ANNALY CAPITAL MANAGEMENT INC 10-K

ITEM 1. BUSINESS transactions. Our registered investment adviser subsidiary is subject to periodic SEC examinations and other requirements under the Investment Advisers Act and related regulations primarily intended to benefit advisory clients. These additional requirements relate to, among other things, maintaining an effective and comprehensive compliance program, recordkeeping and reporting requirements and disclosure requirements. We also have a subsidiary that operates as a licensed mortgage aggregator and master servicer, which subjects it to individual state licensing laws and to supervision and examination by federal authorities, including the Consumer Financial Protection Bureau (“CFPB”), the U.S. Department of Housing and Urban Development (“HUD”), the SEC as well as various state licensing, supervisory and administrative agencies. We and our subsidiaries must also comply with a large number of federal, state and local consumer protection laws including, among others, the Gramm-Leach-Bliley Act, the Fair Debt Collection Practices Act, Real Estate Settlement Procedures Act, the Truth in Lending Act, and the Fair Credit Reporting Act, as well as state foreclosure laws and federal and local bankruptcy rules. These laws and regulations, which are frequently amended and adjusted, have, in recent years, led to an increase in both the scope of the requirements and the intensity of the supervision to which we are subject. The CFTC has jurisdiction over the regulation of swaps. The CFTC has asserted that this causes the operators of mortgage REITs that use swaps as part of their business model to fall within the statutory definition of CPO, and absent relief from the Market Participants Division of the CFTC, such operators generally much register as CPOs or qualify for an exemption from registration. On December 7, 2012, as a result of numerous requests for no-action relief from the CPO registration requirement for operators of mortgage REITs, the Division of Swap Dealer and Intermediary Oversight (the predecessor to the Market Participants Division) of the CFTC issued no-action relief entitled “No-Action Relief from the Commodity Pool Operator Registration Requirement for Commodity Pool Operators of Certain Pooled Investment Vehicles Organized as Mortgage Real Estate Investment Trusts” that permits a CPO to receive relief from the requirement to register by filing a claim to perfect the use of the relief. A claim submitted by a CPO will be effective upon filing, so long as the claim is materially complete. The conditions that must be met relate to initial margin and premiums requirements, net income derived annually from commodity interest positions that are not qualifying hedging transactions, marketing of interests in the mortgage REIT to the public and identification of the entity as a mortgage real estate investment trust in its federal tax filings with the IRS. We have submitted a claim for the relief set forth in the no-action relief entitled “No-Action Relief from the Commodity Pool Operator Registration Requirement for Commodity Pool Operators of Certain Pooled Investment Vehicles Organized as Mortgage Real Estate Investment Trusts” and believe we meet the criteria for such relief set forth therein. Competition We operate in a highly competitive market for investment opportunities. Competition may limit our ability to acquire desirable investments in our target assets and could also affect the pricing of these investments. In acquiring our target assets, we will compete with financial institutions, institutional investors, other lenders, government entities and certain other REITs. For a full discussion of the risks associated with competition see the “Risks Related to Our Investing, Portfolio Management and Financing Activities” section in Item 1A. “Risk Factors.” Corporate Governance We strive to conduct our business in accordance with the highest ethical standards and in compliance with applicable governmental laws, rules and regulations. Our notable governance practices and policies include: • Our Board is composed of a majority of independent directors, and our Audit, Management Development and Compensation, and Nominating/Corporate Governance Committees are composed exclusively of independent directors. • We have separated the roles of Chair of the Board and Chief Executive Officer, and appointed an independent Chair of the Board. • All directors are elected on an annual basis. • We have adopted an enhanced director refreshment policy, which provides that an independent director may not stand for re-election at the next annual meeting of stockholders taking place at the end of his or her term following the earlier of his or her: (i) 15th anniversary of service on our Board or (ii) 73rd birthday. • We have adopted a Code of Business Conduct and Ethics, which sets forth the basic principles and guidelines for resolving various legal and ethical questions that may arise in the workplace and in the conduct of our business. This code is applicable to our directors, officers and employees. • We have adopted Corporate Governance Guidelines which, in conjunction with the charters of our Board committees, provide the framework for the governance of our company. • We have procedures by which any of our employees, officers or directors may raise concerns confidentially about our company’s conduct, 9 ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES ITEM 1. BUSINESS accounting, internal controls or auditing matters with the Chair of the Board, the independent directors, or the Chair of the Audit Committee or through our whistleblower phone hotline or e-mail inbox. • We have adopted an Insider Trading Policy that prohibits our directors, officers and employees, as well as those of our subsidiaries from buying or selling our securities on the basis of material nonpublic information and prohibits communicating material nonpublic information about our company to others. Our Insider Trading Policy prohibits our directors, officers and employees, from (1) holding our stock in a margin account as eligible collateral, or otherwise pledging our stock as collateral for a loan, or (2) engaging in any hedging transactions with respect to our equity securities held by them. • Our executive officers are subject to two clawback policies, one that covers financial restatements and another that covers misconduct. • Our executive officers and directors are subject to stock ownership guidelines and holding restrictions. • Stockholders holding 25% of our common stock have the right to call a special meeting. Distributions In accordance with the requirements for maintaining REIT status, we intend to distribute to stockholders aggregate dividends equaling at least 90% of our REIT taxable income (determined without regard to the deduction of dividends paid and by excluding any net capital gain) for each taxable year and will endeavor to distribute at least 100% of our REIT taxable income so as not to be subject to tax. Distributions of economic profits from our enterprise could be classified as return of capital due to differences between book and tax accounting rules. We may make additional returns of capital when the potential