Annaly Capital Management (NLY) Q2 2021 Earnings Call Transcript

Annaly Capital Management (NLY -0.32%)
Q2 2021 Earnings Call
Jul 29, 2021, 9:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good day, and welcome to the Annaly Capital Management second-quarter 2021 earnings conference call. Today, all participants will be in a listen-only mode. [Operator instructions] Please note today's event is being recorded. At this time, I would like to turn the conference over to Sean Kensil, vice president, investor relations.

Please go ahead, sir.

Sean Kensil -- Vice President, Investor Relations

Good morning, and welcome to the second-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 second-quarter 2021 investor presentation and second-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 imposed 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; and Mike Fania, head of residential credit. 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 second-quarter earnings call. Today, I'll provide an overview of the macro environment and current market dynamics, briefly discuss our performance and capital allocation trends during the quarter. And lastly, I'll highlight our progress on the various strategic initiatives that I outlined on last quarter's call.

Ilker will provide a more detailed commentary on our agency and residential credit portfolio activity, and Serena will review our financial results. Finally, as Sean noted, we are joined by our other business leaders today, who can provide additional context during Q&A as needed. Now economic momentum accelerated in the second quarter as COVID-driven restrictions were lifted and the U.S. economy reopened.

Strong consumption was closely followed by rising prices as several goods, most notably cars and services, were in short supply relative to surging consumer demand. These price pressures are expected to cool from June levels where core CPI rose 4.5% year over year, yet it remains unclear as to how entrenched higher prices will be going forward. In a surprise to many, longer-term interest rates deviated from these positive economic fundamentals and rallied nearly 30 basis points during the quarter. Rate markets seemed to suggest that peak growth momentum is behind us, a narrative that has been fueled in recent weeks by resurgence in COVID cases, as well as the growing realization that elevated valuations require a sustained low-interest rate environment.

The other meaningful economic event during the quarter was the subtle shift in communication from the Fed at the June FOMC meeting. In light of the high inflation readings, the Fed signaled rate hikes might occur as early as 2023. Additionally, the momentum in growth and continued progress in labor markets led the committee to begin discussions around tapering their asset purchases. This pulled forward expectations for a tightening in monetary policy and implies a taper announcement could occur in the coming months.

Although there is plenty of attention on the potential taper timeline and options right now, the Fed will be deliberate and transparent around any announcement as it wants to continue to minimize any potential market disruptions. Turning to our portfolio. We experienced a negative economic return of 4% in the second quarter amid a challenging operating environment for Agency MBS. Rising volatility and persistent elevated prepayment speeds drove much of the deterioration in Agency, as Ilker will discuss in more detail.

We continue to prudently manage the portfolio, reducing leverage and hedging incremental moves in interest rates while allocating capital toward credit investments with more attractive risk-adjusted returns. Consequently, our total portfolio decreased by approximately $7 billion to $93 billion, contributing to a reduction in economic leverage from 6.1 to 5.8 times and an increase in unencumbered assets from $8.9 billion to $9.6 billion quarter over quarter. In light of relatively tight asset spreads and the end of easy monetary policy in sight, we expect to continue to maintain our leverage profile at the lower end of the range that we've historically operated in. Despite the decline in our portfolio, we were able to generate earnings available for distribution exceeding our dividend by $0.08.

Although earnings have been in the proximity of $0.30 for the past several quarters, we view this effectively to represent the high watermark and anticipate earnings will likely moderate going forward. On the financing front, we continue to take advantage of the historically attractive funding markets with sustained record low financing costs, which Serena will expand upon. Further, we amended terms and credit facilities for our residential credit and middle-market lending businesses, increasing capacity, and extending the term on facilities. Notably, we decreased pricing for financing on non-QM loans by nearly 50 basis points during the quarter.

We also expanded collateral eligibility to meet the evolving needs of the residential credit business including newly offered products such as agency eligible and nonagency second homes. Capital allocation continued to shift in favor of credit increasing modestly from 27% to 29% during the quarter despite our exit from the commercial real estate business. Our residential credit business experienced another active quarter as we took advantage of opportunities at shorter spread duration securities, as well as the non-QM loan market, which was bolstered by enhancements to our product sourcing capabilities that I'll discuss further shortly. Due to the more than $1 billion of purchases that were largely unlevered, capital allocation to the business increased 6 percentage points to 19%.

Now shifting to middle-market lending. We saw considerable portfolio activity during the quarter while maintaining our targeted investment approach, closing approximately $450 million in originations across six deals with an average commitment size of $75 million. Our ability to lead and underwrite deals in size as demonstrated this past quarter, further differentiates our business, making us a preferred lender and partner to our private equity sponsors. Our syndication capabilities were also evidenced through seamless execution of one of our larger positions subsequent to quarter-end.

The portfolio continues to exhibit healthy performance, and we remain constructive on our outlook and positioning. Now the previously announced sale of our real estate business remains on track to be completed by the end of the third quarter as planned. Subsequent to this past quarter-end, the bulk of the platform, including a number of Annaly employees, who supported the business, was successfully transitioned as part of the first closing of the transaction. A significant majority of the assets were settled during the first close, and we have received nearly 85% of the capital thus far.

