Annaly Capital Management (NLY) Q1 2022 Earnings Call Transcript

Annaly Capital Management (NLY 1.69%)
Q1 2022 Earnings Call
Apr 28, 2022, 9:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good morning, and welcome to the first quarter 2022 Annaly Capital Management earnings conference call. Today, all participants will be in a listen-only mode. [Operator instructions] Please note that today's event is being recorded. Now, I would like to turn the conference over to Sean Kensil, director investor relations.

Please go ahead, sir.

Sean Kensil -- Director of Investor Relations

Good morning, and welcome to the first quarter 2022 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 the COVID-19 impact, which is outlined in the Risk Factors section in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the disclaimer in our earnings release in addition to our quarterly and annual filings.

Additionally, the content of this conference call may contain time-sensitive information that is accurate only as of the date hereof. We do not undertake and specifically disclaim any obligation to update or revise this information. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our earnings release.

As a reminder, Annaly routinely posts important information for investors on the company's website, www.annaly.com. Content referenced in today's call can be found in our first quarter 2022 investor presentation and first quarter 2022 financial supplement. Both are 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.

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

David Finkelstein -- President and Chief Executive Officer

Thank you, Sean. Good morning, everyone, and thanks for joining us on our first quarter earnings call. Today, I'll review the macro backdrop and how it impacted our performance during the quarter. And then I'd like to discuss the sale of our middle market lending portfolio in the implications of the transactions for our capital allocation and our broader strategic direction.

Ilker will then provide more detailed commentary on our portfolio activity, and then Serena will go over our financial results. Although growth slowed in the first quarter relative to last year, the US economy remains robust. The strength in inflation in the labor market has demonstrated that the Federal Reserve needs to remove monetary policy accommodation much faster than previously anticipated. This led to a sharp repricing of fixed income assets with the aggregate US bond market index facing the worst quarterly performance since 1980.

Consistent with the broader market Annaly's portfolio was vulnerable to the exceptional volatility in this environment. Despite our efforts to defensively position our portfolio experienced an economic return of negative 12% with a reduction in total portfolio size of roughly $5 billion to end the quarter at $84.4 billion in total assets. Returning to the macro landscape, inflation continued to rise during the first quarter, with headline CPI reaching 8.5% in March, driven by a sharp rise in commodity prices. Now, even outside of commodities and food, inflation pressures remain elevated and broad-based as seen.

For example, the Federal Reserve Bank of Dallas estimates that only 10% of PCE components are currently witnessing annualized inflation below 2%. The labor market, however, has arguably been the bigger driver of the Fed's hawkish shift. The employment picture has recovered significantly, with the unemployment rate falling from 1.1% over six months to 3.6% in March. Consequently, the demand for labor remains extremely strong, creating the risk that employers will have to pay even higher wages to attract workers, which could trigger a wage-price spiral.

The combination of these two developments high inflation and tight labor markets have demonstrated the need for much more aggressive monetary policy tightening, as Fed officials have signaled expeditious rate hikes in coming months. Overnight index swaps suggest the Fed will deliver a total of 250 basis points of hikes in 2022, compared to expectations of just 325 basis point increase back in January. And 100 basis points of hikes are likely to come in the second quarter alone. This repricing of Fed expectations led to a meaningful sell-off in treasury rates, where two-year yields rose 160 basis points during the quarter, marking the most severe quarterly sell-off in nearly 40 years.

The long end of the yield curve fared somewhat better, with 10-year notes raising just over 80 basis points leading to a substantial yield curve flattening during the quarter. Given the rate sell-off, as well as concerning geopolitical developments that include the Russian invasion of Ukraine, interest rate volatility, particularly in short and medium-term tenors, rose to the highest realized levels since the financial crisis. And as Ilker will discuss in further detail, the volatile rate environment weighed heavily on mortgages with production coupon nominal spreads widening 40 basis points in the quarter. Agency MBS spreads are now attractive and we are comfortable maintaining our current agency portfolio at prevailing spread levels.

But we remain considerate of heightened interest rate volatility as well as the supply outlook in light of imminent Fed portfolio runoff. Specifically, with respect to the Fed's balance sheet, the March FOMC meeting minutes provided the market with a general framework for the second iteration of quantitative tightening, and the one runoff will be significantly faster, with the Fed planning to retire up to 95 billion and assets per month nearly twice the aggregate cap seen during the 2017 to '19 period. In addition, caps will be phased in more quickly than last time, and we currently expect an announcement at the May FOMC meeting next week and a full ramp decline starting three months later. Runoff is likely to last for multiple years as current Federal Reserve security holdings have resulted in excess liquidity within the financial system.

Best seen in the $1.8 trillion in cash pledged to the Fed's reverse repo facility. Using current runoff parameters, the Fed would have to shrink its balance sheet for roughly 18 months before reserves equivalent to these excess cash balances are extinguished. And also to note, although markets continue to discuss the potential for MBS sales, Fed official communication has indicated runoff will be quote predictable and running in the background. Suggesting that sales will be on the back burner for the next several quarters while accelerating runoff and MBS sales from the Fed's portfolio would further deteriorate.

