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Annaly Capital Management (NLY) Q3 2021 Earnings Call Transcript

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NLY earnings call for the period ending September 30, 2021.

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Annaly Capital Management (NLY 2.38%)
Q3 2021 Earnings Call
Oct 28, 2021, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Good day and welcome to the third quarter 2021 Annaly Capital Management earnings conference call. [Operator instructions] I would now like to turn the conference over to Mr. Sean Kensil. Please go ahead.

Sean Kensil -- Vice President, Investor Relations

Good morning and welcome to the third 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.

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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 third quarter 2021 Investor Presentation and Third 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 to post 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 third quarter earnings call. Today, I'll provide an overview of the broader market environment, including our thoughts on the Federal Reserve's reduction in asset purchases, briefly touch on our performance during the quarter and highlight some of our recent achievements and positioning across our businesses. Ilker will provide more detailed commentary on our agency and residential credit portfolios and Serena will discuss our financial results.

And as Sean noted, our other business heads are also here this morning to provide additional context during Q&A. Now first, with respect to the macro landscape. The COVID Delta wave and related factors have led to a moderation in the economic recovery, labor market gains have slowed relative to the strong pace at the beginning of the summer, production bottlenecks and global supply chain disruptions have caused delays that raise prices on products and high demand. And while inflation has been boosted by higher goods and energy prices, record home price appreciation has started to filter into inflation shelter component, suggesting that price pressures may persist for longer than previously anticipated.

Meanwhile, interest rates experienced meaningful intra-quarter volatility given the shifting narrative on the economic recovery and inflation. Early in the quarter, rates rallied as market saw direction on the magnitude of the impact of the Delta variant. And later in the quarter, as a relative reduction in COVID case counts led to a return to economic optimism, rates slowed off and the curve steepened in the quarter. Now, the greater near-term focus in the macro landscape, however, is the imminent reduction in the Fed's pace of asset purchases.

Following the September FOMC meeting, we now have a clear picture as to what the taper will likely look like, that is expected to reduce treasury and agency MBS purchases by roughly $10 million and $5 billion per month, respectively, beginning in as early as November. This pace would result in the Fed halting balance sheet expansion in the summer of 2022, though we expect reinvestment of portfolio runoff to persist well beyond the end of the taper consistent with the QE3 experience. Most notably, the Fed's transparent communications have helped to limit the market impact to both interest rates and agency MBS spreads ahead of the official taper announcement. While the Fed has attempted to decouple the taper and eventual rate hikes, elevated inflation readings and more hawkish central bank messaging globally have accelerated investors' expectations of a rate hike.

With markets currently pricing as many as two hikes in 2022, we remain vigilant in managing analysts duration exposure, both in the front end and the long end as Ilker will expand later on. Now, reflecting briefly on the agency MBS supply and demand outlook in light of the taper announcement, private market participants will need to absorb an increased amount of mortgages in 2022. Elevated net issuance remains an uncertainty in the supply demand outlook, but we currently estimate supply to the private market next year will be similar to levels seen in recent years pre-pandemic. And several factors are supportive of a more limited widening in spread before buyers merge.

Banks are flush with deposits and see little loan demand, suggesting strong appetite for securities is likely to continue, particularly at potential wider spread levels and money managers remain underweight mortgages, but will likely increase the relative allocation mortgage spreads become more attractive. Ample liquidity, best seen in the $1.6 trillion pledged to the Fed's reverse repo facility at quarter end and readily available financing remain the main factors underlying the current accommodative financial conditions. The repo market remains highly liquid and has allowed us to decrease our cost of funds to another record low. In line with efforts earlier in the year, we continue to broaden our financing through increased use of credit facilities by funding high-quality credit securities for longer terms.

These actions help to enhance Annaly's liquidity profile at extremely attractive spread in haircut levels as Serena will discuss in more detail. Now, turning to Annaly's performance in the third quarter. Our portfolio generated a positive economic return of 2.9%, reflecting a $0.02 gain on book value and earnings available for distribution of $0.28. We achieved these returns and made continued conservative portfolio positioning, maintaining economic leverage at the low end of our historical range and unchanged quarter over quarter at 5.8 times.