On behalf of the entire Annaly team, I'd like to thank our departing colleagues for their numerous contributions and wish them continued success as they embark on this new chapter. Now as I discussed on last quarter's call, our commercial real estate divestiture gives us additional capacity and strategic flexibility to further expand our leadership and operational capabilities across all aspects of the residential housing finance market. I would like to now provide an update on key milestones related to our top two initiatives, building our mortgage servicing rights business and portfolio, and expanding our residential credit platform. First, with respect to our MSR business.

We have two avenues for investment in the sector: first, through a set of committed third-party partnerships; and second, by means of a build-out of our own capabilities to own and overseas servicing of MSR in-house through our Onslow Bay subsidiary. We continue to make key hires in this area with decades of industry expertise to lead the effort. We began this process over a year ago and have now built its critical mass with over $400 million of exposure to MSR, nearly doubling our portfolio during the second quarter. As expected, diminished originator profitability in the first half of 2021 has led to elevated secondary MSR volumes from originators providing ample supply.

We expect this dynamic to continue, and Annaly is a synergistic partner to originators, given our deep capital base and ability to acquire a wide array of products. Ultimately, MSR is an efficient hedge to our core agency portfolio, given its negative duration and positive yield, and we believe it will significantly enhance the long-term sustainability of our returns. However, given the inherent structural leverage of MSR, we are not currently employing financing for the strategy and do not foresee our capital allocation to MSR to exceed 10%. As such, given the size and scale of our balance sheet, we expect to be able to sufficiently scale the MSR business and maintain a strong industry presence within these parameters.

However, as we have noted previously, we expect to grow our portfolio responsibly, highly considerate of valuations. Now expanding on residential credit, as I noted earlier, we deliberately increased our exposure to the sector during the quarter, and we remain positive on housing fundamentals, given the monetary and fiscal stimulus and the undersupply of single-family homes in the U.S. Annaly has expanded its residential whole loan acquisition channels by initiating in-house aggregation through Onslow Bay correspondent channel. Launched in April, this channel offers a broad and diversified program suite to purchase residential mortgage loans on a best-efforts flow basis that adhere to our rigorous credit standards, and we continue to expand our network with new partners.

Now our big-picture view is that the further development of these two initiatives, combined with our best-in-class agency business and our size and liquidity increases our presence throughout the spectrum of residential housing finance and allows optionality to allocate capital where it is most attractive based on where we are in the cycle. And lastly, before turning it over to Ilker, I do want to highlight that we published our second corporate responsibility report earlier this month. The 2020 report titled, Leading with Purpose, demonstrates our continued focus on high-quality disclosure with respect to our ESG endeavors and provides an update on our ESG goals and commitments. With this year's report, we included additional SASB disclosures under the mortgage finance standards for our residential credit business and made a new commitment to further assess climate change risks and opportunities through the consideration of the task force on climate-related financial disclosures.

At Annaly, we are constantly striving to improve our corporate responsibility practices and to further integrate ESG considerations into our overall strategy to benefit all stakeholders. Now with that, I'll hand it over to Ilker to provide a detailed overview of our agency and residential credit portfolio activity and outlook for each sector.

Ilker Ertas -- Head of Securitized Products

Thank you, David. As you noted, MBS underperformed rate hedges into the bull flattening rally and a hockey shift by the Fed that pulled forward rate hike and taper timelines. Over the quarter, MBS widened across the stack with lower coupons impacted by heavy supply and accelerated taper outlook and higher coupons influenced by persistence of fast speeds, which further delayed the eventual burnout expectations. In anticipation of market volatility by mid-May, we opportunistically reduced our agency portfolio by nearly $9 billion, ahead of the most of the spread widening across a mix of outright sales and portfolio runoff.

As we manage the size of our portfolio, we maintained our barbell strategy consisting of lower coupon TBAs and high-quality prepaid protected specified pools in our coupons. We continue to believe this strategy best positions us for the current environment. Lower-coupon carry remains strong, and roll should remain special well into 2022, and our higher coupon specified post provide defensive positioning ahead of any supply induced widening or further volatility in interest rates. Turning to our hedge portfolio.

On aggregate, our hedge position declined during the quarter in conjunction with the lower leverage and rally in interest rates. As yield curve flattened, we reduced treasury future stages at the long end of the curve to actively manage our duration profile. The swaption portfolio declined as we exercised $2 billion of in the money payer swaption effectively locking in the negative duration from positions that we scheduled to expire in the quarter. Swaptions have been a crucial convex to hedge for us with the reversal in the yields.

For example, with much steeper curve in early April, we opportunistically added our receiver position at very attractive levels. The last two quarters have highlighted the importance of the liquidity and optionality in our hedge profile, and we remain poised to adjust swiftly across the yield curve if needed. As David discussed, we have also been actively growing our MSR portfolio. In Q2, we committed to purchase approximately $220 million in market value across four bulk purchases, bringing our economic exposure over $400 million.