An elevated supply outlook risks excessive tightening of financial conditions and could be difficult to implement effectively. Now, with that said, let's turn to our recent strategic activity. We are pleased to have announced the sale of our middle market lending portfolio to Ares this past Monday. The $2.4 billion transactions, inclusive of our own balance sheet portfolio, as well as assets managed for third parties, follow the completion of a highly competitive process that is expected to be accretive to book value and validate the quality of our differentiated corporate credit portfolio.

While the middle market lending portfolio has been a source of complimentary returns. It was an opportunistic time to pursue a transaction given the relative valuation ascribed to middle-market assets in the current environment as broader fixed income markets have come under pressure. Middle market lending was one of the few areas of the market that commanded a premium while attracting a significant amount of new capital. Accordingly, the sale provided an efficient way to monetize a less liquid non-core business at an attractive valuation and redeploy over $1 billion in capital into cheaper assets in our core strategies.

We expect to close the deal by the end of the second quarter following customary closing conditions and we believe Ares is a clear strategic fit for the assets going forward. Now finally, turning to our long-term strategy, the MML sale furthers our natural progression toward becoming a dedicated housing finance REIT. Combined with the sale of our commercial real estate business last year. The transaction moves Annaly closer to the vision we laid out when I stepped into the role of CEO two years ago.

As a relative value investor, our permanent capital base allows us to increase our exposure to lower levered, less liquid assets with a premium return, which serves to enhance the durability and quality of our earnings. Accordingly, we expect to expand our capital allocation in non-agency mortgage finance over the long term and solidify our role as a market leader within the MSR and non-agency residential credit sectors. Annaly is well-positioned to leverage operational synergies across these businesses, which we expect to provide a unique advantage in these high barriers to entry to more operationally intensive businesses. Regarding our MSR business specifically, we expect it will grow to represent a greater steady-state capital allocation than the approximately 10% guideline we've discussed in the past.

Following the removal of MML assets from our capital allocation framework, we will be able to devote more capital to MSR while still maintaining our high liquidity and risk management standards. The increased emphasis on MSR is further informed by both the attractiveness of the asset class within our portfolio, as well as the more rapid pace of establishment of our platform in the market. We've grown the asset base by more than five times over the past year and ended the quarter as a top 10 secondary market purchaser of MSR. And as noted on previous calls, the sector remains highly active due to the consistent disposition of MSR by the originator community.

Given reduced profitability, a trend we see is likely to persist. Coupled with wider spreads, we expect MSR to remain a vehicle for growth that should improve our overall returns and book value stability over the long term. Additionally, we expect to build on momentum within our residential credit group, which recently surpassed over $1 billion in closed loans through our correspondent channel, with the opportunity to further scale both our securities and home loan portfolio, we are poised to take advantage of substantial opportunity across residential credit, where private capital is primed to play an even greater role. While the sector grows to post-global financial crisis highs Annaly continues to broaden its presence, as demonstrated by Onslow Bay, becoming the second-largest non-bank issuer of prime jumbo and expanded credit MBS.

As we further increase our products, partnerships, and resources, we're well prepared to capitalize on organic as well as external growth opportunities throughout the marketplace. Now, ultimately, following our MML disposition, Annaly is positioned for its next phase of growth with a scaled and diversified portfolio backed by three distinct but complementary businesses. The power of Annaly's capital allocation framework lies in our ability to calibrate our investments based on where we are in the cycle, as seen through the relative growth of our agency and residential credit assets in recent years. Looking ahead, I'm excited about Annaly's future as we continue to develop our housing finance capabilities propelled by strong tailwinds within MSR and residential credit while taking advantage of a more attractive reinvestment landscape for our core agency business.

And now with that, I'll hand it over to Ilker to provide a more detailed overview of our portfolio activity for the quarter and outlook for each sector.

Ilker Ertas -- Chief Investment Officer

Thank you, David. As you discussed, the first quarter was characterized by a challenging macroeconomic outlook that led to extreme volatility in fixed income markets. Mortgages underperformed significantly given the added headwinds of historically high levels of net supply, as speculation about asset sales from the Federal Reserve. Normal spreads widened by roughly 40 basis points and a primary mortgage trade increased by over 150 basis points, marking one of the sharpest backups in the history of the mortgage market.

With respect to how we managed our portfolio in this environment, we began the year with our leverage at its lowest level since 2014 and maintained a stable notional exposure to MBS throughout the quarter. Within the portfolio, however, the actively managed outages and rebalanced our coupon exposures to better position ourselves considering three key market themes. First, there was disparate performance across the mortgage stacks. Mortgages that were being produced underperformed lower coupons which were largely locked up in Fed and bank portfolios, and therefore more insulated from the consistent selling pressure driven by elevated origination volumes.

We use this opportunity to shift up in coupons, selling roughly 7.5 billion lower coupons, predominantly choose and moving into a higher purpose. Second, as mortgage rates sharply sold off, prepaid dynamics in the market changed rapidly. With mortgage rates at roughly 5% at quarter-end, only a small fraction of borrowers maintain an incentive to refinance their mortgages. At the same time, cash-out activity should remain somewhat elevated due to the recent strong housing market and summer seasonals.