Our liquidity remains at our highest levels with total unencumbered assets of $9.8 billion at quarter end. We continue to see relatively tight spreads and as a result, are comfortable with our more cautious approach to managing the portfolio. Now that being said, should spreads become more attractive, our nimble positioning leaves us prepared to take a more offensive posture and increased leverage should it be justified. Now over the quarter, mortgages performed in line with hedges in this environment as the sector benefited from clarity surrounding the upcoming taper and healthy demand from banks.

We increased our agency portfolio by nearly $3 billion in Q3 as we invested a portion of the proceeds from our previously announced commercial real estate sale. Additions to our agency portfolio, which Ilker will cover in more detail, were primarily a placeholder as agency MBS remain fully valued, while credit sectors offer attractive pockets of opportunity but deployment of capital is more episodic. With respect to capital allocation at the end of the third quarter, 30% of our capital was allocated to credit, up slightly from 29% in the prior quarter in line with our view on the relative value equation vis-a-vis agency and our deliberate portfolio positioning ahead of the taper. Our residential credit business represents the majority of our credit allocation at 21% and had another strong quarter as the group continues to successfully execute on their strategy.

With assets of $4.3 billion, the residential credit group is now larger than it was pre-COVID and assets are up over 70% since year-end 2020. We maintain an optimistic outlook on the business given persistent robust housing market fundamentals and long-term tailwinds driving the need for private capital in the market. Now on to our base, securitization platform remains very active, completing nearly $2 billion of securitization since the start of the third quarter and nearly $3 billion of securitizations year-to-date. We expect to maintain our securitization footprint and we are continually adding to our partnerships to drive new sources of securitization collateral.

Additionally, our correspondent network is adding new partners in Annaly's large capital base and market expertise uniquely positioned on to our base as an aggregator within the industry. And also as it relates to OBX, I wanted to briefly touch on the impact of the recent suspension of the FHFA's cap on second homes and investor properties. While the decision will have an impact on the delivery of agency-eligible loans to our platform, it does not temper our bullish outlook for the sector. Annaly was an active issuer of agency-eligible investor loans before the cap was put in place and notably, we issued three securitizations in 2019 and 2020 backed by $1.15 billion of collateral prior to the PSP amendment, limiting delivery of investor loans for GSEs in March of this year.

As the FHFA has reversed the introduction of the caps, we expect Annaly in private markets more broadly to be able to compete with GSE LLPA adjusted pricing, again, assuming securitization execution remains attractive. Now, regarding progress on our MSR business, we grew our holdings by more than 40% on the quarter with the portfolio representing $575 million in market value and 4% of dedicated capital. As we scale the business, we have solidified our position as a reliable partner in the MSR sector, supplementing our bulk transactions with acquisitions through flow relationships. We've increased our MSR holdings by $470 million in 2021 and we anticipate responsibly growing the portfolio through our unique position as a noncompetitive partner to originators that need liquidity and capital.

Turning to our middle market lending business. We closed our inaugural private closed-end funds subsequent to quarter end, which is north of $370 million of capital. The fund is approximately two times larger than the median size of first-time direct lending and private debt funds. It includes a mix of both U.S.

and European investors comprised of public and corporate pensions, insurance companies and asset managers. The fund has supported nearly $450 million of middle market loan investments to date, with an attractive risk-adjusted return profile. Italy is co-investing 50-50 alongside each fund investment, bringing a strong alignment of interest. But we believe the fund serves as a testament to the track record and expertise of our dedicated middle market lending team allows for enhanced capital allocation flexibility to further scale the strategy and provide recurring fee revenue to the REIT.

Including the fund, the middle market lending strategy managed $2.3 billion in funded assets at quarter end. And lastly, as the largest mortgage REIT with the capability to invest across all aspects of the mortgage loan, our strategic initiatives over the past year, including investing in MSR and balance sheet and expanding our residential credit business have prepared us to be a leading source of capital in residential housing finance. Ultimately, the strength of Annaly's diversified model is enabled by our size and scale and we remain confident in our ability to generate stable returns throughout various market environments and across economic cycles as we have done historically. And now, with that, I'll turn it over to Ilker to provide a more detailed lens into our agency and residential credit portfolio activity and outlook.

Ilker Ertas -- Head of Securitized Products

Thank you, David. Against the economic and interest rate backdrop David described, agency MBS performed broadly in line with hedges, but performance was mixed across the coupon stack. Specifically lower-coupon MBS widened modestly due to continued record supply levels, Feds taper moving closer and elevated prepayment speeds. At the same time, higher coupons outperformed hedges into the retracement of higher interest rates that materialized later in the quarter and emerging signs of prepayment burnout.