MSR provides an additional tool for hedging MBS spread and interest rate risk while earning high single digits. More importantly, our expertise managing prepayment risk and in-house modeling capabilities in the context of our MBS business provide us unique perspective on MSR speeds and valuations, supporting the reasonable growth David mentioned. Turning to residential credit business, we continue to grow the portfolio through purchase of expanded credit whole loans and predominantly short duration unrated NPL/RPL securities. Total economic risk of the residential credit portfolio now stands at $4.2 billion, a 67% increase from the beginning of the year.

Although credit spreads tightened on the quarter, monetary stimulus and subsequent availability of balance sheets had led to more attractive financing into our supporting levered returns in the sector. Our securities portfolio increased by approximately $200 million over the quarter, driven by $330 million of NPL/RPL purchases. As we previously stated, NPL/RPL securities are high-quality, short-duration assets with expansion protection that provide attractive net interest margins and have low correlation to our longer-duration, fixed-rate agency MBS portfolio. In residential whole loans, we settled approximately $1 billion of assets in Q2 and priced three rated securitizations, totaling approximately $1.1 billion since March.

The securitizations were comprised of a $376 million non-QM transaction, which generated approximately $35 million of retained assets at a projected level return into low to mid-teens. The remaining two securitizations were opportunistic prime jumbo transactions where we retained subordinate securities, generating approximately $27 million of assets at high single-digit ROEs. As we look ahead, Agency MBS valuations are in a healthier place following the widening in the second quarter with levered ROEs in the high to single low double digits. However, technical headwinds persist out the horizon, and therefore, we remain focused on diversifying the portfolio across various opportunities within housing finance.

We continue to see attractive opportunities in MSR and residential credit. And with low overall leverage and high levels of liquidity, we are well-positioned to take advantage of the potential price dislocations across all of our investable asset classes. With that, I will turn the call over to Serena.

Serena Wolfe -- Chief Financial Officer

Thank you, Ilker, and good morning, everyone. This morning, I'll provide brief financial highlights for the quarter ended June 30, 2021. As noted in our earnings materials, in line with the evolving industry practices, the company has relabeled core earnings, excluding PAA, as earnings available for distribution or EAD. I want to be very clear that this is a name change only and that the composition of the non-GAAP metrics, core earnings, excluding PAA and EAD are precisely the same.

Consistent with prior quarters, while earnings release discloses both GAAP and non-GAAP earnings metrics, my comments will focus on our non-GAAP EAD and related key performance metrics, all excluding PAA. The general themes for this quarter's earnings are consistent with Q1. As we generated strong results from the portfolio, benefiting from the continued low interest rates in the funding market, marking another quarter of record low cost of funds and sustained specialness in dollar roll financing. To set the stage with some summary information, our book value per share was $8.37 for Q2, a decrease of 6.5% from Q1.

And we generated earnings available for distribution per share of $0.30, an increase of 3% or $0.01 per share from the prior quarter. As David and Ilker have both touched on, the second quarter was a challenging environment for Agency MBS. Book value decreased primarily due to the common and preferred dividend declarations of $345 million or $0.24 per share, a GAAP net loss, and lower other comprehensive income of $222 million or $0.16 per share. Our book value reflects the challenges outlined by my colleagues, whereby the decline was driven by agency mortgage spread widening.

As treasury rates rallied, reflected in reductions in our derivative market values, MBS yield changes were muted. As a result, our agency portfolio did not see book value gains to offset the derivative losses. Combining our book value performance with the $0.22 common dividend we declared during Q2, our quarterly economic and tangible economic return were both negative 4%. Economic return and tangible economic return for Q1 were 2.8% and 3.6%, respectively.

As we take a closer look at the GAAP results, the challenges in the interest rate environment are further illustrated here as we generated a GAAP net loss of $295 million or $0.23 per share, down from GAAP net income of $1.8 billion or $1.23 per common share in the prior quarter. This quarter slipped many of the GAAP drivers I discussed in Q1. That is, in Q2, GAAP net income decreased primarily on higher unrealized losses on our interest rate swaps and derivatives portfolio. Specifically, declining interest rates impacted GAAP net income, reflected in unrealized losses on; interest rate swaps of $141 million, which was $772 million of unrealized gains in the prior quarter; other derivatives led by futures of $578 million, which was $517 million of unrealized gains in the prior quarter; and swaptions of $233 million, which is $306 million of unrealized gains in the prior quarter.

On a positive note, GAAP comp benefited from lower interest expense on lower average repo rates and slightly lower average repo balances at roughly $62 billion versus $65 billion in the preceding quarter. Now for a further look at earnings available for distribution. The most significant factors that impacted EAD quarter over quarter included, first, consistent with my commentary around GAAP drivers, interest expense of $61 million was lower than $76 million in the prior quarter due to lower average repo rates and balances. We had slightly increased expenses related to the net interest component of interest rate swaps of $83 million relative to $80 million in the prior quarter as the swap portfolio notional balance increased by $2.2 billion.

Higher TBA dollar roll income of $110 million versus $99 million in Q1, as the desk was able to extract marginally greater specialness in Q2 relative to Q1. And finally, we had lower interest income primarily driven by lower average Agency MBS balances. The continued stability of the funding market was a bright spot in the quarter, with Q2 marking eight consecutive quarters of reduced cost of funds for the company. We continue to opportunistically target extended term, that six to 12 months, for our repo book with our weighted average days to maturity consistent with the prior quarter at 88 days.