As a result, the conversion of our mortgage portfolio improved meaningfully. Speed slowed 22% quarter-over-quarter with the aggregate portfolio paying 16.7% CPR in Q1. In addition, we believe our specified portfolio remains well-positioned for a discount environment due to around four years of average seasoning, roughly 60% of our post being a low loan balance, and the weighted average coupon on our portfolio being 50 basis points higher than the 30-year mortgage universe. Lastly, as production shifted into higher coupons, the TBA deliverable in higher coupons shifted from seasoned faster-paying pools to new production, resulting in collateral scarcity and meaningful loss specialness in these coupons.

While the specialists will not last in perpetuity, we expect to continue to shift up in coupons while preferring TBA or post given the favorable carrying spread dynamics. In terms of hedges, we entered the quarter conservatively positioned with our portfolio nearly fully hedged. However, as interest rates increased, we added hedges throughout the quarter across treasury futures and interest rate swaps, with most of our activity concentrated in the internal part of the curve to help protect against expansion in our portfolio. This contributed to an increase in our hedge ratio with the notional balance of our hedges to the balance of our liabilities increasing by 14 percentage points to 109%.

We ended the quarter with over 70% of our hedges concentrated around seven to a 10-year point, which has been beneficial as intermediate and long-run rates have continued to rise to start the second quarter. Looking forward, we will remain disciplined in managing our duration given the elevated volatility, uncertainty in the macro-environment, and tighter financial conditions as Fed continues to normalize monetary policy. Turning to MSR. The market was extraordinarily active, with traded volumes nearly reaching levels seen in the full year 2020 in the first quarter alone.

We used this opportunity to grow our portfolio through a net purchase of over $400 million in market value. Combined with mark-to-market gains, we increased our MSR position by 91% to over $1.2 billion. Mortgage originators continue to be active sellers as operating profitability has come under pressure from rising mortgage rates. We continue to see MSR as complementary to our agency strategy due to its negative interest rate and mortgage spread duration and attractive unlevered returns, which remain in the high single digits.

And we expect to continue to grow our allocation to MSR in the coming quarters should market conditions remain favorable. In residential credit, our economic portfolio ended the quarter with $4.4 billion of assets, with the capital contribution closing at $2.1 billion. The modest decline in the portfolio was primarily driven by our robust securitization activity as we converted home loans to OBX securities. The residential credit market was not immune to the volatility in the broader rates and credit markets, with key benchmark asset classes establishing their widest levels since the onset of the pandemic two years ago.

AAA non-QM spreads widened 75 basis points to 175 to the curve while investment-grade CRT M2s widened 160 basis points, ending the quarter at 325 basis points. Credit spreads have subsequently tightened post-quarter end, with AAA non-QM and CRT M2s 40 and 25 basis points tighter, respectively. Despite the challenging environment, our OBX platform had its most active quarter-to-date, with $2.5 billion of whole loans securitized across six transactions. Our commitment and discipline to being a programmatic issuer have allowed us to lock in financing on 87% of our whole loan portfolio at an average cost of funds of 2.3%, approximately 240 basis points below the current market cost of funds.

The recent sell-off has incentivized originators to expand product offerings beyond agency mortgages into alternative credit products. And we expect this to have a positive impact on the development of the non-QM market over time. We continue to dedicate resources to the growth of our correspondent loan channel while also expanding our securitization partners. Also to note, this year's volatility has led to the increasing number of smaller originators turning to our correspondent channel given the certainty of execution, which we have ample liquidity to accommodate.

Housing fundamentals remain strong with healthy consumer balance sheets, a systematic shortage of single-family housing, low available-for-sale inventory, and a robust labor market. While there are increasing headwinds, namely around the higher mortgage rates and affordability, we continue to expect to allocate incremental capital to the residential credit sectors. While thus far, 2022 has proved to be one of the most difficult periods for mortgage investors in recent memory, the outlook for agency MBS has improved significantly. As David alluded to, spreads are materially wider compared to recent historical averages.

Comex has improved, funding markets remain robust, and there is more clarity on the Fed outlook as they have effectively laid out their plan for the balance sheet reduction. And we believe these dynamics result in an attractive investment environment for agency MBS. And while agency MBS is currently a threshold for capital return through the middle market disposition, looking further out the horizon and as market conditions warrant, we will continue to strategically grow our MSR and residential credit businesses as we further diversified across housing finance. With that, I will hand it over to Serena to discuss the financials.

Serena Wolfe -- Chief Financial Officer

Thank you, Ilker, and good morning, everyone. Today, I'll provide brief financial highlights for the quarter ended March 31, 2022, and discuss select quarter-to-date metrics. Consistent with prior quarters, while our earnings release discloses GAAP and non-GAAP earnings metrics, my comments will focus on our non-GAAP EAD and related key performance metrics, which exclude PAA. As David and Ilker have touched on, Q1 was a challenging quarter for the economic return given the extreme volatility in fixed income markets.