Our portfolio performance showed the benefits of the buy out strategy we have discussed in several of our recent earnings calls. In third quarter, the outperformance of higher coupons more than offset the widening experience in the lower production coupons. We believe the approach is also efficient in protecting the portfolio from any potential taper-induced widening as nearly 60% of our agency portfolio consists of non-Fed supported coupons, that is 3% and higher. In addition, our specified pool portfolio is more than 45 months seasoned on average, which provides a strong source of durable earnings with minimal duration and convexity risk.

Turning to our portfolio activity. We tactically increased our agency portfolio by nearly $3 billion during the quarter, predominantly in lower coupon TBAs to opportunistically redeploy a portion of the proceeds from our previously announced commercial real estate sale. Our purchases consisted of primarily lower coupon TBAs, which exhibited spread widening earlier in the quarter. We have favored TBAs over course than lower coupons due to attractive implied financing rates in the dollar roll market, which remained quite special in the context of negative 30 to 40 basis points financing and enhanced levered returns.

We expect these favorable conditions to persist well into 2022 as the Fed remains a net wide of MBS throughout the taper. In addition, the sector offers strongest liquidity, should we choose to redeploy the capital into other opportunities. Regarding prepayment speeds, recent prints have mirrored the divergent performance across the coupon stack. Lower coupons have been very reactive in what remains a historically low mortgage rate environment in which mortgage originators have ample capacity, while higher coupons have exhibited moderate burn-out since peak prepayment speeds in March.

At current mortgage rates, roughly 31% of mortgage universe has greater than 50 basis points of refinancing incentive, which is down significantly from the 72% at the beginning of the year. The restriking of the universe along with slower speeds and higher coupons has improved the prepayment outlook going forward. Additionally, the historically strong housing market has led to elevated cash-out refinancing activity, which should help mitigate expansion risk for mortgage portfolios should interest rates continue to rise. Our portfolio prepaid 13% lower quarter over quarter and our outlook is for a further 10% to 15% reduction in the fourth quarter due to higher rates, less reactive borrowers and slower housing seasonal.

In our hedge portfolio, we added duration hedges at lower rates throughout the quarter, positioning the portfolio for modestly higher yields. We added treasury futures shorts across the curve and increase our long and swap position by exercising $3 billion in the money's swaptions. We also took advantage of relatively lower levels of implied volatility to replace our exercise swaptions with higher strike swaptions at longer expiries. This productive approach has already proven worthwhile given the rise in interest rates in September and October.

The interest rate outlook remains cloudy due to uncertainties over inflation, the Fed's response and market positioning. We will continue to minimize our interest rate exposure in fourth quarter. It was an active quarter for our mortgage servicing rights business. We grew our portfolio through $200 million in bulk purchases and began transacting through flow arrangements, which we see as a good growth opportunity going forward.

Additionally, in the fourth quarter, we expect to sell vast majority of our legacy MSR portfolio for roughly $85 million in estimated proceeds. The sale of higher coupon seasoned MSR will provide additional capacity to grow our allocation to newer production low coupon MSR, which will serve as more effective hedge to the MBS basis. Additionally, the planned transaction is with an operational partner that ascribes a higher value to customer acquisition, which will drive strong execution for both parties. We believe this transaction highlights Annaly's unique position in the MSR market as a capital partner for the originator community that does not compete for their customers.

Moving to our residential credit business. We continue to increase our allocation to the sector as measured by both assets under management and capital deployed. The residential portfolio ended the quarter at $4.3 billion of market value and $2.9 billion of dedicated capital, representing 21% of the firm's capital. The growth of the portfolio was predominantly through our acquisition of residential whole loans as we purchased $1.4 billion throughout the third quarter.

Our Q3 acquisitions were across both expanded prime non-QM markets and agency-eligible investor loans. Our securities portfolio was up modestly, approximately $125 million as we saw diminished opportunities in third-party securities relative to prior quarters. As David mentioned, our OBX securitization platform was active in Q3 with $1.1 billion of securitizations across three separate deals. Also to note, post quarter end, we priced two additional transactions representing another $800 million of issuance.