This strategy served us well during the quarter as the Fed increase in RRP, IOER has resulted in approximately 3 to 4 basis point rise in overnight rates with a slight upward bias in term markets as well. Additionally, the funding markets are continuing to improve in credit, particularly regarding structured products, as we've seen tightening from both a spread and a haircut standpoint, up and down the stack. And while we expect funding markets out one year to remain relatively flat, uncertainty around the debt ceiling, infrastructure bill, and possible Fed taper could prove as headwinds in the funding markets over the second half of the year. Providing additional color regarding our reduced interest expense for the quarter.

Our overall cost of funds decreased 4 basis points quarter over quarter from 87 basis points to 83 basis points. Our average repo rate for the quarter was 18 basis points, compared to 26 basis points in the prior quarter, and we ended June with a repo rate of 16 basis points, down from 32 basis points at the end of December 2020. In my prepared remarks last quarter, I referenced our efforts to fund credit assets selectively. As I mentioned earlier, dealer appetite for credit assets is strong.

However, given the conducive funding environment, we opted to optimize the use of our liquidity and hold a portion of our credit assets with equity, thus further reducing the firm's interest expense. The portfolio generated 209 basis points of NIM, up from 191 basis points as of Q1, driven by the 5 basis point increase in average yields and the decrease mentioned earlier in cost of funds. Average yields increased due to an increase in agency yields of approximately 9 basis points during the quarter, mostly because of declines in projected CPR and the impact on amortization for the quarter, and the change in portfolio mix to resi credit, that is lower agency average balances and higher resi credit securities, average balances on CRT and NPL/RPL purchases. Moving now to our operating expenses.

Efficiency ratio for the quarter increased in comparison to Q1 ratio of 1.36% due to declines in equity during Q2 and timing differences in the true-up of certain accruals. Our opex-to-equity ratios were 1.55% and 1.46% for the quarter and year to date, respectively, which is within the revised range of 1.45% to 1.6% provided in Q1. And to wrap things up, Annaly ended the quarter with an excellent liquidity profile with $9.6 billion of unencumbered assets, up from the prior quarter's $8.9 billion, including cash and unencumbered Agency MBS of $4.7 billion. The increase in unencumbered assets is associated with the lower leverage and our approach to funding credit assets I mentioned earlier.

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

Questions & Answers:

Operator

We will now begin the question-and-answer session. [Operator instructions] Today's first question comes from Steve Delaney with JMP Securities. Please proceed.

Steve Delaney -- JMP Securities -- Analyst

Good morning, everyone, and thanks for taking my question. We noticed that you tapped your ATM plan in the quarter for about $400 million. Was that specifically related to the $200 million-plus MSR growth? Or what other things did you have in mind with that issuance? Thank you.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Good morning, Steve, and how are you?

Steve Delaney -- JMP Securities -- Analyst

Well.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Thank you. So with respect to the ATM, it actually had to do with a lot of factors. I think when you look back to last year, we used our buyback program to buy back stock in an accretive fashion. In December, we called a preferred issue, our 7.5%, which is about $460 million.

And also, to your point, in terms of growth of MSR and expansion of resi credit, that influenced as well. So the way I would look at it from one point, we improved our overall capital structure by somewhat legging the call of the preferred to issuance of common, but also it's about growth of our alternative products and the build-out of that infrastructure.

Steve Delaney -- JMP Securities -- Analyst

Great. Well, certainly -- you certainly have indicated where you're going to be growing on the credit side, and that certainly makes sense. One follow-up. We heard last night on a call that the nonagency RMBS, the new issue market was getting a bit crowded.

The comment was from an originator who would normally execute securitizations, and it sounded like the economics of the securitization weren't as attractive because just the buyers were maybe just getting too much on their plate. So with that in mind, can you talk about the ability of Annaly's balance sheet at your size? Can you pretty much acquire whole loans without an immediate securitization execution, and just hold them with alternative short-term financing until the securitization market appears optimal? And if so, if you have the flexibility to do that, could you kind of size what you would be comfortable with in terms of unsecuritized whole loans? Thank you.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

That's a great question, Steve. So first off, I'll say that the securitization market has been quite robust, and we've had a lot of success as recently as last week issuing transactions. With respect to capacity and availability of our own balance sheet to warehouse loans and Mike can expand on this, but I will say that we did settle roughly a little over $1 billion whole loans last quarter. We do have another $800 million in the pipeline, and we have considerable warehouse line capacity.

And we also have ample liquidity on the balance sheet as we discussed. And so we feel good about where we're at. And Mike can talk a little bit more about the securitization market and the dynamics associated with it. Thanks.

Mike Fania -- Head of Residential Credit

Sure, Steven, and thanks for the question. I think in terms of the originator that was claiming that the securitization market was "full," a lot of that is the prime jumbo market and then also agency investor as because of the PSPA changes you've seen issuance there. So if you look at that market at the beginning of July, there was about $27 billion of issuance. If you look at last year, in total, there was about $22 billion.