Notwithstanding with challenging market environment, we continue to deliver solid earnings and ample coverage, approximately 125% of our dividend. To set the stage with some summary information, our book value per share was $6.77 for Q1, and we generated earnings available for distribution per share of $0.28. Book value decreased by $1.20 for the quarter, primarily due to lower other comprehensive income of $3.4 billion or $2.34 per share on higher rates and spread widening, and the related declining valuations on our agency positions as well as the common and preferred dividend declarations of $349 million or $0.24 per share, partially offset by GAAP net income of $2 billion or $1.37 per share. Consistent with the prior quarter, our multifaceted hedging strategy supported book value, providing a partial offset to the agency declines due to the basis widening mentioned above, with swaps, futures, and MSR valuations contributing $1.98 per share to the book value during the quarter.

MSR valuations alone were $0.12 per share higher in the quarter than in Q4 2021. Combining our book value performance at our first quarter dividend of $0.22, our quarterly economic return was negative 12.3%. Diving deeper into the GAAP results. As I noted above, we generated GAAP net income for Q1 of $2 billion or $1.37 per common share, net of preferred dividends, up from GAAP net income of $418 million or $0.27 per common share in the prior quarter.

The most significant drivers of higher GAAP income for the quarter were unrealized gains on derivatives of $1.6 billion, in comparison to unrealized gains of $135 million in Q4. GAAP net income also benefited from higher net interest income of $581 million compared to $361 million in Q4 2021, primarily due to premium accretion of $25 million compared to premium amortization of $219 million in Q4 2021 due to lower CPR, and higher net servicing income of $31 million compared to $27 million in Q4 2021 on higher average balances of MSR. As I mentioned earlier, the portfolio generated strong income with EAD per share at $0.28, consistent with Q4 earnings. We have, in recent quarters, communicated that we anticipate earnings to moderate, which we still foresee, though we continue to expect earnings to sufficiently cover the dividend for the near term, all things equal.

Average yields x-PAA remained relatively consistent with the prior quarter at 2.62%, down one basis point in comparison to the prior quarter. However, higher dollar roll income continues to contribute significantly to EAD, reaching another record level at $128.4 million. EAD also benefited from higher MSR net servicing income, associated with the growth of the MSR portfolio. These increases were offset by higher interest expense of $75 million compared to $62 million in Q4, primarily as a result of higher average securitized debt and repo balances as well as higher rates, higher net swaps expense of $63 million compared to $59 million in Q4 2021 on higher average notional balances, and higher G&A in the first quarter due to timing of payroll taxes and other compensation items.

The portfolio generated 204 basis points of NIM x-PAA, up one basis point from Q4, driven by the higher TBA dollar roll income yield that surpassed higher economic interest expense. Net interest spread does not include dollar roll income and therefore, was down 15 basis points and 1.73% compared to 12/31/21 due to a higher cost of funds. Now turning to our financing. Funding markets continue to function well, with liquidity for agency MBS robust throughout the quarter as ample reserves and strong demand kept overnight levels trading on top of SOFA.

Following the Fed's rate with stock in March, markets continue to reprice the increased pace of Fed hikes and the possibility of balance sheet reduction. Considering these factors, we maintained a disciplined approach in our overall liability portfolio, opportunistically extending funding on our agency and non-agency securities this past quarter, where the economics made sense. This positioning increased our weighted average days to maturity for our ending the quarter at 68 days versus 52 days in the prior quarter. And we will continue to evaluate term premiums in funding markets as we get more clarity from the Fed throughout the year and position our weighted average days to maturity accordingly.

The upward trend in the interest rate, along with higher swap rates, impacted our overall cost of funds for the quarter, rising by 14 basis points to 89 basis points in Q1. And our average repo rate for the quarter was 20 basis points compared to 16 basis points in the prior quarter. Our activity in the securitization market also impacted funding costs, increasing the weighting of securitizations on the composition of cost of funds, along with higher effective rates of 2.27% compared to 2.06%, resulting in an increase of seven basis points to cost of funds overall. Finally, swaps had an impact of four basis points on interest expense due to higher swap notional, partially offset by lower average net rates during the quarter.

Additionally, to further enhance the firm's overall liquidity profile, we continue to focus on securing financing facilities and structures for our growing resi loan and MSR businesses, including a new $250 million facility for our residential credit group subsequent to quarter-end. Moving now to our operating expenses. The efficiency ratio has worsened during the quarter due to income compensation expenses in Q1, one-time items that are not considered run rate, and the impact of degradation and equity on the computation of the ratio. The recently announced disposition of our MML business should have an impact on expenses, as we ought to drive cost savings from this transaction in the long term and therefore expect to see an improvement in efficiency ratios in future periods.

The sale of MML assets is also expected to be executed at a price above the current carrying value. And as such, book value will benefit in the range of $0.02 to $0.03 per share upon the completion of this deal. And in closing, Annaly maintained an abundant liquidity profile, with $7.2 billion of unencumbered assets down from the prior quarter at $9.3 billion, including cash and unencumbered agency MBS of approximately $4 billion. Much of the reduction in unencumbered agency securities was due to pressure on valuations and increased leverage on credit assets, partially offset by increased unencumbered MSR.