Life-to-date leverage returns of our whole loan strategy remains in low to mid-double digits, utilizing minimal recourse leverage. Our GAAP residential whole loan portfolio ended Q3 at $5.8 billion, 70% of which is currently term financed with non-mark-to-market securitizations. In summary, MBS technicals remain proactive as strengths in prepays continue to improve and recent price action highlights the amount of support for MBS into higher yields. Although spreads have potential to drift wider as the taper commences and supply remains elevated.

We believe any widening is likely to be orderly but we expect to maintain a conservative leverage profile and proactively manage our basis and interest rate exposure. With that, I will now turn the call over to Serena to discuss our financial results.

Serena Wolfe -- Chief Financial Officer

Thank you, Ilker and good morning, everyone. This morning, I'll provide brief financial highlights for the quarter ended September 30, 2021. Consistent with prior quarters, while our earnings release discloses GAAP and non-GAAP earning metrics, my comments will focus on our non-GAAP EAD and related key performance metrics, which exclude PAA. At the risk of repeating myself, I would say that the general scenes for this quarter's earnings are consistent with recent quarters.

That is, this quarter, we continued to generate 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 $8.39 for Q3 and we generated earnings available for distribution per share of $0.28. Book value increased primarily due to GAAP net income of $522 million or $0.34 per share, partially offset by the common dividend declaration of $320 million or $0.22 per share and other comprehensive loss of $142 million or $0.10 per share on higher rates. The negative impact to our book value from our agency MBS valuations was more than offset by the gains on our swaps resulting from higher hedge rates and higher mark-to-market valuations on our MSR and resi credit portfolios, which together contributed approximately $0.06 per share to book value during the quarter.

Combining our book value performance for the $0.22 common dividend we declared during Q3, our quarterly economic and tangible economic returns were both 2.9%. As we take a closer look at the GAAP results, the valuation drivers, as we mentioned above, benefited GAAP results as we generated GAAP net income to Q3 of $522 million or $0.34 per common share, up from GAAP net loss of $295 million or $0.23 per common share in the prior quarter. Expanding further on those summary comments, specifically, GAAP net income increased due to net realized and unrealized gains on the swaps portfolio in the third quarter of $130 million compared to losses of $224 million in the second quarter, lower net losses on other derivatives and financial instruments in the third quarter of $45 million compared to $358 million in the second quarter and net unrealized gains on instruments measured at fair value through earnings in the third quarter of $91 million compared to $4 million in Q2. As David mentioned during our second quarter earnings call, we anticipated that EAD would moderate slightly.

This is reflected in a $0.02 reduction in EAD compared to the second quarter. The most significant factors that impacted EAD quarter over quarter included lower interest income predominantly related to the runoff of higher-yielding assets and the reduction in investment balances, which was offset by higher TBA dollar roll as the debt position in our TBA portfolio based on the relative attractiveness compared to pool. EAD benefited from lower expenses on the net interest component on swaps from the termination of $28 billion gross notional swaps as the swaps portfolio was repositioned to reduce exposure to LIBOR. And finally, lower interest expense of $50 million in comparison to $61 million in the prior quarter due to lower average repo rates and balances.

It should also be noted that the sale of our commercial real estate business allowed us to shift capital allocation to a higher percentage in resi credit, where we saw higher levels of EAD on whole loan and NPL, RPL purchases throughout the quarter. Now, turning to our financing. Early in 2021, we communicated that we were forecasting lower repo rates for an extended period. As such, we have begun to opportunistically target extended term that is six to 12 months for our repo books.

And this has resulted in higher weighted average base maturity for our book during 2021 in comparison to recent years. And in doing this, we believe that we have appropriately managed the risk of our liabilities, while capturing the lows of the interest rate market. Additionally, given our ample liquidity in the prior quarters, we elected to fund certain credit assets with equity, further contributing to a lower cost of funds. These strategies resulted in the third quarter marking nine consecutive quarters of reduced cost of funds for the company.

Our weighted average days to maturity for Q3 was 75 days, slightly less than the prior quarter at 88 days. This reduction in days is due to the timing of rolling repo extended earlier in the year and not a function of a change in strategy by the company. As David discussed, the market is pricing in rate hikes to begin in the latter half of 2022. Therefore, we have seen steepening in the repo curve as of late.