risk-adjusted returns from new investments fail to exceed our cost of capital. Subject to the limitations of applicable securities and state corporation laws, we can return capital by making purchases of our own capital stock or through payment of dividends. Available Information Our website is www.annaly.com . We make available on this website under “Investors - SEC Filings,” free of charge, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports as soon as reasonably practicable after we electronically file or furnish such materials to the SEC pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 (the “Securities Exchange Act”). Our website and the information contained therein are not incorporated into this annual report on Form 10-K. Also posted on our website, and available in print upon request of any stockholder to our Investor Relations Department, are charters for our Audit Committee, Management Development and Compensation Committee, Nominating/Corporate Governance Committee, Risk Committee and Corporate Responsibility Committee, our Corporate Governance Guidelines and our Code of Business Conduct and Ethics. Within the time period required by the SEC, we will post on our website any amendment to the Code of Business Conduct and Ethics and any waiver applicable to any executive officer, director or senior financial officer. Our Investor Relations Department can be contacted at: Annaly Capital Management, Inc. 1211 Avenue of the Americas New York, New York 10036 Attn: Investor Relations Telephone: 888-8ANNALY E-mail: investor@annaly.com The SEC also maintains a website that contains reports, proxy and information statements and other information we file with the SEC at www.sec.gov . 10 ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 1A. Risk Factors ITEM 1A. RISK FACTORS An investment in our stock involves a number of risks. Before making an investment decision, you should carefully consider all of the risks described in this annual report on Form 10-K. If any of the risks discussed in this annual report on Form 10-K actually occur, our business, financial condition and results of operations could be materially adversely affected. If this were to occur, the trading price of our stock could decline significantly and you may lose all or part of your investment. Readers should not consider any descriptions of these factors to be a complete set of all potential risks that could affect us. INDEX TO ITEM 1A. RISK FACTORS Page Summary of Risk Factors 12 Risks Related to Our Liquidity and Funding 14 Risks of Ownership of Our Common Stock 19 Compliance, Regulatory & Legal Risks 20 Risks Related to Our Taxation as a REIT 25 Counterparty Risks 31 Investment and Market Related Risks 31 Operational and Cybersecurity Risks 37 Other Risks 43 11 ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 1A. Risk Factors Summary of Risk Factors Risks Related to Our Liquidity and Funding • Our strategy involves the use of leverage, which increases the risk that we may incur substantial losses. • Our use of leverage may result in margin calls and defaults and force us to sell assets under adverse market conditions. • We may exceed our overall Company target leverage ratios. • We may not be able to consistently achieve our optimal leverage. • Failure to procure or renew funding on favorable terms, or at all, affects our results and financial condition. • Effectively managing our liquidity affects our results and financial condition. • Volatile market conditions for our assets can result in contraction in liquidity for those assets and the related financing. • An increase in the interest payments on our borrowings relative to the interest we earn on our interest earning assets adversely affects our profitability. • Differences in timing of interest rate adjustments on our interest earning assets and our borrowings affect our profitability. • It may be uneconomical to “roll” our TBA dollar roll transactions or we may be unable to meet margin calls on our TBA contracts. • Our use of derivatives exposes us to counterparty and liquidity risks. • Securitizations expose us to additional risks. • Our use of non-recourse securitizations exposes us to risks which could result in losses to us. • Counterparties may require us to enter into restrictive covenants. • We may be unable to profitably execute or participate in future securitization transactions. Risks of Ownership of Our Common Stock • Our charter does not permit ownership of over 9.8% in number of shares or value of our common stock or any class of our preferred stock. • Provisions contained in Maryland law have anti-takeover effects, potentially preventing investors from receiving a “control premium” for their shares. • We have not established a minimum dividend payment level and cannot assure stockholders of our ability to pay dividends in the future. • Our reported GAAP financial results may not be an accurate indicator of future taxable income and dividend distributions. Compliance, Regulatory & Legal Risks • Accounting rules related to certain of our transactions are highly complex and involve significant judgment and assumptions. Our application of GAAP produces financial results that fluctuate from one period to another. • Any new laws modifying the relationship between Fannie Mae, Freddie Mac and the federal government could affect our business model or business operations. • The Truth in Lending Act or other similar consumer protection laws and regulations expose an owner of whole mortgage loans and mortgage servicing rights to potential civil and administrative liability. • Our Residential Credit and MSR businesses are subject to complex and evolving legal and regulatory requirements, including how we oversee and are responsible for the actions of our third-party service providers, which exposes us to increased compliance, legal, and regulatory risk. • Changes in laws or regulations governing our operations or our failure to comply with those laws or regulations affects our business. • The focus on environmental, social, and governance and climate change issues by some investors, governmental bodies and other stakeholders, as well as existing and proposed laws and regulations related to these topics, and any divergence in the approach to these subjects by investors, governmental bodies and other stakeholders, affects our business, financial results and reputation. • We are subject to complex and evolving laws, regulations, rules, standards and contractual obligations regarding data privacy and security, which increases the cost of doing business, compliance risks and potential liability. • We are subject to risks and liabilities in connection with sponsoring, investing in and managing new funds and other investment accounts, including potential regulatory risks. • Loss of our Investment Company Act exemption from registration would adversely affect us. Risks Related to Our Taxation as a REIT • Our failure to maintain our qualification as a REIT would have adverse tax consequences. • Our distribution requirements could adversely affect our ability to execute our business plan. • Distributions to tax-exempt investors may be classified as unrelated business taxable income. • We have flexibility to pay dividends in our own stock. • Our TRSs cannot constitute more than 20% of our total assets. • TRSs are subject to tax at the regular corporate rates, are not required to distribute dividends, and the amount of dividends a TRS can pay to its parent REIT may be limited by REIT gross income tests. • If transactions between a REIT and a TRS are entered into on other than arm’s-length terms, the REIT may be subject to a penalty tax. • Even if we remain qualified as a REIT, we may face other tax liabilities that reduce our cash flow. • Complying with REIT requirements may cause us to forgo otherwise attractive opportunities and may force us to liquidate otherwise attractive investments. 