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

Questions & Answers:

Operator

[Operator instructions] Today's first question comes from Rick Shane with J.P. Morgan. Please proceed.

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

Hey, guys. Thanks for taking my question this morning. And now that you've sold the middle -- or selling the middle market business, I'm not necessarily sure I have that much to ask. That seems to be my routine question.

I do want to double a little into Serena's comment related to dividend coverage in the near term. That's helpful context. I'd love to get your thoughts longer-term about what the opportunity is and your confidence around the dividend. When we look at things, obviously we're looking at the margin expansion opportunity, but the trade-off there being potentially less specialists in the role.

And just curious, as you roll out further how do you think about dividend coverage.

David Finkelstein -- President and Chief Executive Officer

Sure. Good morning, Rick. So look, as we've said in the past, we set the dividend based on what we think is an appropriate level, consistent with our historical yield and competitive in the market. And we always look at it with our board quarter by quarter.

We have outearned the dividend really since the second quarter of 2020 post-COVID. I think we've ranged between $0.27 and $0.30 in terms of earnings available for distribution. Coming into this year, we did think that EAD would be a touch lower in the first quarter. But with dollar roll income increasing and a couple of other areas that benefited earnings, we matched that last quarter.

$0.28 going forward, we continue to think that it's going to moderate toward the dividend. This coming quarter, we're going to well cover it, although $0.28 is certainly ambitious. And how we think about it over the long run is we have to assess what the returns are across the businesses, what the capital allocation is, and determine what we think to be a level that we can consistently earn out the horizon. Right now, we feel good about our dividend.

The returns on agencies, as both Ilker and I discussed, have increased a fair amount. We're in the low to mid-teens in terms of levered returns on agencies and so we feel good about that. But the Fed is raising rates. Out the horizon, it's a little bit difficult to predict exactly how earnings are going to evolve, but we feel good about it right now.

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

Great. And again, just to sort of be clear about this, there's no implication about some specific concern. It's just a reflection of the uncertainty you're willing to sort of making a near-term call, but given what's sort of an unprecedented environment, less certain further out?

David Finkelstein -- President and Chief Executive Officer

Yes. And you're speaking with respect to the fact that we're out earning the dividend right now and what our intention is, why we're being conservative with the dividend? Is that your question?

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

That's exactly it.

David Finkelstein -- President and Chief Executive Officer

Yeah. And look, I think as I've said, we do think that earnings available for distribution will moderate toward the dividend, but we're comfortable that we're going to outearn it in Q2, for example. But we do think that when we look at the forwards, EAD will moderate.

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

Great. Terrific. Thank you, guys.

David Finkelstein -- President and Chief Executive Officer

You bet, Rick.

Operator

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

Bose George -- KBW -- Analyst

Just in terms of returns, so you mentioned low to mid-teens on agencies. Can you just talk about how that compares to credit? And also just in the returns on the MSR, what's the return on the invested capital there?

Ilker Ertas -- Chief Investment Officer

Sure. So yes, agencies are, as we said, close to the mid-teens, low to mid-teens as David said. And in fact, if you look at the headline numbers, it will be higher than that. But this is an environment where you need to be hedging a little bit more and then you need to pay more hedging costs.

So let's call it low to mid-teens on agencies. And on the residential credit, it will be very similar, low to mid-teens because they also widened. And in terms of MSR, as we always evaluate MSR on an unlevered basis and unlevered returns are very high singles right now.

Bose George -- KBW -- Analyst

OK. Great. Thanks. And then, can you just give an update on your book value quarter-to-date?

David Finkelstein -- President and Chief Executive Officer

Sure, Bose. So it's been a little bit of a volatile start to the quarter. Rates are up 30 to 50 basis points across the curve and mortgages are about 10 to 12 wider. I'm a little hesitant to put an exact pin in it just given that things are moving around, but it's off roughly mid-to-upper single digits on the quarter thus far.

But things said, mortgages have found their footing, it seems like this week, and we got two months left to go in the quarter.

Bose George -- KBW -- Analyst

OK. Great. Thanks a lot.

David Finkelstein -- President and Chief Executive Officer

You bet, Bose.

Operator

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

Eric Hagen -- BTIG -- Analyst

Hey, thanks. Good morning. Maybe just one on the market to start. How much connectivity do you guys see between higher Fed funds and mortgage spreads? In other words, we know that there's this tight connection between the Fed securities portfolio and mortgage spreads.

But do you see the strong linkage between Fed funds and spreads? Or is there anything specific in this tightening cycle that could change that relationship?

Ilker Ertas -- Chief Investment Officer

Hi, Eric. That's an excellent question. So the way that we look at it, it's not the level of Fed funds, but how Fed is raised? Namely the velocity of the Fed funds. So this will affect the yield curve and overall monetary tightness in the system.