And so while longer-term repo does come at a higher cost today, our over $30 billion in shorter-dated 0 to three-year pay swaps has been of considerable benefit to hedging this eventuality. And given the strong liquidity in the repo market that will likely persist beyond initial rate hikes, we have focused our effort on hedging short-term rates as opposed to repo spreads versus policy rates. Additionally, although our overall repo balances have been reduced since the beginning of 2021, we have tried to maintain steady balances within our broker-dealer. This has given us the opportunity to take advantage of attractive overnight funding conditions amid excess reserves and steady decline in TBA balances.

As in prior quarters, we continue to see strong demands to credit assets on the part of repo lenders. And we have opportunistically begun to lever credit assets at very competitive terms, both rates and haircuts. Our weighted days for credit assets are approximately 100 and we continue to target longer duration funding to lock in those competitive spreads and haircuts at all-time highs, consistent with our prudent and conservative approach to maximize liquidity. Given the growth in our resi credit businesses, we continue to add new warehouse facilities and amend existing facilities to meet the business' needs with a further $300 million facility put in place during the quarter and increased capacity for our resi credit partnership with a southern fund.

To provide additional color regarding our reduced interest expense for the quarter, our overall cost of funds decreased 17 basis points quarter over quarter from 83 basis points to 66 basis points. Our average repo rate for the quarter was 15 basis points compared to 18 basis points in the prior quarter and we ended September with a repo rate of 15 basis points, down from 32 basis points at the end of December 2020. With LIBOR reform looming, we took the opportunity during the third quarter to reposition our swap portfolio and reduce our exposure to LIBOR resulting in an aforementioned termination of $28 billion of swap notional and reduced interest component of swaps for the quarter and future periods. The portfolio generated 204 basis points of NIM, down 5 basis points from the record NIM level of 209 basis points in Q2, driven by the lower interest income, partially offset by lower interest expense and improved TBA dollar roll income up 3 basis points.

Average yields decreased 13 basis points from 2.76% to 2.63%, mainly because of the change in the composition of assets toward lower-yielding assets in the quarter, both agency and resi credit. Moving now to our operating expenses. Efficiency ratios for the quarter decreased in comparison to Q2's ratio of 1.55%. As expected, we saw a reduction in our opex to equity ratios during Q3 as we realize the benefits of the reduced compensation and other expenses from the disposition of our ACREG business and we saw a reduction due to the timing of certain fee payments and professional fees along with the true-up of prior period accruals in the second quarter.

Our opex to equity ratios were 1.28% and 1.4% for the quarter and year-to-date, respectively, with the full year expenses expected to be at the lower end, if not below the revised range of 1.45 to 1.60 provided in the first quarter. And to wrap things up, Annaly ended the quarter with an excellent liquidity profile with $9.8 billion of unencumbered assets, up from the prior quarter's $9.6 billion, including cash and unencumbered agency MBS of $5.9 billion. The composition of our unencumbered assets changed slightly this quarter with an increase in agency due to lower on balance sheet leverage and an increase in unencumbered assets due to MSR growth, partially offset by reductions due to investments sold during the quarter and the levering of certain non-agency securities that I discussed earlier. That concludes our prepared remarks.

Operator, we can now open it up to Q&A.

Questions & Answers:


Operator

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

Steve Delaney -- JMP Securities -- Analyst

Thanks. Good morning, everyone. Given the GF 13 analysts following the company. I'm just going to ask one question to lead off.

David, curious your quarterly dividend, $0.22 has been stable for the past six quarters going back to 2Q '20 after COVID. What does management and the board want to see that would give support to increasing that quarterly payout? Thanks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Good morning, Steve and it's good to hear from you. So first and foremost, just to back up in terms of how we set the dividend and obviously, our board is -- provides strong guidance on that front. And in conjunction with the board, we look at the overall dividend yield, what the earnings outlook looks like and we want to achieve a competitive yield. And currently, our yield on book value is 10 and a half percent, 10 and a quarter percent on the actual stock price this morning.

In terms of what we want to look for to increase the yield, or increase the dividend, we would need to see obviously, wider asset spreads, better investment opportunity, more durable earnings. We feel good about where earnings are this quarter and we feel good about covering the dividend into 2022, certainly. But we do recognize that we have outearned the dividend consistently since the second quarter of 2021. And we're comfortable with that and we're very comfortable where the dividend yield is today.