So year to date, you've already surpassed issuance last year. However, Steve, most, if not the majority, of our purchases are in the non-QM market. And when you look at the non-QM market, it's actually probably the most advantageous time to issue, given where spreads are. So at the beginning of the year, non-QM spreads on the AAA, that makes up about 75% of what you sell was 85% to swaps.

If you fast forward to today, that's 60% to swaps. So I think that -- your point is valid in that there are certain components of the market that have widened given supply. However, the majority of our risk and our exposure is in a different market and different structure that is actually executing at what we would say the best economics we've seen. And the non-QM deal that we did over this quarter, we issued at a 90% advance rate, 80% to swaps -- with a weighted average cost of 80% to swaps.

And lastly, we did have two prime jumbo securitization since the end of March, and that is the market at which you have seen a lot of supply. However, those securitizations are a partnership where we don't actually have any economic risk until the deal closes. So hopefully, that's able to answer your question.

Steve Delaney -- JMP Securities -- Analyst

Now that's extremely -- that level of detail with respect to different products is extremely helpful to clarify my mind as to what I heard last night. Thank you, everyone. Appreciate all the comments. Thank you.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Steve. Thanks.

Operator

The next question comes from Doug Harter with Credit Suisse. Please go ahead, sir. Mr. Harter, your line is on mute.

Doug Harter -- Credit Suisse -- Analyst

Sorry. Is that better? 

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yep.

Doug Harter -- Credit Suisse -- Analyst

Sorry. Sticking with residential credit, can you talk about what are the advantages that come from opening the conduit that you talked about?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yes, largely price, but I'll let Mike expand on that.

Mike Fania -- Head of Residential Credit

Sure. Sure, Doug. I think that we've shown over the years since the inception of this business, the ability to purchase residential loans in size without having exposure or a direct investment with an originator. We have a number of different pricing avenues and strategic relationships that allow us to be accretive outside of the bulk market.

However, we have always participated in the bulk and mini-bulk markets. And I think the launch of the correspondent channel, really what that does is that it allows you to face smaller originators and the ability to lock best efforts allows you to own the economic of the loan at a much more accretive price than it would if you would participate in the bulk or mini-bulk market. And it's easy as just the fact that you have to have infrastructure, personnel additions, sales, business development, etc., that -- those developments allow you to get entry into the market at a much more advantageous price. So that is the main reason.

And we also have the ability to control our own credit, control pricing and control our partners. So it's a multitude of factors.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yes. And it's providing certainty of execution to originators, which is a service that they value, and we're consistent with it.

Doug Harter -- Credit Suisse -- Analyst

Got it. And then as you think about the equity allocation, capital allocation to credit, it ticked up in this quarter, exciting to see that trending over the next year. And what's kind of the longer-term range that you see it in?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

So as Ilker discussed, our aspiration is to continue to grow our alternative products, and we're certainly sensitive to relative value. Quarter over quarter, the growth that we saw in residential credit, we were very happy with. And as Serena noted that a lot of that capital allocation was -- because we didn't lever a lot of the assets. And one thing I'll note is that when we're not as optimistic on agency, and this sounds counterintuitive, you will see leverage on our credit products actually go down.

And that's because typically, we're going to have ample liquidity because we're reducing agency and then we can look to use that liquidity to offset financing costs associated with credit products. But first and foremost, it starts with our overall liquidity position, and when we're in an abundant liquidity position that level of leverage is going to fluctuate. Does that help?

Doug Harter -- Credit Suisse -- Analyst

It does. Thank you.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Doug.

Operator

The next question comes from Bose George with KBW. Please proceed.

Bose George -- KBW -- Analyst

Good morning. Actually, just switching back to the agencies. In terms of spread widening, how much of the spread widening do you think related to tapering has already happened? And is there a way to think about the spread level at which you guys get -- decide to get more aggressive in terms of capital deployment?

Ilker Ertas -- Head of Securitized Products

Sure. We think -- look, let's basically look at the landscape of the mortgage universe. So roughly 50% of entire mortgages are in healthy maturity portfolio of banks and fed. So if you add available for sale securities for bank portfolios also, you get that number to be around 66%, 67%.

So given that, this time around, taper will be much less impactful in the mortgage market than before. In fact, I would argue that there are a lot of like money managers, and even like other relative value investors are waiting on the sidelines for the taper to relocate the Agency MBS. So I would think that a good chunk of the taper is being priced and agencies are in a healthier place right now. And they were like -- as we said, they were very tight at the end of Q1.

Bose George -- KBW -- Analyst

OK. Great. Thanks. Yeah, great.

That's helpful. And actually, just on the trends since quarter-end, can you just give an update on book value quarter to date?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure, Bose. We've moved around a little bit, but we're within $0.01 or $0.02 of flat on the quarter as of last night.

Bose George -- KBW -- Analyst

OK. And then actually just one clarification on the capital allocation you mentioned for the MSR. Did you say about 10% of the capital is what you would be willing to allocate?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

That's what we would like to get to over time, but we're very patient about that. We will certainly be responsible about the growth of that portfolio, and we're OK to take our time. But we do expect to grow it deliberately over the coming quarters and years.