And we have these two channels, it has an indirect but very strong effect on MBS valuations and MBS spreads. Having said that, when we look at the market today, it is [Inaudible] in the forward space. And mortgage spreads are close to the historical wide with the exception of like a funding problem days. So one would think that most of these things have been priced in, and that's what we believe right now.

But that's a very good observation. So this time around, it's how fast it's raising, but it seems like the market is already prepared for like, for example, coming 50 and another 50. So most of that velocity has been priced in.

David Finkelstein -- President and Chief Executive Officer

And Eric, I'll just add, one thing to note really since the onset of COVID and the intervention by the Fed, markets have been very fast at the pricing in the eventual policy in the markets, and you saw that in the first quarter. The yield curve is inverted one year forward between 2s and 10s were like negative 15 basis points and mortgage spreads are obviously quite a bit wider. So it does feel like the market has done an effective job of pricing in a considerable amount of policy tightening.

Eric Hagen -- BTIG -- Analyst

It's really helpful, guys. Thank you. One on the portfolio, just what kind of ratio, I think you mentioned this in your prepared remarks, but maybe some more color. Just the ratio that you see yourselves being comfortable with between pass-throughs financed with repo and then TBAs financed with the role.

And then when you reinvest the capital from the middle market portfolio, if nothing else changes, where do you see yourselves kind of leaning with respect to that breakdown?

Ilker Ertas -- Chief Investment Officer

Yes. Again, Eric, as, we have been elevated on TBA levels. And we think in the short term, we will still be able to be elevated on the TBA levels because the production coupon TBAs is very, very special. But you can see us going more into pulls down the road.

But we will still be maintaining like, let's call it, 20% TBA type thing that we'll be getting the more long-run average on that. But in the short term, we will be held a bit heavy on the TBA side.

David Finkelstein -- President and Chief Executive Officer

Yeah. And Eric, we're not constrained by limits on TBAs versus pools in light of the fact that there's ample liquidity in the market and financing, while the Fed's tightening policy still remains quite ample. And so really, it's a purely relative value play between TBAs and pools and whatever offers the best value. There are always limits with respect to being a REIT and the like, but we have ample latitude within those two buckets.

And then on your question on overall capital allocation post-MML, in my prepared remarks, I did discuss the fact that we will expect to increase our MSR position over time. And the way we look at it with the three buckets, three verticals between agency, resi credit, and MSR, we would like to get a better balance over the long term into residential credit and MSR and reduce our exposure to the agency, but we're not in a hurry to do that by any stretch. In fact, if you fast forward this quarter, you will see the capital allocation to the agency modestly higher with the return of that capital. Agency serves as a good placeholder.

And then episodically, we'll reallocate into both the MSR and residential credit, but we're not -- we're in no rush, we'll be patient, and we'll invest as we see it appropriate.

Eric Hagen -- BTIG -- Analyst

It's helpful. Thank you guys very much.

David Finkelstein -- President and Chief Executive Officer

Good talking to you, Eric.

Operator

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

Kenneth Lee -- RBC Capital Markets --- Analyst

Hi. Good morning and thanks for taking my question. I'm wondering if you could just share with us your thoughts about how funding costs would trend in the near term and consequently, implications for investment spreads?

David Finkelstein -- President and Chief Executive Officer

Sure. I'll start, and Serena, feel free to jump in here. But in spite of the volatility in short rates, funding costs on a spread basis have actually been rather stable. So if you look out the curve in the front end of the curve out to three months versus OIS, you can term for two to four basis points or thereabouts on top of OIS, and then it spreads out to about five to seven basis points on top of OIS out the curve.

So there's still a considerable amount of liquidity in financing markets. Rates are volatile, but spreads have been reasonably consistent. And Ilker, did you have anything to add there?

Ilker Ertas -- Chief Investment Officer

Actually, I do. David, as you said, yes, funding is available at the spread to the curve of OIS or at very attractive levels. And this was our point, as you and I have been discussing. That's why MBS looks very, very attractive right now.

This kind of MBS valuation only happens when there's like extreme stress in the funding markets and a lack of balance sheet. Where funding markets are a bit stable, I have never seen MBS this wide in nominal spreads.

Serena Wolfe -- Chief Financial Officer

And Ken, thanks for your question. When we're looking forward with regards to the cost of funds and agency repo rates, we -- our expectations are that agency repo rates will be about 20 basis points higher for the second quarter. So you should think about that when you think about our cost of funds as well.

Kenneth Lee -- RBC Capital Markets --- Analyst

Great. Very helpful. And one follow-up, if I may. Just wondering if you could just talk a little bit more about some of the growth opportunities around the prime jumbo expanded credit MBS assets?

Michael Fania -- Managing Director, Head of Tax

Sure. Thanks, Ken. Prime jumbo, I'll say that we have a number of strategic partners that we've utilized over the past year, a year and a half. We don't necessarily take balance sheet risk with prime jumbo.

A lot of that is that our cost of capital and our cost of funds is inferior to banks. And we don't really feel as if we have any real competitive advantage. However, we're a very active and large buyer of subordinate securities. And, we do have a fee structure in place that makes economic sense for us to issue those deals with our partners.