It's certainly competitive with the rest of the market and we're content right here. 

Steve Delaney -- JMP Securities -- Analyst

Yup. Well, I would certainly agree that a 10% dividend yield is too high and then therein comes the catch 22 of what comes first. But we certainly look at 10% and say, there's certainly upside in the stock as that dividend comes down, the credit-oriented names are more in the 8% to 9% and you're certainly adding a good bit of that. Thank you for the commments.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yeah. Thanks, Steve.

Steve Delaney -- JMP Securities -- Analyst

OK.

Operator

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

George Bose -- KBW -- Analyst

Hey, guys. Good morning. This is Bose. I wanted to ask about the $1.5 billion resi portfolio.

Can you just give us some color on that? What are the returns going to be? And how much capital is that going to use in the end once that's securitized?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure, Bose. Good morning. And I'll start off and then hand it over to Mike. I would separate both loans from securities.

We have had an emphasis on growing our loan portfolio and securitizing. The securitized portfolio has grown. But I will say from a return standpoint, the loan to securitization market is more attractive in terms of what we can generate relative to where our securities are currently priced. Mike, you can jump in here?

Mike Fania -- Head of Residential Credit

Sure. Thanks. I think we ended the quarter $3.2 billion in securities on an economic basis and then $1.1 billion in terms of whole loans. And I think when you think about the conversion of whole loans to securities on balance sheet, we're rotating anywhere between, I'll say, between 7% to 8%.

So I will say between $75 million to $80 million to $85 million is what ultimately will be created from that $1.1 billion of whole loans. But to note, we settled $2.8 billion of whole loans year-to-date and we ended the quarter with a $1.2 billion pipeline. So we remain positioned to continue to go through the securitization markets to the extent that they're open. But I would think about it probably 7% to 8% of the whole loan portfolio is openly converted to securities on balance sheet.

George Bose -- KBW -- Analyst

OK, great. And then the target ROE on that on a levered basis?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yeah. On securitization, we're in the low double digits right now, Bose.

George Bose -- KBW -- Analyst

OK. Great. Thanks. And then on the MSR investment, how large could that get as a percentage of your capital? And in terms of the yields on the MSR that you're buying, can you just give us some color?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. And as we've talked about both the last two quarters, we would like to get our MSR portfolio up to 10% of capital but we've also stressed that we're going to be patient in doing so. We're not going to chase returns in the sector. We are happy with the growth that we achieved in the third quarter.

But again, it may take time because the market is competitive, but we're finding opportunities and Ilker can talk a little bit about returns.

Ilker Ertas -- Head of Securitized Products

Yes. The purchases that we were buying with the hedge benefit will be very low doubles. But at the current pricing, it will be high singles. So that's why like we reduced our purchases, we reduced our purchase pace recently.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yes. We can also distinguish both purchases versus flow where with flow purchases, you can get into the double digits current quarter.

George Bose -- KBW -- Analyst

OK. Thanks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Thanks, Bose.

Operator

The next question will come from Rich Shane with J.P. Morgan. Please go ahead.

Rich Shane -- J.P. Morgan -- Analyst

Thanks, everybody for taking my question this morning. I just wanted to talk a little bit about the disparity between actual prepayment speeds and the long-term CPR assumption's fairly wide. I'm curious how we should think about the convergence of that over time and the implications in terms of your reported numbers?

Ilker Ertas -- Head of Securitized Products

Sure. One of the main reason is the steepness of the curve. So long-term speeds are at the forwards and as the curve steepens, like mortgage rate goes up and forwards speeds goes down. So that's one of the reason.

And second reason is the burnout. As the portfolio burns out, speed will slow down. So -- but the curve is the bigger reason. If curve flattens, you will see those two numbers approach to each other.

Rich Shane -- J.P. Morgan -- Analyst

And how should...

Ilker Ertas -- Head of Securitized Products

From the top?

Rich Shane -- J.P. Morgan -- Analyst

And how should -- it does, but at the same time, how should we think about the -- ultimately, they have to converge at some point. So how do we think about that from a reporting perspective, what we should anticipate and really what the time frame on that convergence should be? I mean, it's -- we're wider than 10 points at this point and that just seems unsustainable. So trying to think about the time line and the accounting implications.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yeah. So Rick, I'd say there is a consistent catch-up that is adjusted on a quarterly basis, number one. Number two, let's just look back. I realize the disparity between actuals and long-term projection is quite wide now.

