back pre-GFC, some of the challenges folks have had with the MBS. I'm curious why do to keep your -- sort of keep your nose under tense at this point.

David Finkelstein -- Chief Executive Officer

Great question, Rick. So first, I'll say with respect to history, I think a lot of the problems that were exhibited from a liquidity standpoint existed with firms that were overly concentrated in credit sectors. And when you look at Annaly with our assets in the agency sector, we do have capacity to have alternative products and not sacrifice liquidity as was the case, which you saw last March. Now with respect to CMBS versus the commercial real estate platform, It's largely about efficiency.

Look, our commercial real estate business had been on balance sheet for eight years. It was a very solid contributor to the bottom line for Annaly. When we brought it on balance sheet, as I talked about in the prepared comments, it was a great decision on part because of the relative attractiveness of those assets compared to agency at the time. As the years went on, more and more capital came into the sector, whether it be debt funds, so wealth, insurance com, and it did quite crowded, and it became harder for commercial to compete with the agency sector.

And as you know, it's a highly operationally intensive business. There's north of 20 people in our CRE operation. And it really has to be scaled to make sure you're generating the right returns. And over the years 2017, '18, and '19, It did become harder to do that as spreads tightened.

And as a consequence, the compatibility with agency was a key driver of decision, notwithstanding the considerable contribution that, that business provided to Annaly over the years. Now with respect to CMBS, it's a very efficient, lean business. And we see it within the framework of our securitized products. So we have resi credit and securitized products and CMBS fits right in there.

We have good credit work provide the team and a great trading effort, but it's lean, and we can be very opportunistic in it, and it's likely to be higher up the capital stack relative to some of the things we were doing on the direct lending side.

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

Got it. Look, I think it also highlights perhaps a challenge for companies that are so associated with particular products, which is that you probably don't get credit for the diversification But at the same time, when there are challenges, you get penalized for them. So it almost feels like a one-way risk.

David Finkelstein -- Chief Executive Officer

Exactly. Exactly. And with a relatively small footprint, when there is a dislocation within the CMBS market or CMBX, you can relatively quickly and efficiently add to the portfolio, if you think the fundamentals are attractive relative to what's going on in the market.

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

OK. That's very helpful. Thank you, guys.

David Finkelstein -- Chief Executive Officer

You bet, Rick.

Operator

The next question we have will come from Mark DeVries of Barclays.

Mark DeVries -- Barclays -- Analyst

Yes. Thanks. Just a couple of follow-up questions on the decision to exit commercial loan business. First of all, is it fair to think that with some of the operating efficiencies you're going to generate from exiting that, that the overall kind of blended return expectations for the business get a bit of a boost here?

David Finkelstein -- Chief Executive Officer

You're saying just from an expense reduction standpoint? Or --

Mark DeVries -- Barclays -- Analyst

Yes. Just like kind of an all-in return across the business without having to carry those expenses.

David Finkelstein -- Chief Executive Officer

Yes. At the margin, we expect, as Serena talked about a lower expense ratio, so yes.

Mark DeVries -- Barclays -- Analyst

OK. And then, David, I think one of the things you guys have highlighted with all the different asset classes you invested, there's some diversification benefit with returns being at least somewhat uncorrelated. Does it feel like what you've up here is in terms of the diversification kind of minimal when you think about the impact to kind of the broader returns for the business?

David Finkelstein -- Chief Executive Officer

Yes. I would characterize it as that, Mark. And when you think about substituting MSR for commercial, I think you get a much more complementary portfolio to the agency business. And obviously, as you know, it fits the hedge profile nicely.

It is a modest basis hedge. So overall, when you look at the portfolio years out, holistically, I think we're going to have a better risk-adjusted return profile for the overall portfolio, and we'll still maintain that diversification just in a slightly different way.

Mark DeVries -- Barclays -- Analyst

OK. Got it. All right. Thank you.

David Finkelstein -- Chief Executive Officer

Thanks, Mark.

Operator

The next question we have will come from Eric Hagen of BTIG.