On the extended credit non-QM side, we feel very strongly that that market will continue to have solid origination activity. I think if you look at the top four banks are down 30% origination volume in Q1. We do think non-QM will be more stable in terms of origination volumes. About 60% of that market is purchase money.

About 25% of the market is cash-out. So 85% of non-QM originations in 2021. We're not with a rate in term refi. If you look at the agency market, that's closer to 40% in terms of purchase.

And, David and Ilker both mentioned this in their script but we have also seen a number of the non-bank community start to originate and start to roll out non-QM platforms and underwriting guidelines and products. And this has been very beneficial in terms of bringing supply. So this year-to-date, we've locked over 800 million to our correspondent channel of non-QM. And also in Q1, we locked 520 million.

It was our highest quarter-to-date. So, there's fierce, fierce competition on the agency side, origination volumes are down, margins are down. And you have seen originators come to the non-QM market to fill that gap.

Kenneth Lee -- RBC Capital Markets --- Analyst

Gotcha. Very helpful. Thanks again.

David Finkelstein -- President and Chief Executive Officer

Yeah. Thanks, Ken.

Operator

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

Doug Harter -- Credit Suisse -- Analyst

Thanks. Mike, I was wondering if you see opportunities kind of on the bulk purchase side in non-QM, especially in light of the middle market sale and kind of having additional capital deployed?

Michael Fania -- Managing Director, Head of Tax

Yes. Sure, Doug. What I'll see, well in terms of transaction activity, in January, in the bulk market, we saw $2 billion of flow available for us to bid. In March, that number was $750 million.

And a lot of what's transpired is origination volumes are down, but you're also seeing these smaller nonbank originators and some of the larger nonbank originators move away from the bulk market to delivering best efforts and wanting to deliver through our correspondent channel. So we certainly have seen a number of opportunities. I think the challenge that the market is going through, and it's more on the originator side, is that non-QM rates have increased so fast that originators have been caught off guard, not necessarily having appropriate hedging strategies, and they continue to sell discount loans. So since the end of the year, we've seen non-QM rates go from 425.

We think the 102 rates walking in here today is six and three quarters, and unfortunately, for a lot of these originators, they've been trying to sell that bulk through the market, but it continues to be out of the money. So we've evaluated our preferences for at-the-money collateral and not necessarily continuing to buy discount pools on the way up. But I'll say that in the bulk market, you have seen less supply and you are seeing more originators willing to engage and lock best efforts given the dynamics and given the hedging practices of those originators.

David Finkelstein -- President and Chief Executive Officer

And Doug, just to add to that, the silver lining in the volatility we experienced year-to-date is the fact that we have a deep capital base and can provide a lot of liquidity, and so when you look at bulk versus flow and originators, not wanting to warehouse loans, rather opting for that certainty of execution, we've been open for business and it's helped build Mike's correspondent channel. We're very happy about that.

Doug Harter -- Credit Suisse -- Analyst

Great. And David, you talked about being willing to take MSR kind of beyond the 10%. Any way to dimension kind of how much beyond 10% you're willing to go on that?

David Finkelstein -- President and Chief Executive Officer

Sure. So looking at the less liquid bucket, obviously middle-market lending off-balance sheet, that was roughly 10% of capital. And I would think that MSR over time could make up that balance and get to an upwards of 20% of capital over time.

Doug Harter -- Credit Suisse -- Analyst

Great. Thanks for the answers.

David Finkelstein -- President and Chief Executive Officer

Thanks, Doug.

Operator

The next question comes from Kevin Barker with Piper Sandler. Please proceed.

Kevin Barker -- Piper Sandler -- Analyst

Good morning. Thank you for taking my questions. I just wanted to follow up on the proceeds from the middle market portfolio. You touched on it earlier.

Could you talk to us about how you weigh the differences between reallocating that capital between MSRs, [Inaudible] mortgage backs, or maybe even look at other sources, whether it's M&A or other things that are out there as potential proceeds from the middle market?

David Finkelstein -- President and Chief Executive Officer

Sure. Yeah. So with respect to the actual $1 billion in the capital, as I mentioned, the placeholder's agency MBS, but we will look to redeploy it episodically in resi and/or MSR over time. And ultimately, the longer-term objective is to get those two non-agency and MSR buckets up to a higher percentage of capital.

But we're perfectly comfortable with the agency taking on that responsibility of redeployment over the near term. And then in terms of other opportunities out the horizon, we're always looking at everything, whether it's M&A or new sectors. We're consistently evaluating different opportunities in the market. And as Serena mentioned, in terms of liquidity on the balance sheet, cash, and agency MBS, $4 billion, another $1 billion coming in, we can engage in a lot of potential strategies should the opportunity materialize.

M&A has been tough over the past couple of years after some pretty high price points in the sector. We're not actively seeking to buy another company, but it's always something we look at.

Kevin Barker -- Piper Sandler -- Analyst

So when you think about the opportunity set for other companies, I mean do you -- as you said it seems you indicated a pretty broad range of different things you're looking at. Is there anything in particular, any sectors that screen as particularly attractive just given your overall strategy today?