12 ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 1A. Risk Factors • Liquidation of assets may jeopardize our REIT qualification or create additional tax liability for us. • The failure of assets subject to repurchase agreements to qualify as real estate assets could adversely affect our ability to remain qualified as a REIT. • Complying with REIT requirements may limit our ability to hedge effectively and may cause us to incur tax liabilities. • Qualifying as a REIT involves highly technical and complex provisions of the Code. • The tax on prohibited transactions limits our ability to engage in certain transactions. • Certain financing activities may subject us to U.S. federal income tax and could have negative tax consequences for our stockholders. • Uncertainty exists with respect to the treatment of our TBAs for purposes of the REIT asset and income tests. • Dividends payable by REITs generally receive different tax treatment than dividend income from regular corporations. • New legislation or administrative or judicial action, in each instance potentially with retroactive effect, could make it more difficult or impossible for us to remain qualified as a REIT. Counterparty Risks • The soundness of our counterparties and other financial institutions affects us. • We are subject to counterparty risk and may be unable to seek indemnity or require counterparties to repurchase residential whole loans if they breach representations and warranties, which could cause us to suffer losses. • Our rights under our repurchase and derivative agreements are subject to the effects of the bankruptcy laws in the event of the bankruptcy or insolvency of us or our lenders. Investment and Market Related Risks • We may experience declines in the market value of our assets. • Investments in MSR expose us to additional risks. • A prolonged economic slowdown or declining real estate values could impair the assets we may own. • An increase in interest rates adversely affects the market value of our interest earning assets and, therefore, also our book value. • Actions by the Federal Reserve may affect the price and returns of our assets. • We invest in securities that are subject to mortgage credit risk. • Our investments in real estate and other securities are subject to changes in credit spreads as well as available market liquidity, which affect our ability to realize gains on the sale of such investments. • Geographic concentration exposes investors to greater risk of default and loss. • Inadequate property insurance coverage impacts on our operating results. • Our assets may become non-performing or sub-performing assets in the future. • We may be required to repurchase residential mortgage loans or indemnify investors if we breach representations and warranties. • Our and our third party service providers’ and servicers’ due diligence of potential assets may not reveal all of the weaknesses in such assets. • When we foreclose on an asset, we may come to own the property securing the loan. • Proposals to acquire mortgage loans by eminent domain affect the value of our assets. • Subordinated tranches of non-Agency mortgage-backed securities are subordinate in right of payment to more senior securities. • Our hedging strategies may be costly, and may not hedge our risks as intended. • We are subject to risks of loss from weather conditions, man-made or natural disasters and the direct and indirect effects of climate change. Operational and Cybersecurity Risks • Reliance on inaccurate models or the data used by models exposes us to risk. • We are highly dependent on information systems and networks, many of which are operated by third parties. • Cyberattacks or other information security breaches of our Company’s, service providers’ or counterparties’ systems or networks affect our business, reputation and financial condition. • We may utilize artificial intelligence, which could expose us to liability and affect our business. • We depend on third party service providers, including mortgage loan servicers and sub-servicers, for a variety of services related to our business. • Our investments in residential whole loans subject us to servicing-related risks. • The performance of loans underlying our MSR related assets is affected by the performance of the related mortgage servicer. • We are subject to prepayment rate risk. • We are subject to reinvestment risk. • Competition may affect availability and pricing of our target assets. • We may enter into new lines of business, acquire other companies or engage in other strategic initiatives. • Some of our investments, including those related to non-prime loans, involve credit risk. • Any inability to attract, motivate and retain qualified talent, including our key personnel, affects us. Other Risks • The market price and trading volume of our shares of common stock may be volatile. • We may change our policies without stockholder approv al. 13 ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 1A. Risk Factors Risks Related to Our Liquidity and Funding Our strategy involves the use of leverage, which increases the risk that we may incur substantial losses. We expect our leverage to vary with market conditions and our assessment of risk/return on investments. We incur this leverage by borrowing against a substantial portion of the market value of our assets. Leverage, which is fundamental to our investment strategy, creates significant risks. The risks associated with leverage are more acute during periods of economic slowdown or recession. Because of our leverage, we have in the past and may in the future incur substantial losses if our borrowing costs increase, and we may be unable to execute our investment strategy if leverage is unavailable or is unavailable on attractive terms. The reasons our borrowing costs may increase or our ability to borrow may decline include, but are not limited to, the following: • short-term interest rates increase; • the market value of our investments available to collateralize borrowings decreases; • the “haircut” applied to our assets under the repurchase agreements or other secured financing arrangements increases; • interest rate volatility increases; • disruption in the repo market generally or the infrastructure, including technology infrastructure, that supports it; or • the availability of financing in the market decreases. Our use of leverage may result in margin calls and defaults and force us to sell assets under adverse market conditions. Because of our leverage, a decline in the value of our interest