Eric Hagen -- BTIG -- Analyst

Hey. How are you, guys? A couple from me. I think you noted about how your paydowns were reinvested in spec pools, the other half went into TBAs. Just curious your approach to reinvestment what that could look like going forward.

Maybe you can only describe your approach, the relative value approach between picking up higher quality versus medium quality cohorts. And then it looks like you guys picked up some more agency CRT in the quarter. I'm just curious how you think about additional opportunities there and just the liquidity in the asset class considering Fannie Mae hasn't issued since the pandemic? And can you also just share how conditions and availability for financing those positions with repo looks right now?

Ilker Ertas -- Head of Securitized Products

Sure. Let me start with the specified versus TBAs. Last quarter's pool additions were like mostly TBA surrogates like very, very low pay-up post, which most likely will be delivered into the high role in this quarter or depending on where the roles are. So we see the picture, not much different than what we talked last quarter.

So we have a barbell portfolio, high-quality high coupon specs and on the lower coupons, in this case, two and a halfs and threes, we are mostly long in TBAs. And we intend to continue this. And as I said in my prepared remarks, even though mortgage rates are higher, we are still in a high prepayment environment, so we don't want to give up the core protection on that.

David Finkelstein -- Chief Executive Officer

And, Eric, I'll pick up on CRT. So I would characterize the purchases in CRT as very short duration, seasoned assets that offer attractive spreads relative to that duration exposure. So yes, Fannie Mae is not back in the market. Freddie has been very active, but the assets we're buying are the more seasoned very short duration, one-year type spread duration assets that fit nicely on the balance sheet.

And we were buying just north of LIBOR plus 200 on late last year, and that's subsequently tightened in. So it's not quite as attractive now. But for the relative -- for the spread duration, those assets were quite attractive, and we're just under a billion on the overall sector now. We also did substitute away from Bs into more M2s.

Eric Hagen -- BTIG -- Analyst

Got it. Maybe you can address the leverage part of the equation as it applies to CRT, the availability of repo leverage that you're seeing from dealers, and your comfort level and applying leverage to the CRT portfolio here?

David Finkelstein -- Chief Executive Officer

Yes. And again, goes back to my comments about the overall portfolio liquidity. Certainly, CRT financing was dislocated last March. It has come back quite strong -- very strongly, I would say, and more and more dealers are providing financing, and financing rates are coming in lower and lower.

Now that being said, as I mentioned in my prepared comments, some of those assets are funded with capital simply because we're in an abundant liquidity position. So It's always a risk with respect to financing of credit assets. But when you're running liquidity as we are, becomes less of a concern, and dealer balance sheets are opening up or have continued to open up. And if you can about it from their standpoint, with the abundant haircuts, and the spread you're earning with just the amount of liquidity in the system.

It's not a bad use of balance sheet on the part of the banks.

Eric Hagen -- BTIG -- Analyst

Thanks for the comment.

David Finkelstein -- Chief Executive Officer

You bet.

Operator

The next question we have will come from Doug Harter of Credit Suisse.

Doug Harter -- Credit Suisse -- Analyst

Thanks. Just a bit more on strategy, David. Can you just give us a little bit more, is how you're thinking about the middle market lending in the context of the decision to sell commercial real estate and kind of just how and kind of that fits in to kind of the otherwise residential focused business.

David Finkelstein -- Chief Executive Officer

Sure, Doug. Good question. And I have focused a lot of my commentary recently on the build-out of the housing finance function. And now with our rebuilding of the MSR effort were across all aspects, housing finance.

But middle-market lending is a core part of the company. It's a core part of the portfolio and it has been very complementary to the agency business over the years. It's had very consistent returns that have been uncorrelated with agency. It also happens to be a scaled business, and it's very efficient.

And the cost structure as a stand-alone looks very, very attractive relative to peers in the space. Our middle market lending franchise also is quite unique in that we're largely in niche sectors, which are highly valued. Our participation is highly valued by our PE sponsors that Tim's business interacts with on a daily basis. And also there's a bit of a symbiotic relationship with the REIT because he's able to do things in that business, which are much more considerable than a lot of his peers given the amount of liquidity that can offer.