David Finkelstein -- President and Chief Executive Officer

Yeah, hopefully, it fits within the three verticals that we're looking at. With an agency, you're looking largely at price. With MSR, it's potentially in the realm of other portfolio companies or origination, which we do not need. We've been very successful with respect to partnerships with large originators.

So we're not looking at the origination market right now. And then in the resi credit space, we have looked at smaller originators in the past, but the development of the correspondent channel and actually partnering with originators as opposed to competing with originators has worked out quite well. And again, we're relied on for that certainty of execution. So to paint a broad picture, if there is a need for liquidity in the mortgage REIT space, and it's at the right price and it presents a strategic fit, we certainly evaluate it, and we have the liquidity to execute on it.

But outside of the portfolio management sector, we don't have aspirations to do anything at this time.

Kevin Barker -- Piper Sandler -- Analyst

OK. Thank you for taking my questions. Thank you.

David Finkelstein -- President and Chief Executive Officer

You bet, Kevin.

Operator

[Operator instructions] Our next question comes from Mark DeVries with Barclays. Please proceed.

Mark DeVries -- Barclays -- Analyst

Thank you. David, Annaly's been on quite the journey over the years. Building out its businesses, creating the most diversified mortgage REIT platform, and then kind of under your leadership, narrowing that focus back to a residential mortgage. So can you just talk more about kind of the strategic benefits you expect to realize from this more narrow focus?

David Finkelstein -- President and Chief Executive Officer

You bet. So look, I've always -- I've known Annaly really since the beginning well before I came to work here, and Annaly has always been residential housing finance and has always been a market leader in it. That I've known. And that's my background.

And as I laid out two years ago in terms of the strategic direction, that we are going, it is refocusing on the roots of the company. But being broader within housing finance and creating a platform whereby we don't just invest in securities. We invest across the loan, whether it's the rate and convexity component of the loan in agency MBS, the credit component in residential credit, or the IO in MSR, we want to look at the loan and allocate capital across the cheapest component of the loan. And there are considerable synergies across these three functions as we've talked about in the past, whether it's MSR hedging, agency, or residential credit having less correlated returns with both MSR and agency.

And we think it leads to the best risk-adjusted returns for this company. Now the question is those are the ingredients but make sure you get the measurements appropriate so that you're liquid and that you're generating the best risk-adjusted return. And so longer-term, the agency is always going to be the anchor of the company and the mother ship, but increasing these other 2 ingredients we think will create a better balance in the overall portfolio, better risk-adjusted returns, lower leverage, and actually more liquidity because of these lower levered sectors, and we think that's the optimal direction for the company. Is that --

Mark DeVries -- Barclays -- Analyst

OK. Yeah, that's helpful. And then with agencies kind of near their wides, what's the greatest risk that's keeping you from levering up more? Is it just a concern that the Fed may need to tighten conditions even more than currently expected and become a seller as opposed to just letting the portfolio run-off? And do you see kind of risk of that at least as great as tightening here?

David Finkelstein -- President and Chief Executive Officer

Yeah, we don't see that risk in 2022. And I think, look, the Fed has talked about the possibility of selling mortgages, although they recently said QT is well underway. They don't want to sell mortgages. They've never sold mortgages in the past other than test trades, and it's not an optimal approach.

They would love to just let the portfolio run-off naturally. But nonetheless, it could be an eventuality out the horizon. We just don't think it's in 2022. The other risk in the market, and Ilker can expand on this is that there is still volatility in the rates markets, and that gives us a little bit of hesitation.

We got pretty meaningful risks in the system, whether it's geopolitical or economic uncertainty. And so we're waiting for a little bit more calmness to prevail. But the other point to note is that with agency spreads where they're at, you don't need to add a lot of leverage to really get ample returns, and we will certainly benefit from spread tightening. But between the volatility in the market and the supply picture, we're comfortable.

Mark DeVries -- Barclays -- Analyst

Got it. Thank you.

David Finkelstein -- President and Chief Executive Officer

You bet. Thanks, Mark.

Operator

At this time, there are no further questions in the queue. And this concludes our question-and-answer session. I would now like to turn the conference back over to David Finkelstein, president, and chief executive officer, for any closing remarks.

David Finkelstein -- President and Chief Executive Officer

Well. Thank you, everybody. And we will talk to you in the summer.

Operator

[Operator signoff]

Duration: 54 minutes

Call participants:

Sean Kensil -- Director of Investor Relations

David Finkelstein -- President and Chief Executive Officer

Ilker Ertas -- Chief Investment Officer

Serena Wolfe -- Chief Financial Officer

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

Bose George -- KBW -- Analyst

Eric Hagen -- BTIG -- Analyst

Kenneth Lee -- RBC Capital Markets --- Analyst

Michael Fania -- Managing Director, Head of Tax

Doug Harter -- Credit Suisse -- Analyst

Kevin Barker -- Piper Sandler -- Analyst

Mark DeVries -- Barclays -- Analyst

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