earning assets has in the past and may in the future result in our lenders initiating margin calls. A margin call means that the lender requires us to pledge additional collateral to re-establish the ratio of the value of the collateral to the amount of the borrowing. Borrowings secured by our fixed-rate mortgage-backed securities generally are more susceptible to margin calls as increases in interest rates tend to more negatively affect the market value of fixed-rate securities. Margin calls are most likely in market conditions in which the unencumbered assets that we would use to meet the margin calls have also decreased in value. The risks associated with margin calls are more acute during periods of economic slowdown or recession. If we are unable to satisfy margin calls, our lenders may foreclose on our collateral. This could force us to sell our interest earning assets under adverse market conditions, or allow lenders to sell those assets on our behalf at prices that could be below our estimation of their value. Additionally, in the event of our bankruptcy, our borrowings, which are generally made under repurchase agreements, may qualify for special treatment under the U.S. Bankruptcy Code. This special treatment would allow the lenders under these agreements to avoid the automatic stay provisions of the U.S. Bankruptcy Code and to liquidate the collateral under these agreements without delay. We may exceed our overall Company target leverage ratios. We generally expect to maintain an overall Company economic leverage ratio of less than 10:1. However, we are not required to stay below this economic leverage ratio. We may exceed this ratio by incurring additional debt without increasing the amount of equity we have. For example, if we increase the amount of borrowings under our master repurchase agreements or other borrowing arrangements with our existing or new counterparties or the market value of our portfolio declines, our economic leverage ratio would increase. If we increase our economic leverage ratio, the adverse impact on our financial condition and results of operations from the types of risks associated with the use of leverage would likely be more severe. Our target economic leverage ratio is set for the portfolio as a whole, rather than separately for each asset type. The economic leverage ratio on Agency mortgage-backed securities has in the past and may in the future exceed the target ratio for the portfolio as a whole. Because credit assets are generally less levered than Agency mortgage-backed securities, at a given economic leverage ratio an increased allocation to credit assets generally means an increase in economic leverage on Agency mortgage-backed securities. The economic leverage on our Agency mortgage-backed securities is the primary driver of the risk of being unable to meet margin calls discussed above. We may not be able to consistently achieve our optimal leverage. We use leverage as a strategy to increase the return to our investors. However, we may not be able to consistently achieve our desired leverage if we determine that the leverage would expose us to excessive risk, our lenders do not make funding available to us at acceptable rates, or our lenders require that we provide additional collateral to cover our borrowings. Failure to procure or renew funding on favorable terms, or at all, affects our results and financial condition. 14 ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 1A. Risk Factors One or more of our lenders could be unwilling or unable to provide us with financing. This potentially increases our financing costs and reduces our liquidity. Furthermore, if any of our potential lenders or existing lenders are unwilling or unable to provide us with financing or if we are not able to renew or replace maturing borrowings, we could be forced to sell our assets at an inopportune time when prices are depressed. Our business, results of operations and financial condition have in the past and may in the future be materially affected by disruptions in the financial markets. We cannot assure you that these markets will remain an efficient source of financing for our assets. If our strategy is not viable, we will have to find alternative forms of financing for our assets, which may not be available. Further, as a REIT, we are required to distribute annually at least 90% of our REIT taxable income (subject to certain adjustments) to our stockholders and are, therefore, not able to retain significant amounts of our earnings for new investments. We cannot assure you that any, or sufficient, funding or capital will be available to us in the future on terms that are acceptable to us. If we cannot obtain sufficient funding on acceptable terms, there may be a negative impact on the market price of our common stock and our ability to make distributions to our stockholders. Moreover, our ability to grow will be dependent on our ability to procure additional funding. To the extent we are not able to raise additional funds through the issuance of additional equity or borrowings, our growth will be constrained. Effectively managing our liquidity affects our results and financial condition. Our ability to meet cash needs depends on many factors, several of which are beyond our control. Ineffective management of liquidity levels could cause us to be unable to meet certain financial obligations. Potential conditions that could impair our liquidity include: unwillingness or inability of any of our potential lenders to provide us with or renew financing, margin calls, additional capital requirements applicable to our lenders, a disruption in the financial markets or declining confidence in our creditworthiness or in financial markets in general. These conditions have in the past and may in the future force us to sell our assets at inopportune times or otherwise cause us to potentially revise our strategic business initiatives. Volatile market conditions for our assets can result in contraction in liquidity for those assets and the related financing. Our results of operations are materially affected by conditions in the markets for mortgages and mortgage-related assets, including Agency mortgage-backed securities, as well as the broader financial markets and the economy generally. Significant adverse changes in financial market conditions can result in a deleveraging of the global financial system and the forced sale of large quantities of mortgage-related and other financial assets. Concerns over economic recession, pandemic diseases, geopolitical issues, trade wars, unemployment, inflation, government actions to combat inflation, rising interest rates, the availability and cost of financing, the mortgage market, the repurchase agreement market, a declining real estate market or prolonged government shutdown may contribute to increased volatility and diminished expectations for the economy and markets. For example, as a result of the financial crises beginning in the summer of 2007 and through the subsequent credit and housing crisis, many traditional mortgage investors suffered severe losses in their residential mortgage portfolios and several major market participants failed or were impaired, resulting in a significant