Bose George -- KBW -- Analyst

OK. And so just when we think about the size of that MSR, then we should think over time, 10% of capital, whatever advance rate you can get on that and sort of size the potential MSR down the road that way?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yeah. And you should think about it unlevered. There may be a case where we get a warehouse line, but that's simply for liquidity purposes, how we look at MSRs on an unlevered basis. So from that standpoint, roughly $1.5 billion at steady-state peak at some point in the future.

Bose George -- KBW -- Analyst

OK, great. Thanks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Bose.

Operator

Our next question comes from Rick Shane with J.P. Morgan. Please proceed.

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

Hey, good morning everybody, and thanks for taking my question. This actually kind of dovetails with the conversation you're having with Doug Harter. But when you look at your comments related to the MSR and the fact that you plan to own that on an unlevered basis, can you talk about the return profile owning MSR unlevered? And should we really think of that as -- consider that in the context of the fungibility of your assets that you will increase and decrease the leverage on your other assets to fund MSRs based upon sort of interest rate outlook and more efficient financing for those other assets?

Ilker Ertas -- Head of Securitized Products

Sure. So let me start with the last part of it. The funding decision will be based on the liquidity of the overall portfolio. But when we analyze MSR, we analyze the returns unlevered.

So right now, you are getting high single-digit returns on MSRs with the hedge benefit that's coming from the TBA hedges unlevered returns of high single digits, which is good enough. But we expect MSR availability will be higher down the road, and we probably can find opportunities to add like double-digit returns unlevered with the help of the hedges.

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

OK. And can you explore the second part of that, which is that, really, you're looking at the fungibility of the funding to support the MSR and the efficiency of, for example, levering up the agency MBS a little bit more as opposed to some of the risks associated with MSR financing?

Ilker Ertas -- Head of Securitized Products

Yeah. Absolutely. Again, David put that out very nicely that we never look at that way. So we never say that agency funding is here.

So let me use the agency funding to fund other assets, including MSR and other credit assets. We never look at that rate. That's a slippery slope. But what we are saying is that when we have excess liquidity in excess of what we will need down the road with the stress scenarios, then we may not fund some of our other assets.

This includes MSR and then use the agency funding on that. So funding decision is based on our overall liquidity needs and then we try to optimize the funding portfolio. But we will never look at the agency funding and then use that funding leverage to get the returns on other asset classes, that will not be done. So then we are analyzing MSR, for example, or any other credit instrument, we will always look at the funding of debt instrument when you are doing the analytical work, when you are designing your hedges.

But when it comes to funding, it depends on how much excess liquidity you have in the box. Does that help?

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

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

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Rick. Thanks.

Operator

The next question comes from Eric Hagen with BTIG. Please proceed.

Eric Hagen -- BTIG -- Analyst

Hi. Thanks. Good morning. I hope you guys are well.

The first one on specified pools. I mean, premiums still remain, I think, well above their historical levels, although mortgage rates are, of course, lower right now. I'm mainly wondering if you feel like the structure of the market has changed because of how much of the agency market the Fed owns at this point, where maybe a new premium floor has been established for spec pools, even if we do get some backup in rates and mortgage rates, etc.?

Ilker Ertas -- Head of Securitized Products

Yeah, that's a good one, actually. You're right. Like a big chunk -- like the cheapest deliverable market has really been taken away both by banks and Fed. And that makes specified pools a little bit in a unique place.

But as you said, like levels are a little bit elevated given the historical levels, but also speeds also suggest this, right? Specified pools, especially on the lower coupons are prepaying much better, for example, on Fannie 2.5%, much better than the TBA 2.5%. And TBAs are supporting that with the special rolls. So if you ask me what I expect, I expect specified pay-ups will moderate a little bit because this roll specialness on the lower coupons will persist. When it comes to higher coupon-specified pools, payout really doesn't mean that much in all honesty because there's very little CDT float.

So almost every pool is a specified pool when you are talking about 4s and 4.5s.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

So you look at it specifically on a cash flow basis irrespective of the TBA contract, Eric.

Ilker Ertas -- Head of Securitized Products

For high coupons, yes.

Eric Hagen -- BTIG -- Analyst

Got it. I follow you. One on the hedging side, a lot of swaps concentrated at the short end of the yield curve. I just want to get a sense for how much duration you feel like your assets have that short on the curve, and what you feel like the effectiveness of those hedges are in this environment?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Well, I'll just back up and note that last year, we actually did put a lot of those swaps on it at close to negative rates or low single digits. So they've been perfectly fine. In terms of curve positioning, we do have a modest steepener on. So a lot of our duration is still concentrated in the front end, notwithstanding shorter duration swaps.

And generally, our view is obviously, rates are artificially low. We think they're a little bit too low here. And with respect to the curve, we do feel it should be a bit steeper. The way we look at it at one metric that uses five-year -- forward five-year rates, which currently this morning are around 1.90%.

At the beginning of Q2, it was around 2.60% or thereabouts. So arguably, it was a bit cheap then. But to us, the forwards look rich, which suggests higher rates and a slightly steeper curve. And so that's how we're positioned.