For example, large positions that we can subsequently syndicate and then that certainty of execution that the sponsors have become accustomed to have confidence and has also been beneficial. So generally, I'll say to sum it up, it is complementary to the agency business. We haven't had conflict with respect to relative returns on a risk-adjusted basis, and it's worked for us.

Doug Harter -- Credit Suisse -- Analyst

Great. Appreciate that, David. And then just on the MSR, do you imagine building that up kind of through flow programs? Or are you expecting to be active in looking at purchases?

David Finkelstein -- Chief Executive Officer

Sure. And it's a combination of the two. We do have a partnership, which will likely be flow or will be flow. But the way we view the business, it's not like when we own Pingora, where we had dozens of flow partners, and it was very operationally intensive.

The core business that is being run out of Annaly will be focused on partnering with large originator servicers, where we will buy bulk packages And we're very confident that given the dynamics in the industry right now with the contraction in primary secondary spread and our ability to provide liquidity to that sector and not compete with those institutions that we're going to be a very favorable participant in that market in the eyes of servicers. And over time, we'll grow the portfolio responsibly. We do have a pipeline that is about $130 million, $140 million in market value between three different packages that we have agreed to buy thus far, which will be coming on balance sheet in the not-too-distant future. And we'll grow it over time responsibly and very considerate of the operational risk, which is why we want to partner with large institutions where we can buy both packages, but then we're still going to engage in that flow -- coissue business through another partnership.

Doug Harter -- Credit Suisse -- Analyst

Great. Thank you, David.

David Finkelstein -- Chief Executive Officer

You bet.

Operator

And the next question we have will come from Brock Vandervliet of UBS. Please go ahead.

Vilas Abraham -- UBS -- Analyst

Hey. Good morning, everyone. This is Vilas Abraham in for Brock. Most of my questions have been asked and answered.

Maybe on the credit portfolio overall, how are you guys thinking about the target capital allocation there. I think you mentioned in the prepared remarks, it was around 27%. So what's the target there now? And are you trying to hit that sooner rather than later, or are you going to take maybe a more patient posture in getting there? Thanks.

David Finkelstein -- Chief Executive Officer

Yes, Vilas. Look, I'll say there isn't a specific target. We have historically said that agency will be between 60% and 80% of our capital allocation and relative value is going to dictate that range. Now obviously, we're substituting away from commercial and MSR, you can consider that alternative outside of pure agency capital allocation.

But overall, that hasn't changed. We think that the liquidity of the Agency portfolio and our footprint in that business, and how well it's worked for us over the years will enable us to maintain that core capital allocation, and we don't envision a meaningful shift from our philosophy of that 60% to 80% range. Now depending on relative value, it's going to fluctuate, but it's all dependent on the state of the market at a particular time and what's attractive. And the good thing about our credit business is that they're not forced deployers of capital.

We can be opportunistic. They're all scaled with the exception of the MSR, which we'll get to scale. But we're not forced to do anything. We can pay attention to the do what's right for the portfolio.

Vilas Abraham -- UBS -- Analyst

OK. Got it. That's helpful. Just maybe quickly on -- I mean, just overall, funding costs, I appreciate the swap book sizing up a bit and costs kind of staying flat at that 87 bps.

It's just moving forward given the mix is changing a little bit. How should we think about that? Are we kind of troughed here now, or is there incremental funding costs decline to be seen still? Thanks.

Serena Wolfe -- Chief Financial Officer

Yes, Vilas. It's Serena. So we do actually contemplate a continued reduction in funding costs going through to the second quarter.

David Finkelstein -- Chief Executive Officer

Vilas, I'll just add to that. With respect to MSR, we have said in the past that it's an instrument that we do not lever. That being said, you could see a scenario where we do have a warehouse line simply as an insurance policy. But, again, as I said in my prepared comments, we expect it to be at scale at 10% of capital business, and we're not going to look at it on a levered basis.