contraction in market liquidity for mortgage-related assets. This illiquidity negatively affected both the terms and availability of financing for all mortgage-related assets. Volatility and deterioration in the markets for mortgages and mortgage-related assets as well as the broader financial markets may adversely affect the performance and market value of our Agency mortgage-backed securities. If these conditions exist, institutions from which we seek financing for our investments may tighten their lending standards or become insolvent, which could make it more difficult for us to obtain financing on favorable terms or at all. Our profitability and financial condition may be adversely affected if we are unable to obtain cost-effective financing for our investments. An increase in the interest payments on our borrowings relative to the interest we earn on our interest earning assets adversely affects our profitability. We generally earn money based upon the spread between the interest payments we earn on our interest earning assets and the interest payments we must make on our borrowings. Our profitability is affected if the interest payments on our borrowings increase relative to the interest we earn on our interest earning assets. A significant portion of our assets are longer-term, fixed-rate interest earning assets, and a significant portion of our borrowings are shorter-term, floating-rate borrowings. Periods of rising interest rates or a relatively flat or inverted yield curve could decrease or eliminate the spread between the interest payments we earn on our interest earning assets and the interest payments we must make on our borrowings. 15 ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 1A. Risk Factors Differences in timing of interest rate adjustments on our interest earning assets and our borrowings affect our profitability. We rely primarily on short-term borrowings to acquire interest earning assets with long-term maturities. Some of the interest earning assets we acquire are adjustable-rate interest earning assets. This means that their interest rates may vary over time based upon changes in an objective index, such as: • Treasury Rate. A monthly or weekly average yield of benchmark U.S. Treasury securities, as published by the Federal Reserve Board. • Secured Overnight Financing Rate (“SOFR”). A measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities, as published by the Federal Reserve Bank of New York. • Term SOFR. A benchmark based on Secured Overnight Financing Rate futures, administered by CME Group. These indices generally reflect short-term interest rates. The interest rates on our borrowings similarly reflect short-term interest rates. Nevertheless, the interest rates on our borrowings generally adjust more frequently than the interest rates on our adjustable-rate interest earning assets, which are also typically subject to periodic and lifetime interest rate caps. Accordingly, in a period of rising interest rates, we could experience a decrease in net income or a net loss because the interest rates on our borrowings adjust faster than the interest rates on our adjustable-rate interest earning assets. It may be uneconomical to “ roll ” our TBA dollar roll transactions or we may be unable to meet margin calls on our TBA contracts. From time to time, we enter into TBAs as an alternate means of investing in and financing Agency mortgage-backed securities. A TBA contract is an agreement to purchase or sell, for future delivery, an Agency mortgage-backed security with a specified issuer, term and coupon. A TBA dollar roll represents a transaction where TBA contracts with the same terms but different settlement dates are simultaneously bought and sold. The TBA contract settling in the later month typically prices at a discount to the earlier month contract with the difference in price commonly referred to as the “drop”. The drop is a reflection of the expected net interest income from an investment in similar Agency mortgage-backed securities, net of an implied financing cost, that would be foregone as a result of settling the contract in the later month rather than in the earlier month. The drop between the current settlement month price and the forward settlement month price occurs because in the TBA dollar roll market, the party providing the implied financing is the party that would retain all principal and interest payments accrued during the financing period. Accordingly, TBA dollar roll income generally represents the economic equivalent of the net interest income earned on the underlying Agency mortgage-backed security less an implied financing cost. Consequently, dollar roll transactions and such forward purchases of Agency securities represent a form of off-balance sheet financing and increase our “at risk” leverage. The economic return of a TBA dollar roll generally equates to interest income on a generic TBA-eligible security less an implied financing cost, and there may be situations in which the implied financing cost exceeds the interest income, resulting in a negative carry on the position. If we roll our TBA dollar roll positions when they have a negative carry, the positions would decrease net income and amounts available for distributions to shareholders. There have in the past and may in the future be situations in which we are unable or unwilling to roll our TBA dollar roll positions. The TBA transaction could have a negative carry or otherwise be uneconomical, we may be unable to find counterparties with whom to trade in sufficient volume, or we may be required to collateralize the TBA positions in a way that is uneconomical. Because TBA dollar rolls represent implied financing, an inability or unwillingness to roll has effects similar to any other loss of financing. If we do not roll our TBA positions prior to the settlement date, we would have to take physical delivery of the underlying securities and settle our obligations for cash. We may not have sufficient funds or alternative financing sources available to settle such obligations. Counterparties may also make margin calls as the value of a generic TBA-eligible security (and therefore the value of the TBA contract) declines. Margin calls on TBA positions or failure to roll TBA positions could have the effects described in the liquidity risks described above. Our use of derivatives exposes us to counterparty and liquidity risks. Most swaps that we enter into must be executed on a Swap Extension Facility and/or be cleared by a Derivatives Clearing Organization (“DCO”), both of which are regulated by the CFTC. DCOs are subject to regulatory oversight and use extensive risk management processes, which result in expenses and collateral requirements for our swaps. We access the DCO through several Futures Commission Merchants (“FCMs”). For any cleared swap, we bear the credit risk of both the DCO and the relevant FCM, in the form of potential late or unrecoverable payments, potential difficulty or delay in accessing collateral that we have posted, and potential loss of any positive market value of the swap position. In the event of a default by the DCO or FCM, we also bear market risk, if the asset or liability being hedged is no longer effectively hedged. 