And a lot of the steepening that did occur did come through contraction of the assets in the rally, but we're perfectly content with the position, and we're not running a meaningful duration gap. We're slightly long or pretty close to flat.

Eric Hagen -- BTIG -- Analyst

Got it. Thanks for the comments.

Operator

Our next question comes from Brocker Vandervliet with UBS. Please go ahead.

Brocker Vandervliet -- UBS -- Analyst

Hi. Good morning. Sorry if you covered this, I had to bounce off the call for a minute, but what -- the taper is kind of funny, in that it's obviously destabilizing impact -- as it is destabilizing impact, I would assume on the market. But then again, it's probably the most widely anticipated thing that we've seen in years headed to the market as well.

What would you need to see to either -- during that process or on the back of it or in front of it to take up leverage?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yeah, I'll start, and Ilker can add. And to your point about the taper destabilizing, I wouldn't characterize it at all as such. We've been through this before. And I think the market well anticipates a reduction in the Fed's footprint and is prepared for it.

And if you think about the technicals, to Ilker's point about the stock effect with Fed and bank portfolios held to maturity and also the fact that money managers are underweight, REITs are less levered certainly, so we feel like this time around, it's going to be a much smoother transaction. And in terms of what type of widening we need to add leverage, it's not just about the headline spreads on Agency MBS. It's the quality of those spreads, meaning what's it cost to hedge, what kind of volatility do we expect and how manageable is adding Agency MBS? And what's the relative value equation versus our alternative products. So I can't put an exact spread number on it for you.

It's going to be state-specific. But I will say that the market is in a -- agency market is in a reasonably comfortable place. We're content with our leverage profile. And to the extent there was cheapening, and we felt like that was a manageable proposition from a hedging balance sheet standpoint, we would add.

I just don't have an exact number because it does depend on what the rate landscape looks like and the overall market.

Brocker Vandervliet -- UBS -- Analyst

OK. 

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Brock.

Brocker Vandervliet -- UBS -- Analyst

And just as a follow-up, David, in your opening remarks, you mentioned $0.30 as kind of a high watermark. As you sort of -- could you just break down the major components of the lower numbers going forward, what that would consist of?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yeah. I would say that we certainly expect to out-earn the dividend in Q3. And beyond that, I wouldn't comment. But our TBA position was a little bit smaller.

So roll income should moderate a little bit. And there's other factors from an amortization standpoint and runoff of higher book yielding assets that are in consideration, but we do expect a modest decline for Q3. But nonetheless, well out-earning the dividend.

Brocker Vandervliet -- UBS -- Analyst

Got it. OK. Thank you.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Brock

Operator

The next question comes from Kenneth Lee with RBC Capital Markets. Please proceed.

Kenneth Lee -- RBC Capital Markets -- Analyst

Hi. Good morning. Thanks for taking my question. Wondering if you could just further expand upon comments on what you could see in terms of funding costs for the second half of this year? Thanks.

Serena Wolfe -- Chief Financial Officer

Thanks, Ken. It's Serena. So as I mentioned in my prepared remarks, we think that we continue to have, obviously, reduced cost of funds. We think we've probably hit a bit of a trough with regards to agency repo, though in saying that the average rate for the quarter was 18 bps and we ended the quarter with 16 bps.

So you are going to see some sort of natural benefit from that in the subsequent quarter. And so some you'll see sort of modest -- continued decline in that expense as well. We do see -- continue to see some level of tightening also in the credit side of things, but given the agency repo is the majority of our expense, I would say a little bit of a timing or a reduction in the following quarters. But we do think we've probably hit a bit of a trough when it comes to those types of rates.

Kenneth Lee -- RBC Capital Markets -- Analyst

Great. That's very helpful. And one follow-up if I may. It sounds like there's a couple of opportunities between the MSRs, the residential whole loan channel.

Wondering from a high level, where do you see investment leading toward for the marginal dollar, the incremental dollar? Just wanted to talk about the overall landscape there. Thanks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yes. I would say residential credit is the area where we still feel very good about that marginal dollar. Also, we haven't talked about Tim's business in middle-market lending. There is a lot of activity on that front.

And in MSR, a lot of the MSR we purchased was earlier in the quarter when valuations were cheaper. They're still OK right now, but they're not as cheap as where we added a lot of those assets early in the quarter. And so I'd like to say we're content with the agency portfolio in the alternative sectors is where we want to put money to work, but we're not a forced deployer in any sector, and we can let the market come to us. Does that help?

Kenneth Lee -- RBC Capital Markets -- Analyst

Very helpful. Thanks again.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet. Good talk with you, Ken.

Operator

The next question comes from Derek Hewett with Bank of America. Please proceed.

Derek Hewett -- Bank of America Merrill Lynch -- Analyst

Good morning, everyone. And my question relates to what was discussed on the last question. But just given that increased capital allocation toward residential credit and expectations to grow the MSR in correspondent originations, what is the longer-term plan for middle-market lending? Are there additional opportunities to grow the portfolio since it's been relatively flat for the last few years? Could you just expand on that?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yes, sure, Derek, and good to hear from you. And we talked a little bit on the last call about middle-market lending. You know that business remains a core part of the portfolio at nearly 10% of capital. The returns of the business are largely uncorrelated with agency, so it's incredibly complementary for us.