Vilas Abraham -- UBS -- Analyst

Great. Thank you.

David Finkelstein -- Chief Executive Officer

You bet, Vilas.

Operator

The next question we have will come from Kevin Barker of Piper Sandler.

Kevin Barker -- Piper Sandler -- Analyst

Thanks. Most of my questions have been answered, but just can you give us your view on the outlook for rates and the economy as we move into the back half of the year? I realize you have increasing GDP within your forecast and various other -- it seems like you're positioning for a steeper yield curve. But can you just lay out your expectations? And then what are the biggest risks you see out there given your current strategy?

David Finkelstein -- Chief Executive Officer

Sure. Sure. So look, our view right now is rates could be slightly higher than where they're at now, but we don't expect a meaningful further sell-off in the market, and I think that was reaffirmed by yesterday. If you just think about the Fed's posture and there's been a lot of anxiety about when the will occur and how they're going to position their monetary policy.

But If you just look at their forecast in March, they have a 6.5% GDP forecast, a 4.5% unemployment at year end, and a 2.2% core PCE forecast. And that's obviously very strong data. But they're still steadfast in their accommodative approach. And a lot of that has to do with, they are willing to let the economy run a little bit hot over the near term.

There's still 8-odd million people unemployed. And there's also objectives that they want to achieve with respect to the marginal worker and making sure that they don't take their foot off the gas too early. Now they also -- when you look at their longer-term forecasts, you have effectively a long-term unemployment rate of 4%, GDP 1.8% long term, and inflation around 2% the horizon. If you think about what that world looks like and then you look at the forwards in the rates markets, five years out, twos, 10s is currently between 250 and 270, if you look at the forwards, and that's 2.5% terminal on -- with respect to Fed policy.

It's still a little bit low, but it's not unreasonable. And with the margin, it could be a little bit higher, but we've got a very accommodative Fed and we're respectful of that. That being said, there are risks to your point. And we're obviously experiencing higher inflation over the near term.

The Fed does believe it to be transitory. The market is kind of fighting them on that. Half of the rate increase in the first quarter was attributable to inflation breakevens, with the other half of real rates, and there is the possibility that that does get a little bit out of hand, in which case, the Fed would be back on their heels, but they're not overly concerned about it, and they like to see a bit of inflation. But generally speaking, I think the market could be in a position where rates do get a little bit elevated, and there's further hedging.

And in the mortgage market, there is still extension left in the agency market. And that's why we're being vigilant about managing our duration. We entered the year with less than a quarter-year duration, and we actively managed it as you see in our hedge profile, and we're currently in that context as well, just very slightly along the market. It is expensive to be short and to fully hedge given a steep yield curve, but you do have to be pruned about it.

And as a consequence, we're keeping duration close to home, and we expect that to continue in the foreseeable future.

Kevin Barker -- Piper Sandler -- Analyst

OK. Thank you for the color.

David Finkelstein -- Chief Executive Officer

You bet. Good talking to you.

Operator

Well, showing no further questions at this time, we will go and conclude our question-and-answer session. I would now like to turn the call back over to Mr. David Finkelstein for any closing remarks. Sir?

David Finkelstein -- Chief Executive Officer

Thanks, Mike, and thank you, everybody, for joining us today, and we'll talk to you next quarter.

Operator

[Operator signoff]

Duration: 64 minutes

Call participants:

Sean Kensil -- Vice President, Investor Relations

David Finkelstein -- Chief Executive Officer

Ilker Ertas -- Head of Securitized Products

Mike Fania -- Head of Residential Credit

Tim Coffey -- Chief Credit Officer

Serena Wolfe -- Chief Financial Officer

Steve Delaney -- JMP Securities -- Analyst

Bose George -- KBW -- Analyst

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

Mark DeVries -- Barclays -- Analyst

Eric Hagen -- BTIG -- Analyst

Doug Harter -- Credit Suisse -- Analyst

Vilas Abraham -- UBS -- Analyst

Kevin Barker -- Piper Sandler -- Analyst

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