16 ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 1A. Risk Factors We also bear fees for use of the DCO and Swap Execution Facility, as well as risks associated with trade errors. Because the standardized swaps available on Swap Execution Facilities and cleared through DCOs are not fully customizable, we may bear basis risk from hedge positions that do not exactly reflect the interest rate risk on the asset being hedged. Futures transactions are subject to risks analogous to those of cleared swaps, except that for futures transactions we bear a higher risk that collateral we have posted is unavailable to us if the FCM defaults. Some derivatives transactions, such as swaptions, are not currently required to be cleared through a DCO. Therefore, we bear the credit risk of the dealer with which we executed the swaption or other uncleared transaction. TBA contracts and swaps on CMBX indexes are also not cleared, and we bear the credit risk of the dealer. Certain derivative transactions are subject to margin requirements. The relevant contract or clearinghouse rules dictate the method of determining the required amount of margin, the types of collateral accepted and the timing required to meet margin calls. Additionally, for cleared swaps and futures, FCMs may have the right to require more margin than the clearinghouse requires. The requirement to meet margin calls can create liquidity risks, and we bear the cost of funding the margin that we post. Also, as discussed above, we bear credit risk if a dealer, FCM, or clearinghouse is holding collateral we have posted. Generally, we attempt to retain the ability to close out of a hedging position or create an offsetting position. However, in some cases we may not be able to do so at economically viable prices, or we may be unable to do so without consent of the counterparty. Therefore, in some situations a derivative position can be illiquid, forcing us to hold it to its maturity or scheduled termination date. It is possible that new regulations could be issued governing the derivatives market, including requiring additional types of derivatives to be executed on Swap Execution Facilities or cleared through a DCO. Ongoing regulatory change in this area could increase costs, increase risks, and adversely affect our business and results of operations. Securitizations expose us to additional risks. In a securitization structure, we convey a pool of assets to a special purpose vehicle, the issuing entity, and in turn the issuing entity issues one or more classes of non-recourse notes pursuant to the terms of an indenture. The notes are secured by the pool of assets. In exchange for the transfer of assets to the issuing entity, we receive the cash proceeds of the sale of non-recourse notes and a 100% interest in certain subordinate interests of the issuing entity. The securitization of all or a portion of our residential loan portfolio might magnify our exposure to losses because any subordinate interest we retain in the issuing entity would be subordinate to the notes issued to investors and we would, therefore, absorb all of the losses sustained with respect to a securitized pool of assets before the owners of the notes experience any losses. Moreover, we cannot assure you that we will be able to access the securitization market or be able to do so at favorable rates. The inability to securitize our portfolio could adversely affect our performance and our ability to grow our business. Our use of non-recourse securitizations exposes us to risks which could result in losses to us. We utilize non-recourse securitizations of our assets in mortgage loans, especially loans that we originate, when they are available. Prior to any such financing, we have in the past sought and may in the future seek to finance assets with relatively short-term facilities until a sufficient portfolio is accumulated. As a result, we would be subject to the risk that we would not be able to acquire, during the period that any short-term facilities are available, sufficient eligible assets to maximize the efficiency of a securitization. We also would bear the risk that we would not be able to obtain a new short-term facility or would not be able to renew any short-term facilities after they expire should we need more time to seek and acquire sufficient eligible assets for a securitization. In addition, conditions in the capital markets, including potential volatility and disruption in the capital and credit markets, may not permit a non-recourse securitization at any particular time or may make the issuance of any such securitization less attractive to us even when we do have sufficient eligible assets. While we would intend to retain the non-investment grade tranches of securitizations and, therefore, still have exposure to any assets included in such securitizations, our inability to enter into such securitizations would increase our overall exposure to risks associated with direct ownership of such assets, including the risk of default. Our inability to refinance any short-term facilities would also increase our risk because borrowings thereunder would likely be recourse to us as an entity. If we are unable to obtain and renew short-term facilities or to consummate securitizations to finance our assets on a long-term basis, we may be required to seek other forms of potentially less attractive financing or to liquidate assets at an inopportune time or price. To the extent that we are unable to obtain financing for our assets, and to the extent that we retain such assets in our portfolio, our returns on investment and earnings will be negatively impacted. 17 ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 1A. Risk Factors Counterparties may require us to enter into restrictive covenants. Certain lenders and counterparties impose restrictions on us that would affect our ability to incur additional debt, make certain allocations or acquisitions, allow liquidity or stockholders’ equity to fall below certain levels, increase leverage, make distributions to our stockholders, or redeem debt or equity securities, and may impact our flexibility to determine our operating policies and strategies. In some situations, these restrictions could be breached due to changes in the market value of our assets or liabilities. One way to avoid breaching certain of these restrictions is to sell assets or reduce leverage at an inopportune time. Failing to meet or satisfy any of these covenants is a default under these agreements, and our lenders or counterparties could elect to declare outstanding amounts due and payable, terminate their commitments, require the posting of additional collateral and enforce their interests against existing collateral. A default under one agreement can trigger cross-default rights under other agreements. A default and resulting repayment acceleration could significantly reduce our liquidity, which could require us to sell our assets to repay amounts due and outstanding. This could also significantly harm our business, financial condition, results of operations and ability to make distributions, which could cause our share price to decline. A default could also significantly limit our financing alternatives such