And it's a scaled business with a very efficient cost structure and a solid franchise given the PE relationships. And so we feel good about it. At the end of the day, we do certainly recognize that there are limits to growth given the fact that we're a REIT, but it's a steady-state scale business. And if there's incremental opportunities to grow it, from a return standpoint, we have certainly capacity to do so, and we feel good about that.

And it's not nearly the conflict with the agency business, somewhat like CRE was in terms of competition for capital and the Agency business making up some of the shortfall from lower CRE returns to solid business.

Derek Hewett -- Bank of America Merrill Lynch -- Analyst

OK. And then would you be willing to add a little bit of leverage to boost returns even higher? Or is it still going to be funded basically with equity at this point?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yes. And it depends on the composition between first lien and second lien. The portfolio is two-thirds first lien, a third second lien, and less than a turn of leverage. And if it works from the standpoint of adding leverage to the portfolio, and we do more first lien, then we'll do so.

And as Serena talked about, financing is improving in credit. If there is any potential upside to financing, it's in our credit sectors. And so it's going to be dependent on the composition of the portfolio and the cost of leverage.

Derek Hewett -- Bank of America Merrill Lynch -- Analyst

Ok. Thank you.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Derek.

Operator

The next question comes from Ryan Carr with Jefferies. Please proceed.

Ryan Carr -- Jefferies -- Analyst

Hi. Good morning, guys, and thanks for taking my question. Not to beat a dead horse here, but can you talk about the risk-adjusted return profile in the credit book relative to agencies, given the prevailing environment? And how you're thinking about that going forward?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. So obviously, it's specific to the type of transaction. Ilker talked high single digits on MSR without any leverage. Fania, his transaction -- his securitization transactions are well into double digits.

And with Tim's business, it's probably right around that double-digit level with incredibly low leverage. So those are attractive propositions. Now granted the agency markets cheapened up, and if we apply specialness to TBAs, you do get into the double digits. But for dollar similar returns, the objective is to further diversify, and we expect to have opportunities to do it, but it's product-specific and episodic.

Ryan Carr -- Jefferies -- Analyst

Got it. Thank you. And then turning to the distribution. You noted that the $0.30 is kind of the high end of core earnings at this point and going forward, you're expecting that to drop a bit.

But when would you consider a potential increase in the distribution? And what level would you -- where would you be comfortable in making that decision?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yeah. So obviously, that's a conversation with our board. And what I'll say is we're not forced to adjust the dividend notwithstanding out-earning it. And look, at the end of the day, when we reset the dividend to $0.22, the considerations were, we wanted it to be a competitive yield and consistent with our historical average, and we wanted to make sure it was consistent.

Right now, our dividend yield on book is 10.5% in that proximity on the stock.

Ryan Carr -- Jefferies -- Analyst

Thanks very much.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet. Thanks, Ryan.

Operator

The next question is a follow-up from Rick Shane with J.P. Morgan. Please proceed, sir.

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

Sorry about that. Thanks, guys, for letting me hop back in queue. I just wanted to ask one follow-up question on the MSR. When we think about the movement in book value this quarter, from a descriptive perspective, it was the underperformance of the hedge, and that makes sense in light of what we saw for interest rates.

I am curious if you had a greater hedge position associated with MSR, if that would have, in fact, dampened the book value compression we saw this quarter?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Well, to be clear, as we add MSR, we do adjust the hedge profile. And Ilker talked a little bit about receiver swaptions, which were done in conjunction with MSR purchases. So the answer to your question is, is no. I think we effectively hedge the MSR and it contributed to overall book performance on the quarter from a hedge perspective.

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

OK. But I understand the dynamic there, but what I'm asking is that would the -- in theory should the MSR, which was better correlated to the assets, all other things being equal, without moving the swap position, would it have been a more effective hedge this quarter in light of the environment we're in? Because I'm just thinking about the uncertainty that we're facing going forward as we sort of transition through the rate environment, if you think that will give you a more efficient hedge?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Absolutely, and Ilker can expand on it.

Ilker Ertas -- Head of Securitized Products

Yeah. So in this quarter, yes, because MSR has tightened and it would have reduced your spread duration to Agency MBS, and Agency MBS has widened. For this quarter, your answer is definitely yes. But also, let's not forget that when you are adding MSR, you are also adding the negative convexity that needs to be managed.

But yes, we had our steady state. If we get to David's vision earlier, that would have definitely helped big time on this quarter.

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

Got it. OK. Thank you, guys.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

All right. Thanks, Rick. And I believe that's our last question. So thank you, everybody, for joining us, and we look forward to talking to you again next quarter.

Operator

[Operator signoff]

Duration: 60 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

Mike Fania -- Head of Residential Credit

Doug Harter -- Credit Suisse -- Analyst

Bose George -- KBW -- Analyst

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

Eric Hagen -- BTIG -- Analyst

Brocker Vandervliet -- UBS -- Analyst

Kenneth Lee -- RBC Capital Markets -- Analyst

Derek Hewett -- Bank of America Merrill Lynch -- Analyst

Ryan Carr -- Jefferies -- Analyst

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