But if you go back a few years, when rates were higher, you did have portfolio speeds that were in the low double digits, very consistent with long-term projection. So to the extent rates do normalize, then we're going to ultimately approach those longer-term CPRs if we follow the forwards as Ilker suggested and potentially even through those levels and will leverage out. But it's all dependent on where actual rates do go out the horizon.

Rich Shane -- J.P. Morgan -- Analyst

OK. No, certainly -- look, I don't -- I'm not questioning the long term prepayment speeds, particularly given the burnout that we're all anticipating. I'm just trying to think about what it means if you are persistently above the long-term assumption because obviously, what's left has a very low speed, but there's not much of it remaining. And as you replace or reinvest, you could have this situation where you sort of have this persistent gap between the two?

Ilker Ertas -- Head of Securitized Products

Yeah. You can look at it this way, though. So as long as prepayment models were accurate and if we were, if forwards does not realize and curve stays here, yes, short-term speeds will be higher than the long-term speeds. But to rule that, then you will get the roll-down benefit on your hedges.

So if yield curve does not -- if the forward slope does not materialize, then your hedge costs will never increase as much as the forwards realize. So when you look at the spreads to -- the spread of the mortgages to the hedges, you are taking the forwards roll down into account. So one way is saying that, OK, forwards realized, then your hedge cost goes higher or other way saying that forwards are not realized, then your hedge costs will be lower. So as long as what we are modeling or what market is modeling is consistent with where the mortgage rate and where the prepayments are, then those two effects will offset each other.

Rich Shane -- J.P. Morgan -- Analyst

OK, got it. Thank you and I've taken a lot of time, I apologize. Thank you guys.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Thanks, Rich.

Operator

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

Eric Hagen -- BTIG -- Analyst

Hey. Good morning, guys. So we know that overnight repo is very plentiful in the treasury market, like you noted. But can you share where on the term structure repo liquidity is currently most abundant for agency mortgages and how you expect that could evolve as the Fed begins to taper and more collateral supply gets put onto the market?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure, sure. Good morning. That's a good question. So I'll just give you a quick run on where bilateral repo is right now for a month, it's about 12 basis points, three months, 14, 17 roughly for six months and then in the mid-20s for a year.

So obviously, we have seen a steepening in the slope of that curve. Now, let's look at repo and break it down for clarification. There are two components to repo costs. There's the short rate component or the Fed funds component, if you will and then there's the liquidity component, which is the spread of bilateral repo over that short rate.

And the way we look at the current environment, what we're most concerned about is the rate component and we've seen hikes get priced in, acceleration of hikes get priced into the market as of late. And obviously, that's something we're very focused on. Now, however, when you look at our hedge profile, we're very well covered from that standpoint, $31 billion in 0 to three-year swaps and 80% hedge ratio at quarter end, actually a little bit higher than that now around 84%. So the rate component and the risk associated with short rates going up, we're well covered from.

Now the liquidity component, given our days are about 75 roughly right now, we are not as concerned about that over the very near-to-intermediate term because of the liquidity in the system. The Fed balance sheet of about $8.5 trillion, $1.6 trillion in the reverse repo facility at quarter end, a standing repo facility at that the Fed in case there's any destabilization in repo market. So we're more, much more focused on hedging the rate component, which we have and we're confident that liquidity out the near term is going to be ample. And so we're not as inclined to pay as much of a premium for term repo, but we're actively looking to find good value in, say, six months to a year repo.

Eric Hagen -- BTIG -- Analyst

Got it. That's helpful. And then it seems like it seems like one of the benefits of moving lower in coupon in the agency portfolio is that the premium risk on your capital structure gets reduced or tempered a little bit because you're buying lower-priced securities. Would you agree with that? And do you think that changes the way you think about your leverage and the way you guys manage risk in other areas of the portfolio too?

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Yeah. So just to talk a little bit about premium risk. I'd say it's always a concern of ours. But if you back up to the beginning of the year, it's less of a concern now than it was then because for example, we had $11 billion higher balance in fixed rate securities in the portfolio, largely premiums obviously.

Rates were much lower at the time. So the risk of refi was greater. And then lastly and perhaps most importantly, we did experience a bit of a repricing of higher coupons in the second quarter. And so as a consequence of that, premium coupons are priced to very fast speed.

So we're always concerned about the premium in the portfolio. Right now, I think 27% of our equity balance, which is lower than it's been over the past years certainly. Does it influence our leverage? We do take a holistic approach and what most influences our leverage is the attractiveness in the overall agency market and also our capital allocation, as we've talked about in the past. But generally speaking, we are shifting down in coupon into TBAs because the carry is better and TBAs did -- or lower coupons did cheap in a bit relative to higher coupons, both in the third quarter and on a relative basis to higher coupons and such in the fourth quarter thus far.

So again, we take a holistic look at leverage and a specific amount of premium, obviously has us concerned about refi risk but it's generally a bigger picture than that.

Eric Hagen -- BTIG -- Analyst

Got it. Thank you, David.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet, Eric.

Operator

[Operator instructions] Our next question will come from Kenneth Lee with RBC Capital Markets. Please go ahead.

Kenneth Lee -- RBC Capital Markets -- Analyst

Hi. Thanks for taking my question. Wondering on a broader level, could you talk about what are you looking specifically for before you start taking a more aggressive approach to leverage in portfolio positioning. Is it just a matter of spread widening in certain assets, or are there any macro considerations? Thanks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. Good morning, Ken. And look, this also goes back into the first question with respect to the dividend. When we look at the market and the landscape right now, we are approaching that tapering.

And obviously, rate hikes a little further out the horizon is something that we're obviously very focused on. So it's now the right time to raise leverage. We don't think so asset spreads are relatively tight. We're able to generate what we think to be strong earnings.

But we would need to see wider spreads, particularly in agency before we did raise leverage. And I'll say that given our liquidity profile, as Serena discussed and we are at the low end of the range, we're at the lowest level of leverage that we've been in, in over five years so we do have ample opportunity should that eventuality materialize. But if I, if the market ended the quarter where it is today and the portfolio looks as it looks today, I'd say we're -- our leverage would be here to slightly lower even. And should spreads widen, we will have the capacity to do so, but we do need to see more abundant spreads to take leverage up.

What that is, is depending exactly on what the state of the world is at the time. But generally speaking, it's not a -- we're not inclined at this leverage right at the moment.

Kenneth Lee -- RBC Capital Markets -- Analyst

Got you, very helpful. And one follow-up, if I may. The private closed and middle market lending fund. Could you just talk a little bit more about what you see are opportunities in that area over time with the potential for perhaps additional funds? Thanks.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Sure. And look, I think when we look at the middle market business, we have said repeatedly that the returns in that sector are very complementary to the agency portfolio, given the low correlation and the team has built a great franchise and has very extensive relationships with private equity that we think is having a lot of barriers to entry. And as a consequence, they were able to successfully raise outside capital. And the catalyst was looking through the lens of the Annaly portfolio, we like the business and we very much like the assets.

But given the fact that it's corporate lending and we're REIT, there are limits to the potential growth. And so outside capital, certainly solves the issue of enabling that business and that portfolio to further scale and also it reduces some of the concentration risk of individual positions. So we're very happy with the accomplishment of raising the outside capital. And to the extent there's more opportunities we'll see.

But right now, we feel like we have capacity on the Annaly balance sheet to add to the portfolio and we're happy with how it's performed. And Tim, if you want to add anything to it, by all means.

Tim Coffey -- Janney Montgomery Scott -- Analyst

I think David summed it up beautifully.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Great. 

Tim Coffey -- Janney Montgomery Scott -- Analyst

Great. Very helpful. Thanks again.

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

You bet. Thank you, Ken. 

Operator

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

David Finkelstein -- Chief Executive Officer and Chief Investment Officer

Thanks, Chuck and thank you, guys, for joining us today. Have a good holiday season and we'll talk to you at the beginning of the year.

Operator

[Operator signoff]

Duration: 49 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

George Bose -- KBW -- Analyst

Mike Fania -- Head of Residential Credit

Rich Shane -- J.P. Morgan -- Analyst

Eric Hagen -- BTIG -- Analyst

Kenneth Lee -- RBC Capital Markets -- Analyst

Tim Coffey -- Janney Montgomery Scott -- Analyst

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