that we would be unable to pursue our leverage strategy, which could adversely affect our returns. We may be unable to profitably execute or participate in future securitization transactions. There are a number of factors that can have a significant impact on whether we are able to execute or participate in a securitization transaction, and whether such a transaction is profitable to us or results in a loss. One of these factors is the price we pay for the mortgage loans that we securitize, which, in the case of residential mortgage loans, is impacted by the level of competition in the marketplace for acquiring mortgage loans and the relative desirability to originators of retaining mortgage loans as investments or selling them to third parties such as us. As such, we can provide no assurance that we will be able to identify and make investments in residential mortgage loans at attractive levels and pricing, which could adversely affect our ability to execute future securitizations in this space. Another factor that impacts the profitability of a securitization transaction is the cost to us of the short-term warehouse financing facilities that we use to finance our holdings of mortgage loans prior to securitization, which cost is affected by a number of factors including the availability of this type of financing to us, the interest rate on this type of financing, the duration of the financing we incur, and the percentage of our mortgage loans for which third parties are willing to provide short-term financing. After we acquire mortgage loans that we intend to securitize, we can also suffer losses if the value of those loans declines prior to securitization. Declines in the value of a mortgage loan, for example, can be due to, among other things, changes in interest rates, changes in the credit quality of the loan, and changes in the projected yields required by investors to invest in securitization transactions. To the extent we seek to hedge against a decline in loan value due to changes in interest rates, there is a cost of hedging that also affects whether a securitization is profitable. Other factors that can significantly affect whether a securitization transaction is profitable to us include the criteria and conditions that rating agencies apply and require when they assign ratings to the mortgage-backed securities issued in our securitization transactions, including the percentage of mortgage-backed securities issued in a securitization transaction that the rating agencies will assign a triple-A rating to, which is also referred to as a rating agency subordination level. Rating agency subordination levels can be impacted by numerous factors, including, without limitation, the credit quality of the loans securitized, the geographic distribution of the loans to be securitized, the structure of the securitization transaction and other applicable rating agency criteria. All other factors being equal, the greater the percentage of the mortgage-backed securities issued in a securitization transaction that the rating agencies will assign a triple-A rating to, the more profitable the transaction will be to us. The price that investors in mortgage-backed securities will pay for securities issued in our securitization transactions also has a significant impact on the profitability of the transactions to us, and these prices are impacted by numerous market forces and factors. In addition, the underwriter(s) or placement agent(s) we select for securitization transactions, and the terms of their engagement, impacts the profitability of our securitization transactions. Also, transaction costs incurred in executing transactions impact the profitability of our securitization transactions and any liability that we may incur, or may be required to reserve for, in connection with executing a transaction can cause a loss to us. To the extent that we are not able to profitably execute future securitizations of residential mortgage loans or other assets, including for the reasons described above or for other reasons, it could have a material adverse impact on our business and financial results. 18 ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 1A. Risk Factors Risks of Ownership of Our Common Stock Our charter does not permit ownership of over 9.8% in number of shares or value of our common stock or any class of our preferred stock. To maintain our qualification as a REIT for U.S. federal income tax purposes, not more than 50% in value of the outstanding shares of our capital stock may be owned, directly or indirectly, by five or fewer individuals (as defined in the federal tax laws to include certain entities). For the purpose of preserving our REIT qualification and for other reasons, our charter prohibits direct or constructive ownership by any person of more than 9.8% of the total number or value of any class of our outstanding common stock or any class of our preferred stock. Our charter’s constructive ownership rules are complex and may cause the outstanding stock owned by a group of related individuals or entities to be deemed to be constructively owned by one individual or entity. As a result, the acquisition of less than 9.8% of the outstanding shares of any class of common stock or any class of our preferred stock by an individual or entity could cause that individual or entity to own constructively in excess of 9.8% of the outstanding shares of such class of stock and thus be subject to our charter’s ownership limit. Any attempt to own or transfer shares of our common stock or preferred stock in excess of the ownership limit without the consent of the Board shall be void, or, alternatively, will result in the shares being transferred by operation of law to a charitable trust. Our Board, in its sole and absolute discretion, may waive or modify the ownership limit with respect to one or more persons who would not be treated as “individuals” if it is satisfied that ownership in excess of this limit will not otherwise jeopardize our status as a REIT for U.S. federal income tax purposes. The ownership limit may have the effect of delaying, deferring or preventing a change in control and, therefore, could adversely affect our stockholders’ ability to realize a premium over the then-prevailing market price for our stock in connection with a change in control. Provisions contained in Maryland law have anti-takeover effects, potentially preventing investors from receiving a “control premium” for their shares. Provisions contained in our charter and bylaws, as well as the Maryland General Corporation Law (the “MGCL”), have anti-takeover effects that could delay, defer or prevent a takeover attempt, which may prevent stockholders from receiving a “control premium” for their shares. For example, these provisions may defer or prevent tender offers for our common stock or purchases of large blocks of our common stock, thereby limiting the opportunities for our stockholders to receive a premium for their common stock over then-prevailing market prices. These provisions include the following: • Ownership limit. The ownership limit in our charter limits related investors including, among other things, any voting group, from acquiring over 9.8% of any class our common stock or of our preferred stock, in each case, in number of shares or value, without the consent of our Board. • Preferred Stock. Our charter authorizes our Board to issue preferred stock in one or more classes and to establish the preferences and rights of any class of preferred stock issued. These actions can be taken without soliciting stockholder approval. • Maryland Business Combination Act. The Maryland Business Combination Act provides that, subject to certain exceptions and limitations, certain business combinations between a Maryland corporation and an “interested stockholder” (defined generally as any person who beneficially owns 10% or more of the voting power of our outstanding voting stock or an affiliate or associate of ours who, at any time within the two-year period immediately prior to the date in question, was the beneficial owner of 10% or more of the voting power of our then outstanding shares of stock) or an affiliate of any interested stockholder are prohibited for five years after the most recent date on which the stockholder becomes an interested stockholder, and thereafter imposes two super-majority stockholder voting requirements on these combinations, unless, among other conditions, our common stockholders receive a minimum price, as defined in the MGCL, for their shares of stock and the consideration is received in cash or in the same form as previously paid by the interested stockholder for its shares of stock. We have opted out of the Maryland Business Combination Act in our charter. However, if we amend our charter to opt back in to the statute, subject to stockholder approval, the Maryland Business Combination Act could have the effect of discouraging offers to acquire us and of increasing the difficulty of consummating any such offers, even if our acquisition would be in our stockholders’ best interests. • Maryland Control Share Acquisition Act. The Maryland Control Share Acquisition Act provides that, subject to certain exceptions, holders of “control shares” (defined as voting shares that, when aggregated with all other shares controlled by the stockholder, entitle the stockholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of ownership or control of issued and outstanding “control shares”) have no voting rights except to the extent approved by our stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding 19 ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES Item 1A. Risk Factors shares owned by the acquirer, by our officers, or by our employees who are also directors of our company. We are currently subject to the Maryland Control Share Acquisition Act. • Title 3, Subtitle 8 of the MGCL: These provisions of the MGCL permit our Board of Directors, without stockholder approval and regardless of what is provided in our charter or bylaws, to implement certain takeover defenses, including adopting a classified board or increasing the vote required to remove a director. We have not established a minimum dividend payment level and cannot assure stockholders of our ability to pay dividends in the future. We intend to pay quarterly dividends and to make distributions to our stockholders in amounts such that all or substantially all of our taxable income in each year (subject to certain adjustments) is distributed. This enables us to qualify for the tax benefits accorded to a REIT under the Code. We have not established a minimum dividend payment level and our ability to pay dividends may be adversely affected for the reasons described in this section. All distributions will be made at the discretion of our Board and will depend on our earnings, our financial condition, maintenance of our REIT status and such other factors as our Board may deem relevant from time to time. Our reported GAAP financial results may not be an accurate indicator of future taxable income and dividend distributions. Generally, the cumulative net income we report over the life of an asset will be the same for GAAP and tax purposes, although the timing of this income recognition over the life of the asset could be materially different. Differences exist in the accounting for GAAP net income and REIT taxable income that have in the past and may in the future lead to significant variances in the amount and timing of when income and losses are recognized under these two measures. Due to these differences, our reported GAAP financial results could materially differ from our determination of taxable income. Compliance, Regulatory & Legal Risks Accounting rules related to certain of our transactions are highly complex and involve significant judgment and assumptions. Our application of GAAP produces financial results that fluctuate from one period to another. Accounting rules for valuations of investments, mortgage loan sales and securitizations, investment consolidations, acquisitions of real estate and other aspects of our operations are highly complex and involve significant judgment and assumptions. These complexities could lead to a delay in preparation of financial information and the delivery of this information to our stockholders. Changes in accounting interpretations or assumptions have in the past and may in the future impact our financial statements and our ability to prepare our financial statements in a timely fashion. Our inability to prepare our financial statements in a timely fashion in the future would likely adversely affect our share price significantly. The fair value at which our assets may be recorded may not be an indication of their realizable value. Ultimate realization of the value of an asset depends to a great extent on economic and other conditions. Further, fair value is only an estimate based on good faith judgment of the price at which an investment can be sold since market prices of investments can only be determined by negotiation between a willing buyer and seller. If we were to liquidate a particular asset, the realized value may be more than or less than the amount at which such asset was recorded. Accordingly, the value of our common shares has in the past and may in the future be adversely affected by our determinations regarding the fair value of our investments, whether in the applicable period or in the future. Additionally, such valuations may fluctuate over short periods of time. We have made certain accounting elections which may result in volatility in our periodic net income, as computed in accordance with GAAP. For example, changes in fair value of certain instruments are reflected in GAAP net income (loss) while others are reflected in Other comprehensive income (loss). Any new laws modifying the relationship between Fannie Mae, Freddie Mac and the federal government could affect our business model or business operations. The interest and principal payments we expect to receive on the Agency mortgage-backed securities in which we invest are guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. Principal and interest payments on Ginnie Mae certificates are directly guaranteed by the U.S. government. Principal and interest payments relating to the securities issued by Fannie Mae and Freddie Mac are only guaranteed by each respective Agency. 20 ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES