ANNALY CAPITAL MANAGEMENT, INC. 2006 Annual Report 2006 ANNUAL REPORT Annaly Capital Management, Inc. ANNALY CAPITAL MANAGEMENT, INC. 2006 Annual Report TABLE OF CONTENTS 2 Corporate Profile 3 The Annaly Team 4 Letter from the Chairman 6 FIDAC 7 Selected Financial Data 8 Management’s Discussion and Analysis of Financial Condition and Results of Operations 18 Management Report on Internal Control Over Financial Reporting and Performance Analysis 19 Report of Independent Registered Public Accounting Firm 20 Consolidated Statements of Financial Condition 21 Consolidated Statements of Operations and Comprehensive Income (Loss) 22 Consolidated Statements of Stockholders’ Equity 23 Consolidated Statements of Cash Flows 24 Notes to Consolidated Financial Statements 32 Common Stock and Market Information IBC Corporate Information PRODESSE NON NOCERE Our family crest and its motto “Prodesse Non Nocere” are trademarks of the Company. The description figuratively means ‘Proceed without fear.’ That symbolizes the confidence we try to instill in our investors. It is reinforced by years of reliable, highly competitive investment performance. Annaly Capital Management, Inc. 2006 ANNUAL REPORT 2006 was a year of transition as the Federal Reserve paused in August after an unprecedented two-year period of seventeen consecutive interest rate hikes. As a result, the pressure on short-term borrowing costs and asset values began to ease. Seeing attractive investment opportunities for new capital, we executed two sec- ondary common stock offerings and one preferred stock offering during the year, raising approximately $1 billion in new stockholders’ equity. With the combina- tion of new capital and improving market conditions, we were able to increase Annaly’s dividend each quarter throughout the year. We declared dividends to common shareholders of $0.57 per share in 2006. FIDAC, which was acquired in June 2004, increased net assets under management by almost 12% and gener- ated $19 million in fee income. In addition, in August, we changed our name to Annaly Capital Management, Inc. in order to better reflect our business and the global reach of FIDAC. STOCKHOLDERS’ EQUITY (dollars in millions) $3,000 2,500 2,000 1,500 1,000 500 0 INTEREST RATE SPREAD 6% 5% 4% 3% 2% 1% 0% Average Yield on Portfolio Average Cost of Funds Federal Funds Rate 2002 $1,080 2003 $1,149 2004 $1,700 2005 $1,504 2006 $2,543 1st 2nd 3rd 4th 1st 2nd 3rd 4th 1st 2nd 3rd 4th 2004 2005 2006 1 2006 ANNUAL REPORT Annaly Capital Management, Inc. Corporate Profile Annaly Capital Management, Inc. man- ages assets on behalf of institutional and individual investors worldwide through Annaly and through the funds managed by its wholly-owned registered invest- ment advisor, FIDAC. The Company’s principal business objective is to gener- ate net income for distribution to investors from the spread between the interest income on its Mortgage-Backed Securities and the cost of borrowing to finance their acquisition and from divi- dends the Company receives from FIDAC, which earns investment advisory fees. We have elected to be taxed as a real estate investment trust (or REIT) under the Internal Revenue Code and therefore are required to pay out at least 90% of our earnings to our shareholders in order to avoid taxation at the corpo- rate level. We commenced operations on February 18, 1997. All of the Mortgage-Backed Securities we own are issued by an agency of the United States government and carry an actual or implied AAA rating. Mortgage- backed securities are ownership interests in mortgage loans made by financial institutions (savings and loans, commer- cial banks and mortgage bankers). When an institution has made enough loans it will “pool” or package them together and sell them to mortgage investors like Annaly. The institution will collect the principal and interest payments made by the homeowners and forward them to the mortgage investor. We structure our portfolio using the Annaly MBS Barbell Strategysm. This strategy utilizes a combi- nation of adjustable-, floating-, and fixed-rate Mortgage-Backed Securities so that it can perform through a wide range of interest rate environments. We employ leverage to enhance our returns. To date, our debt has consisted entirely of borrowings collateralized by a pledge of our Mortgage-Backed Securities. On our balance sheet, these borrowings appear as Repurchase Agreements. Our leverage, measured as a ratio of debt-to-equity, typically is man- aged in a band of 8:1 to 12:1. FIDAC is a registered investment advisor which manages, assists in managing or supervises investment funds for a wide array of clients around the world on a discretionary basis. FIDAC is a fee-based asset management business with a global distribution reach. Michael A. J. Farrell Chairman, President & Chief Executive Officer Wellington J. Denahan-Norris Vice Chairman, Chief Investment Officer & Chief Operating Officer Kathryn F. Fagan Chief Financial Officer & Treasurer R. Nicholas Singh Executive Vice President, General Counsel, Secretary & Chief Compliance Officer 2 Annaly Capital Management, Inc. 2006 ANNUAL REPORT The Annaly Team Annaly’s team is experienced in Wall Street trading, management and opera- tions, with a specialization in investing in mortgage-backed securities on a leveraged basis. Senior management founded FIDAC in July 1994 and Annaly in November 1996. From our IPO in October 1997 through the end of 2006, Annaly has raised almost $2.5 billion in subsequent equity offerings, making us one of the largest mortgage REITs by market capitalization. opportunities and deliver compelling returns in a wide range of interest rate environments. Annaly has consistently generated com- petitive returns for its shareholders. Our success and future growth prospects are based on the proven ability of our strong and seasoned management team to successfully take advantage of market We are self-advised and self-managed. Management incentives are tied to book value. Our low general and administra- tive expense ratio keeps our operating costs low and adds to shareholder return. Matthew Lambiase Executive Vice President Structured Products Eric Szabo, CFA, PRM Senior Vice President Investment Strategist Dennis E. Malloy Senior Vice President Marketing & Sales Ronald D. Kazel Managing Director Kristopher Konrad Executive Vice President Co-Head of Portfolio Management Jeremy Diamond Managing Director James P. Fortescue Executive Vice President Head of Liabilities Rose-Marie Lyght Executive Vice President Co-Head of Portfolio Management 3 2006 ANNUAL REPORT Annaly Capital Management, Inc. Letter From the Chairman Dear Fellow Shareholders, In the waning years of his life, my Dad, an immigrant union construction work- er, took a job as an evening custodian in a local kindergarten in New Jersey to keep himself busy. Nothing had been easy in Dad’s life—hard times in post- World War I Dublin, the Roaring Twenties, the Depression, service as a British army tank driver in Africa and Europe during World War II, marriage to his Irish sweetheart at the end of the war and immigrating to America in 1947 to raise his family—but this tough man found himself becoming quite attached to the children who inhabited the class- rooms he cleaned each night. They start- ed leaving little notes for him pasted on the blackboards or desks, just saying “hello” or “thanks”. He started coming in 2005. As 2006 began to unfold, the stocks of the homebuilders began to fade as reality hit home that the supply- demand curve had been overwhelmed by supply. That supply and its capacity were fed by excessive liquidity sloshing through the debt and equity markets. This led to a dilution of underwriting standards the likes of which had never been seen in consumer and corporate debt. There was no proverbial ‘punch bowl’ at this party. The Federal Reserve had been taking away that ‘juice’ for two years in the longest and most prolific tightening in history on a percentage basis, 425% from the bottom. Usually the Fed accomplishes what it wants in six months to a year with a smaller per- centage move. Regulators restrained credit underwriting at their constituents, As a manager of high quality assets, we were content to be the ‘designated driver’ at this party. We have patiently stuck to our discipline, grew our strengths, did not change or drift from our business model, drew the line on behalf of investors’ capital and protected those who wanted protection in this storm of virtually unchecked credit creation. As we’ve always said, there are always bear markets and bull markets being created in each part of the business cycle, and we experienced ours at the front end of the mortgage yield curve in 2004 and 2005. In 2006, as market sentiment began to shift to our vision, we began to grow the company again. We virtually doubled the market capitalization in 120 days between April and August while stabilizing book value and increasing our “We have patiently stuck to our discipline, grew our strengths, did not change or drift from our business model, drew the line on behalf of investors’ capital and protected those who wanted protection in this storm of virtually unchecked credit creation.” earlier every day, not to clock in for extra pay, but to meet the children he cleaned up after. They were, as he noted in his own way, ‘the future’, and he, who had seen so much in life, was re-ener- gized by the little lives around him. Strange how a little dust and paper waste can lead to such revitalization. As 2006 came to a close for the capital markets, there was an eerie calm as volatility ebbed to 10–year lows. As we noted in our earnings releases, annual letters and in the media, the housing boom actually ended in the summer of the banks, as best they could. The pri- vate sector, however, aided by broker- dealer banking conduits, just piled on wherever they could. Mortgage bankers, builders, hedge funds, credit sensitive originators, under the relentless pressure to compete, created more and more complex and risky mortgage paper and structures. In the search for yield, invest- ment managers, pension funds, offshore investors, foundations and the like poured capital into the bucket of com- placent risk analysis until it overflowed. dividend every quarter. We were able to do this because the acquisition of FIDAC and the portfolio management steps we have taken since 2003 put us in a posi- tion to access capital at a time when oth- ers could not. Like the ‘happy custodian’ of over twenty years ago, we are now prepared to begin to sweep up the dust and paper being created today. We have protected our core businesses, stabilized them, seeded new structures and established the infra- structure and track records to exploit the opportunities that will emerge in the 4 aftermath of the storm in housing and credit. We can more clearly see the future of our asset management busi- ness, and we believe that the disciplines and belief systems we operate under give us a tremendous head start in helping to repair that which is broken in the mar- kets to the benefit of our shareholders and investors. Just like my Dad saw the future in those kids, we at Annaly see the fruits of our labor leading to the future of our busi- nesses. The energy I feel every day starts and ends with the major assets of our firm, our employees. Sometimes in life you get a chance to work with people who are passionate about what they do, yet have the character to face adversity and success with the same demeanor. That describes the team at Annaly, and we are as energized today by the oppor- tunities that lay before us in new products and our core strategy as we were when we started. We have largely been together for over a decade, as we celebrate the tenth anniversary of our NYSE listing on October 8th, 2007. As represented on the cover of this year’s annual report, this train is rolling, and the crew is hard at work at their stations. Prodesse Non Nocere Michael A. J. Farrell March 17, 2007 Annaly Capital Management, Inc. 2006 ANNUAL REPORT MICHAEL A. J. FARRELL 5 2006 ANNUAL REPORT Annaly Capital Management, Inc. FIDAC FIXED INCOME DISCOUNT ADVISORY COMPANY FIDAC generated almost $19 million in fee income in 2006 and over $56 mil- lion in fee income since its acquisition by Annaly in 2004. This fee income adds to the spread income earned by Annaly to benefit shareholders. At December 31, 2006, FIDAC man- aged, advised or sub-advised approxi- mately $2.6 billion in net assets or $15.1 billion in gross assets through numerous offshore and on-shore public and private investment funds distributed globally as well as separate accounts for high net worth individuals, municipal funds and school endowments. In 2006, FIDAC launched its first CDO product, Harp High Grade CDO I Ltd. Harp is a $1 bil- lion multi-tranche collateralized debt obligation that invests in a high-grade portfolio of primarily residential mort- gage-backed securities. Formed in 1994, FIDAC is an asset management firm and one of the leading fixed income management companies in the United States. FIDAC’s team of investment professionals has built a suc- cessful long-term track record through NET ASSETS UNDER MANAGEMENT (dollars in millions) $3,000 2,500 2,000 1,500 1,000 500 0 2003 $1,700 2004 $1,900 2005 $2,300 2006 $2,600 some of the most challenging fixed income markets in memory. The team managing Annaly fills the same roles at FIDAC. The general strate- gy of the investment products managed by FIDAC is to provide net interest income for distribution to investors from the spread between the interest income earned from portfolios of residential mortgage-backed securities and the cost of repurchase agreements entered into to finance their acquisition, while seeking to limit exposure to interest rate risk and credit risk. Since the majority of the assets in FIDAC-managed portfolios are created and guaranteed by a U.S. Agency and further secured by the relevant mortgaged property of the homeowners, FIDAC believes that there is minimal credit risk in its portfolios. FIDAC’s strategy is differentiated from those of most other fixed income and mortgage investment managers by the liquidity of the assets it purchases, its ability to leverage these assets, the trans- parency of the business model and the management compensation structure. Acquiring the most basic and liquid mortgage-backed securities is intended to give investors the desired element of clear and accurate valuation. The management fees payable to FIDAC are not linked to investment perform- ance, but rather they are linked to assets under management. FIDAC believes that this remuneration philosophy increases the returns to investors and encourages a focus on long-term goals. Distribution partners in the U.S. and around the world market the investment vehicles managed by FIDAC. This distribution system and the track record of FIDAC serve as a platform for growth into new investment products and strategies. The long-term growth of FIDAC will enable Annaly shareholders to benefit from a growing stream of dividend income we receive from FIDAC. 6 Annaly Capital Management, Inc. 2006 ANNUAL REPORT SELECTED FINANCIAL DATA (dollars in thousands, except for per share data) December 31, 2006 December 31, 2005 FOR THE YEAR ENDED December 31, 2004 December 31, 2003 December 31, 2002 Statement of Operations Data: Interest income Interest expense Net interest income Other (loss) income: Investment advisory and service fees (Loss) gain on sale of investment securities Gain on termination of interest rate swaps Income from trading securities Loss on other-than-temporarily impaired securities Total other (loss) income Expenses: Distribution fees General and administrative expenses Total expenses Impairment of intangible for customer relationships Income before income taxes Income taxes Income (loss) before minority interest Minority interest Net income (loss) Dividends on preferred stock Net income available (loss related) to common shareholders Basic net income (loss) per average common share Diluted net income (loss) per average common share Dividends declared per common share Dividends declared per preferred Series A share Dividends declared per preferred Series B share $1,221,882 1,055,013 166,869 22,351 (3,862) 10,674 3,994 (52,348) (19,191) 3,444 40,063 43,507 2,493 101,678 7,538 94,140 324 93,816 19,557 $74,259 $0.44 $0.44 $0.57 $1.97 $1.08 $705,046 568,560 136,486 35,625 (53,238) — — (83,098) (100,711) 8,000 26,278 34,278 — 1,497 10,744 (9,247) — (9,247) 14,593 ($23,840) ($0.19) ($0.19) $1.04 $1.97 — $532,328 270,116 262,212 $337,433 182,004 155,429 $404,165 191,758 212,407 12,512 5,215 — — — 17,727 2,860 24,029 26,889 — 253,050 4,458 248,592 — 248,592 7,745 $240,847 $2.04 $2.03 $1.98 $1.45 — — 40,907 — — — 40,907 — 16,233 16,233 — 180,103 — 180,103 — 180,103 — $180,103 $1.95 $1.94 $1.95 — — — 21,063 — — — 21,063 — 13,963 13,963 — 219,507 — 219,507 — 219,507 — $219,507 $2.68 $2.67 $2.67 — — Balance Sheet Data: Mortgage-Backed Securities, at fair value Agency debentures, at fair value Total assets Repurchase agreements Total liabilities Stockholders’ equity Number of common shares outstanding Other Data: December 31, 2006 December 31, 2005 December 31, 2004 December 31, 2003 December 31, 2002 $30,167,509 49,500 30,715,980 27,514,020 28,056,149 2,543,041 205,345,591 $15,929,864 — 16,063,422 13,576,301 14,559,399 1,504,023 123,684,931 December 31, 2006 December 31, 2005 $19,038,386 390,509 19,560,299 16,707,879 17,859,829 1,700,470 121,263,000 FOR THE YEAR ENDED December 31, 2004 $11,956,512 978,167 12,990,286 11,012,903 11,841,066 1,149,220 96,074,096 $11,551,857 — 11,659,084 10,163,174 10,579,018 1,080,066 84,569,206 December 31, 2003 December 31, 2002 Average total assets Average investment securities Average borrowings Average equity Yield on average interest-earning assets Cost of funds on average interest-bearing liabilities Interest rate spread $23,130,057 23,029,195 21,399,130 2,006,206 5.31% 4.93% 0.38% $18,724,075 18,543,749 17,408,828 1,614,743 3.80% 3.27% 0.53% $17,293,174 16,399,184 15,483,118 1,550,076 3.25% 1.74% 1.51% $12,975,039 12,007,333 11,549,368 1,122,633 2.81% 1.58% 1.23% $10,486,423 9,575,365 9,128,933 978,107 4.22% 2.10% 2.12% Financial Ratios: Net interest margin (net interest income/ average total assets) G&A expense as a percentage of average total assets G&A expense as a percentage of average equity Return on average total assets Return on average equity 0.72% 0.17% 2.00% 0.41% 4.68% 0.73% 0.14% 1.63% (0.05%) (0.57%) 1.52% 0.14% 1.55% 1.44% 16.04% 1.20% 0.13% 1.45% 1.39% 16.04% 2.03% 0.13% 1.43% 2.09% 22.44% 7 2006 ANNUAL REPORT Annaly Capital Management, Inc. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This annual report and our public documents to which we refer contain or incorporate by reference certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements which are based on various assumptions (some of which are beyond our control) may be identified by reference to a future period or periods or by the use of forward-looking terminology, such as “may,” “will,” “believe,” “expect,” “anticipate,” “continue,” or similar terms or variations on those terms or the negative of those terms. Actual results could differ materially from those set forth in forward-looking statements due to a variety of factors, including, but not limited to, changes in interest rates, changes in yield curve, changes in prepayment rates, the availability of mortgage-backed securities for purchase, the availability of financing and, if available, the terms of any financing, changes in the market value of our assets, changes in business conditions and the general economy, and risks associated with the investment advisory business of FIDAC, including the removal by FIDAC’s clients of assets FIDAC manages, FIDAC’s regulatory require- ments, and competition in the investment advisory business, changes in government regulations affecting our business, and our ability to maintain our qualification as a REIT for federal income tax purposes. For a discus- sion of the risks and uncertainties which could cause actual results to dif- fer from those contained in the forward-looking statements, see “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006 and all subsequent Quarterly Reports on Form 10-Q. We do not undertake, and specifically disclaim any obligation, to publicly release the result of any revisions which may be made to any forward- looking statements to reflect the occurrence of anticipated or unanticipat- ed events or circumstances after the date of such statements. OVERVIEW We are a self-managed real estate investment trust (“REIT”) that owns and manages a portfolio of mortgage-backed securities and agency debentures. Our principal business objective is to generate net income for distribution to our stockholders from the spread between the interest income on our investment securities and the costs of borrowing to finance our acquisi- tion of investment securities. We are primarily engaged in the business of investing, on a leveraged basis, in mortgage pass-through certificates, collateralized mortgage obli- gations and other mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans (collectively, “Mortgage- Backed Securities”). We also invest in Federal Home Loan Bank (“FHLB”), Federal Home Loan Mortgage Corporation (“FHLMC”), and Federal National Mortgage Association (“FNMA”) debentures. The Mortgage- Backed Securities and agency debentures are collectively referred to herein as “Investment Securities.” Under our capital investment policy, at least 75% of our total assets must be comprised of high-quality mortgage-backed securities and short-term investments. High quality securities means securities that (1) are rated within one of the two highest rating categories by at least one of the nationally recognized rating agencies, (2) are unrated but are guaranteed by the United States government or an agency of the United States gov- ernment, or (3) are unrated but we determine them to be of comparable quality to rated high-quality mortgage-backed securities. The remainder of our assets, comprising not more than 25% of our total assets, may consist of other qualified REIT real estate assets which are unrated or rated less than high quality, but which are at least “investment grade” (rated “BBB” or better by Standard & Poor’s Corporation (“S&P”) or the equivalent by another nationally recognized rating agency) or, if not rated, we determine them to be of comparable credit quality to an investment which is rated “BBB” or better. In addition, we may directly or indirectly invest part of this remaining 25% of our assets in other types of securities, including without limitation, unrated debt, equity or derivative securities, to the extent consistent with our REIT qualification require- ments. The derivative securities in which we invest may include securities representing the right to receive interest only or a disproportionately large amount of interest, as well as inverse floaters, which may have imbedded leverage as part of their structural characteristics. We may acquire mortgage-backed securities backed by single-family resi- dential mortgage loans as well as securities backed by loans on multi-fam- ily, commercial or other real estate related properties. To date, all of the mortgage-backed securities that we have acquired have been backed by single-family residential mortgage loans. We have elected to be taxed as a REIT for federal income tax purposes. Pursuant to the current federal tax regulations, one of the requirements of maintaining our status as a REIT is that we must distribute at least 90% of our REIT taxable income (determined without regard to the deduction for dividends paid and by excluding any net capital gain) to our stockhold- ers, subject to certain adjustments. The results of our operations are affected by various factors, many of which are beyond our control. Our results of operations primarily depend on, among other things, the level of our net interest income, the market value of our assets and the supply of and demand for such assets. Our net interest income, which reflects the amortization of purchase premiums and accretion of discounts, varies primarily as a result of changes in inter- est rates, borrowing costs and prepayment speeds, the behavior of which involves various risks and uncertainties. Prepayment speeds, as reflected by the Constant Prepayment Rate, or CPR, and interest rates vary accord- ing to the type of investment, conditions in financial markets, competition and other factors, none of which can be predicted with any certainty. In general, as prepayment speeds on our Mortgage-Backed Securities portfo- lio increase, related purchase premium amortization increases, thereby reducing the net yield on such assets. The CPR on our Mortgage Backed Securities portfolio averaged 17% and 27% for the years ended December 31, 2006 and 2005, respectively. Since changes in interest rates may significantly affect our activities, our operating results depend, in large part, upon our ability to effectively manage interest rate risks and prepayment risks while maintaining our status as a REIT. The table below provides quarterly information regarding our average balances, interest income, interest expense, yield on assets, cost of funds, net interest income and net interest rate spread for the quarterly periods presented. (ratios for the quarters have been annualized, dollars in thousands) Quarter Ended December 31, 2006 Quarter Ended September 30, 2006 Quarter Ended June 30, 2006 Quarter Ended March 31, 2006 (1) Does not reflect unrealized gains/(losses). Average Investment Securities Held (1) $28,888,956 $24,976,876 $21,660,089 $16,590,859 Total Interest Income $407,092 $339,737 $280,171 $194,882 Yield on Average Interest Earning Assets 5.64% 5.44% 5.17% 4.70% Average Balance of Repurchase Agreements $27,118,402 $23,120,247 $20,060,978 $15,296,893 Interest Expense $349,302 $295,726 $242,473 $167,512 Average Cost of Funds 5.15% 5.12% 4.83% 4.38% Net Interest Income $57,790 $44,011 $37,698 $27,370 Net Interest Rate Spread 0.49% 0.32% 0.34% 0.32% 8 The following table presents the CPR experienced on our Mortgage-Backed Securities portfolio, on an annualized basis, for the quarterly periods presented. Quarter Ended December 31, 2006 September 30, 2006 June 30, 2006 March 31, 2006 December 31, 2005 September 30, 2005 June 30, 2005 March 31, 2005 CPR 15% 16% 19% 18% 28% 28% 27% 25% We believe that the CPR in future periods will depend, in part, on changes in and the level of market interest rates across the yield curve, with higher CPRs expected during periods of declining interest rates and lower CPRs expected during periods of rising interest rates. We continue to explore alternative business strategies, alternative invest- ments and other strategic initiatives to complement our core business strategy of investing, on a leveraged basis, in high quality Investment Securities. No assurance, however, can be provided that any such strategic initiative will or will not be implemented in the future. For the purposes of computing ratios relating to equity measures, throughout this report, equity includes Series B Cumulative Convertible Preferred Stock, which has been treated under GAAP as temporary equity. CRITICAL ACCOUNTING POLICIES Management’s discussion and analysis of financial condition and results of operations is based on the amounts reported in our financial statements. These financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. In preparing the financial statements, management is required to make various judg- ments, estimates and assumptions that affect the reported amounts. Changes in these estimates and assumptions could have a material effect on our financial statements. The following is a summary of our policies most affected by management’s judgments, estimates and assumptions. Market Valuation of Investment Securities: All assets classified as available-for- sale are reported at fair value, based on market prices. Although we gener- ally intend to hold most of our Investment Securities until maturity, we may, from time to time, sell any of our Investment Securities as part our overall management of our portfolio. Accordingly, we are required to classi- fy all of our Investment Securities as available-for-sale. Our policy is to obtain market values from independent sources. Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. The determination of whether a security is other-than-temporar- ily impaired involves judgements and assumptions based on subjective and objective factors. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial con- dition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Investments with unrealized losses are not considered other-than-temporarily impaired if the Company has the ability and intent to hold the investments for a period of time, to maturity if necessary, sufficient for a forecasted market price recovery up to or beyond the cost of the investments. Unrealized loss- es on Investment Securities that are considered other than temporary, as measured by the amount of decline in fair value attributable to factors other than temporary, are recognized in income and the cost basis of the Investment Securities is adjusted. Other-than-temporary impaired losses on securities totaled $52.3 million for the year ended December 31, 2006 and $83.1 million for the year ended December 31, 2005. There were no such adjustments for the year ended December 31, 2004. Interest Income: Interest income is accrued based on the outstanding prin- cipal amount of the Investment Securities and their contractual terms. Premiums and discounts associated with the purchase of the Investment Annaly Capital Management, Inc. 2006 ANNUAL REPORT Securities are amortized or accreted into interest income over the project- ed lives of the securities using the interest method. Our policy for esti- mating prepayment speeds for calculating the effective yield is to evaluate historical performance, street consensus prepayment speeds, and current market conditions. If our estimate of prepayments is incorrect, we may be required to make an adjustment to the amortization or accretion of pre- miums and discounts that would have an impact on future income. Repurchase Agreements: We finance the acquisition of our Investment Securities through the use of repurchase agreements. Repurchase agree- ments are treated as collateralized financing transactions and are carried at their contractual amounts, including accrued interest, as specified in the respective agreements. Income Taxes: We have elected to be taxed as a Real Estate Investment Trust (or REIT) and intend to comply with the provisions of the Internal Revenue Code of 1986, as amended (or the Code), with respect thereto. Accordingly, the Company will not be subjected to federal income tax to the extent of its distributions to shareholders and as long as certain asset, income and stock ownership tests are met. The Company and FIDAC have made a joint election to treat FIDAC as a taxable REIT subsidiary. As such, FIDAC is taxable as a domestic C corporation and subject to federal and state and local income taxes based upon its taxable income. Impairment of Intangibles: The Company’s acquisition of FIDAC was accounted for using the purchase method. The cost of FIDAC was allocat- ed to the assets acquired, including identifiable intangible assets, and the liabilities assumed based on their estimated fair values at the date of acquisition. The excess of cost over the fair value of the net assets acquired was recognized as goodwill. Intangible assets are periodically reviewed for potential impairment. This evaluation requires significant judgment. During 2006, we recognized impairment charges totaling $2.5 million on intangible assets relating to customer relationships. RESULTS OF OPERATIONS NET INCOME SUMMARY For the year ended December 31, 2006, our net income was $93.8 mil- lion or $0.44 basic income per average share related to common share- holders, as compared to $9.2 million net loss or $0.19 basic loss per average share for the year ended December 31, 2005. For the year ended December 31, 2004, our net income was $248.6 million or $2.04 basic income per average share related to common shareholders. Net income per average share increased by $0.63 per average share available to com- mon shareholders and total net income increased $103.0 million for the year ended December 31, 2006, when compared to the year ended December 31, 2005. We attribute the increase in total net income for the year ended December 31, 2006 compared to the year ended December 31, 2005 to the increase in net interest income, reduction in losses on sales of securities and losses on other-than-temporarily impaired securities, and gains on termination of interest rate swaps. Net interest income increased by $30.4 million for the year ended December 31, 2006, as compared to the year ended December 31, 2005, due to the increase in interest earning assets from the deployment of additional capi- tal we raised in 2006. For the year ended December 31, 2006, net loss on sale of Mortgage-Backed Securities was $3.9 million, as compared to a net loss of $53.2 million in 2005. The loss on other-than-temporary impaired securities totaled $52.3 million for the year ended December 31, 2006, as compared to $83.1 million for the year ended December 31, 2005. During the year ended December 31, 2006, the Company realized a gain on the termination of interest rate swaps of $10.7 million. There was no gain on termination of swaps for the year ended December 31, 2005. We attribute the decrease in total net income for the year ended December 31, 2005 compared to the year ended December 31, 2004 to the decline in interest rate spread, losses on sales of securities, and losses on other-than-temporarily impaired securities. The interest rate spread decreased from 1.51% for the year ended December 31, 2004 to 0.53% for the year ended December 31, 2005. The total amortization for the year ended December 31, 2005 was $154.3 million and for the year ended December 31, 2004 was $179.6 million. For the year ended December 31, 2005, net loss on sale of Mortgage-Backed Securities was $53.2 million, as compared to a net gain of $5.2 million in 2004. 9 2006 ANNUAL REPORT Annaly Capital Management, Inc. The table below presents the net income (loss) summary for the years ended December 31, 2006, 2005, and 2004. NET INCOME (LOSS) SUMMARY (dollars in thousands, except for per share data) December 31, 2006 FOR THE YEAR ENDED December 31, 2005 Interest income Interest expense Net interest income Other (loss) income: Investment advisory and service fees (Loss) gain on sale of investment securities Gain on termination of interest rate swaps Income from trading securities Loss on other-than-temporarily impaired securities Total other (loss) income Expenses: Distribution fees General and administrative expenses Total expenses Impairment of intangible for customer relationships Income before income taxes Income taxes Income (loss) before minority interest Minority interest Net Income (loss) Dividends on preferred stock Net income available (loss related) to common shareholders Weighted average number of basic common shares outstanding Weighted average number of diluted common shares outstanding Basic net income (loss) per average common share Diluted net income (loss) per average common share Average total assets Average equity Return on average total assets Return on average equity $1,221,882 1,055,013 166,869 22,351 (3,862) 10,674 3,994 (52,348) (19,191) 3,444 40,063 43,507 2,493 101,678 7,538 94,140 324 93,816 19,557 $74,259 167,666,631 167,746,387 $0.44 $0.44 $23,130,057 2,006,206 0.41% 4.68% $705,046 568,560 136,486 35,625 (53,238) — — (83,098) (100,711) 8,000 26,278 34,278 — 1,497 10,744 (9,247) — (9,247) 14,593 ($23,840) 122,475,032 122,475,032 ($0.19) ($0.19) $18,724,075 1,614,743 (0.05%) (0.57%) December 31, 2004 $532,328 270,116 262,212 12,512 5,215 — — — 17,727 2,860 24,029 26,889 — 253,050 4,458 248,592 — 248,592 7,745 $240,847 118,223,330 118,459,145 $2.04 $2.03 $17,293,174 1,550,076 1.44% 16.04% INTEREST INCOME AND AVERAGE EARNING ASSET YIELD We had average earning assets of $23.0 billion for the year ended December 31, 2006. We had average earning assets of $18.5 billion for the year ended December 31, 2005. We had average earning assets of $16.4 billion for the year ended December 31, 2004. Our primary source of income is interest income. Our interest income was $1.2 billion for the year ended December 31, 2006, $705.0 million for the year ended December 31, 2005, and $532.3 million for the year ended December 31, 2004. The yield on average investment securities was 5.31%, 3.80%, and 3.25% for the respective periods. INTEREST EXPENSE AND THE COST OF FUNDS Our largest expense is the cost of borrowed funds. We had average bor- rowed funds of $21.4 billion and total interest expense of $1.1 billion for the year ended December 31, 2006. We had average borrowed funds of $17.4 billion and total interest expense of $568.6 million for the year ended December 31, 2005. We had average borrowed funds of $15.5 bil- lion and total interest expense of $270.1 million for the year ended December 31, 2004. Our average cost of funds was 4.93% for the year ended December 31, 2006 and 3.27 % for the year ended December 31, 2005 and 1.74% for the year December 31, 2004. The cost of funds rate increased by 166 basis points and the average borrowed funds increased by $4.0 billion for the year ended December 31, 2006 when compared to the year ended December 31, 2005. Interest expense for the year 2006 increased by $486.5 million over the prior year due to the substantial increase in the average repurchase balance and the increase in the cost of funds rate. The cost of funds rate increased by 153 basis points and the average borrowed funds increased by $1.9 billion for the year ended December 31, 2005, when compared to the year ended December 31, 2004. Interest expense for the year ended December 31, 2005 increased by $298.5 million over the previous year due to the increase in the aver- age repurchase balance and substantial increase in the cost of funds rate. Since a substantial portion of our repurchase agreements are short term, changes in market rates are directly reflected in our interest expense. Our average cost of funds was 0.10% below average one-month LIBOR and 0.28% below average six-month LIBOR for the year ended December 31, 2006. Our average cost of funds was 0.06% below average one-month LIBOR and 0.45% below average six-month LIBOR for the year ended December 31, 2005. Our average cost of funds was 0.24% above average one-month LIBOR and 0.06% below average six-month LIBOR for the year ended December 31, 2004. Since the Federal Reserve continued to raise the federal funds rate after December 31, 2005, we experienced an increase in our funding costs. 10 Annaly Capital Management, Inc. 2006 ANNUAL REPORT The table below shows our average borrowed funds and average cost of funds as compared to average one-month and average six-month LIBOR for the years ended December 31, 2006, 2005, 2004, 2003, and 2002 and the four quarters in 2006. AVERAGE COST OF FUNDS (Ratios for the four quarters in 2006 have been annualized, dollars in thousands) For the Year Ended December 31, 2006 For the Year Ended December 31, 2005 For the Year Ended December 31, 2004 For the Year Ended December 31, 2003 For the Year Ended December 31, 2002 For the Quarter Ended December 31, 2006 For the Quarter Ended September 30, 2006 For the Quarter Ended June 30, 2006 For the Quarter Ended March 31, 2006 Average Borrowed Funds $21,399,130 $17,408,828 $15,483,118 $11,549,368 $9,128,933 $27,118,402 $23,120,247 $20,060,978 $15,296,893 Interest Expense $1,055,013 $568,560 $270,116 $182,004 $191,758 $349,302 $295,726 $242,473 $167,512 Average Cost of Funds Average One-Month LIBOR Average Six-Month LIBOR Average One-Month LIBOR Relative to Average Six-Month LIBOR Average Cost of Funds Relative to Average One-Month LIBOR Average Cost of Funds Relative to Average Six-Month LIBOR 4.93% 3.27% 1.74% 1.58% 2.10% 5.15% 5.12% 4.83% 4.38% 5.03% 3.33% 1.50% 1.21% 1.77% 5.27% 5.29% 5.03% 4.55% 5.21% 3.72% 1.80% 1.23% 1.88% 5.31% 5.43% 5.27% 4.84% (0.18%) (0.39%) (0.30%) (0.02%) (0.11%) (0.04%) (0.14%) (0.24%) (0.29%) (0.10%) (0.06%) 0.24% 0.37% 0.33% (0.12%) (0.17%) (0.20%) (0.17%) (0.28%) (0.45%) (0.06%) 0.35% 0.22% (0.16%) (0.31%) (0.44%) (0.46%) NET INTEREST INCOME Our net interest income which equals interest income less interest expense, totaled $166.9 million for the year ended December 31, 2006, $136.5 million for the year ended December 31, 2005 and $262.2 mil- lion for the year ended December 31, 2004. Our net interest income increased for the year ended December 31, 2006, as compared to the year ended December 31, 2005, because of the increased average asset base in 2006. In 2006 average assets increased because of the deployment of additional capital. Our net interest spread, which equals the yield on our average assets for the period less the average cost of funds for the period, was 0.38% for the year ended December 31, 2006 as compared to 0.53% for the year ended December 31, 2005 and 1.51% for the year ended December 31, 2004. This 15 basis point decrease was the result in the increased funding cost of 166 basis points, offset by the increase in yield of 151 basis points. Our net interest income increased for the year ended December 31, 2006 as compared to the year ended December 31, 2005 by $30.4 million because of the increased average asset base for 2006. The net interest income for the year ended December 31, 2005 decreased by $125.7 million, when compared to the year ended December 31, 2004. This reduction was the result of the interest rate spread decreasing by 98 basis points. The table below shows our interest income by earning asset type, average earning assets by type, total interest income, interest expense, average repurchase agreements, average cost of funds, and net interest income for the years ended December 31, 2006, 2005, 2004, 2003 and 2002 and the four quarters in 2006. NET INTEREST INCOME (Ratios for the four quarters in 2006 have been annualized, dollars in thousands) For the Year Ended December 31, 2006 For the Year Ended December 31, 2005 For the Year Ended December 31, 2004 For the Year Ended December 31, 2003 For the Year Ended December 31, 2002 For the Quarter Ended December 31, 2006 For the Quarter Ended September 30, 2006 For the Quarter Ended June 30, 2006 For the Quarter Ended March 31, 2006 Average Investment Securities Held $23,029,195 $18,543,749 $16,399,184 $12,007,333 $9,575,365 $28,888,956 $24,976,876 $21,660,089 $16,590,859 Total Interest Income $1,221,882 $705,046 $532,328 $337,433 $404,165 $407,092 $339,737 $280,171 $194,882 Yield Average Interest Earning Assets 5.31% 3.80% 3.25% 2.81% 4.22% 5.64% 5.44% 5.17% 4.70% Average Balance of Repurchase Agreements $21,399,130 $17,408,827 $15,483,118 $11,549,368 $9,128,933 $27,118,402 $23,120,247 $20,060,978 $15,296,893 Interest Expense $1,055,013 $568,560 $270,116 $182,004 $191,758 $349,302 $295,726 $242,473 $167,512 Average Cost of Funds Net Interest Income 4.93% $166,869 3.27% $136,486 1.74% $262,212 1.58% $155,429 2.10% $212,407 $57,790 5.15% $44,011 5.12% $37,698 4.83% $27,370 4.38% Net Interest Rate Spread 0.38% 0.53% 1.51% 1.23% 2.12% 0.49% 0.32% 0.34% 0.32% INVESTMENT ADVISORY AND SERVICE FEES FIDAC is a registered investment advisor which specializes in managing fixed income securities. FIDAC expanded its line of business in 2006 to include the management of equity securities, initially for us and an affili- ated person and collateralized debt obligations. FIDAC generally receives annual net investment advisory fees of approximately 10 to 20 basis points of the gross assets it manages, assists in managing or supervises. At December 31, 2006, FIDAC had under management approximately $2.6 billion in net assets and $15.1 billion in gross assets, compared to $2.3 billion in net assets and $18.7 billion in gross assets at December 31, 2005. Net investment advisory and service fees for the years ended December 31, 2006, 2005, and 2004 totaled $18.9 million, $27.6 mil- lion, and $9.7 million, respectively, net of fees paid to third parties pur- suant to distribution service agreements for facilitating and promoting distribution of shares or units to FIDAC’s clients. Gross assets under man- agement will vary from time to time because of changes in the amount of net assets FIDAC manages as well as changes in the amount of leverage used by the various funds and accounts FIDAC manages. Although net assets under management increased by approximately $300 million from December 31, 2005 to December 31, 2006, gross assets under manage- ment declined during the same time period, as leverage declined on the assets under management. GAINS AND LOSSES ON SALES OF INVESTMENT SECURITIES AND INTEREST RATE SWAPS For the year ended December 31, 2006, we sold investment securities with an aggregate historical amortized cost of $3.2 billion for an aggregate loss of $3.9 million. In addition, the Company had a $10.7 million gain on the termination of interest rate swaps with a notional value of $1.2 bil- lion. For the year ended December 31, 2005, we sold investment securi- ties with an aggregate historical amortized cost of $3.4 billion for an aggregate loss of $53.2 million. For the year ended December 31, 2004, 11 2006 ANNUAL REPORT Annaly Capital Management, Inc. we sold mortgage-backed securities with an aggregate historical amortized cost of $591.7 million for an aggregate gain of $5.2 million. The loss on sale of assets for the year ended December 31, 2005 was due to portfolio rebalancing that was initiated in the fourth quarter of 2005. We deter- mined that certain assets purchased in a much lower interest rate environ- ment of 2003 and 2004 were unlikely to receive their amortized cost basis, and commenced selling these assets. The rebalancing was done with the objective of improving future financial performance. A positive difference between the sale price and the historical amortized cost of our Mortgage-Backed Securities is a realized gain and increases income accordingly. We do not expect to sell assets on a frequent basis, but may from time to time sell existing assets to move into new assets, which our management believes might have higher risk-adjusted returns, or to man- age our balance sheet as part of our asset/liability management strategy. INCOME FROM TRADING SECURITIES Income from trading securities totaled $4.0 million for the year ended December 31, 2006. FIDAC expanded its line of business in 2006 to include the management of equity securities, initially for us and an affili- ated person. During the year ended December 31, 2005 and 2004, we did not earn income from trading securities. IMPAIRMENT OF INTANGIBLE FOR CUSTOMER RELATIONSHIPS During the year ended December 31, 2006, intangibles were evaluated for possible impairment. It was determined that an impairment charge of $1.4 million was necessary based on the decline in expected future cash flows on one customer relationship. We also terminated an investment advisory agreement during the year ended December 31, 2006. The expected cash flows from the contract were valued as a component of the intangible for customer relationships on June 4, 2004, the date of the acquisition of FIDAC. The value of $1.1 million was deemed to be impaired. The total impairment of intangible assets relating to customer relationships is $2.5 million for the year ended December 31, 2006. There were no impairment charges during the years ended December 31, 2005 and 2004. LOSS ON OTHER-THAN-TEMPORARILY IMPAIRED SECURITIES At each quarter end, the Company reviewed each of its securities to deter- mine if an other-than-temporary impairment charge would be necessary. It was determined that for certain securities that were in an unrealized loss position, the Company did not intend to hold them for a period of time, to maturity if necessary, sufficient for a forecasted market price recovery up to or beyond the cost of the investments. For the years ended December 31, 2006 and 2005, the loss on other-than-temporarily impaired securities totaled $52.3 million and $83.1 million, respectively. GENERAL AND ADMINISTRATIVE EXPENSES General and administrative (or G&A) expenses were $40.1 million for the year ended December 31, 2006, $26.3 million for the year ended December 31, 2005, $24.0 million for the year ended December 31, 2004. G&A expenses as a percentage of average total assets was 0.17%, 0.14%, and 0.14% for the years ended December 31, 2006, 2005, and 2004, respectively. The increase in G&A expenses of $13.8 million for the year December 31, 2006, was primarily the result of increased salaries, directors and officers insurance and additional costs related to FIDAC. Staff increased from 30 at the end of 2004 to 31 at the end of 2005 and 34 at the end of 2006. Salaries and bonuses for the years ended December 31, 2006, 2005, and 2004 were $28.7 million, $18.8 million and $17.2 million, respectively. The table below shows our total G&A expenses as compared to average total assets and average equity for the years ended December 31, 2006, 2005, 2004, 2003 and 2002 and the four quarters in 2006. G&A EXPENSES AND OPERATING EXPENSE RATIOS (Ratios for the four quarters in 2006 have been annualized, dollars in thousands) Total G&A Expenses Total G&A Expenses/ Average Assets Total G&A Expenses/ Average Equity For the Year Ended December 31, 2006 For the Year Ended December 31, 2005 For the Year Ended December 31, 2004 For the Year Ended December 31, 2003 For the Year Ended December 31, 2002 For the Quarter Ended December 31, 2006 For the Quarter Ended September 30, 2006 For the Quarter Ended June 30, 2006 For the Quarter Ended March 31, 2006 $40,063 $26,278 $24,029 $16,233 $13,963 $12,219 $11,542 $8,985 $7,177 0.17% 0.14% 0.14% 0.13% 0.13% 0.16% 0.18% 0.18% 0.18% 2.00% 1.63% 1.55% 1.45% 1.43% 1.86% 2.08% 2.19% 1.95% NET INCOME AND RETURN ON AVERAGE EQUITY Our net income was $93.8 million for the year ended December 31, 2006, our net loss was $9.2 million for the year ended December 31, 2005, and our net income was $248.6 million for the year ended December 31, 2004. Our return on average equity was 4.68% for the year ended December 31, 2006, (0.57%) for the year ended December 31, 2005, and 16.04% for the year ended December 31, 2004. Even with the increase in G&A expenses and the reduction of net investment advisory and service fees, net income for the year increased by $103.0 million. We attribute the increase in total net income for the year ended December 31, 2006 over the year ended December 31, 2005 to the increase in net inter- est income, the reduction in losses realized on sale of assets and the loss on other-than-temporarily impaired securities, and the gains realized on the termination of interest rate swaps. We attribute the decrease in total net income for the year ended December 31, 2005 over the year ended December 31, 2004 to the decrease in interest rate spread, the loss real- ized on sale of assets during the repositioning and the loss on other-than- temporarily impaired securities. 12 Annaly Capital Management, Inc. 2006 ANNUAL REPORT The table below shows our net interest income, net investment advisory and service fees, gain on sale of investment securities and termination of interest rate swaps, G&A expenses, loss on other-than-temporarily impaired securities, income from equity investment, income taxes, impairment of intangible and minority interest, each as a percentage of average equity, and the return on average equity for the years ended December 31, 2006, 2005, 2004, 2003, and 2002 and for the four quarters in 2006. COMPONENTS OF RETURN ON AVERAGE EQUITY (Ratios for the four quarters in 2006 have been annualized) For the Year Ended December 31, 2006 For the Year Ended December 31, 2005 For the Year Ended December 31, 2004 For the Year Ended December 31, 2003 For the Year Ended December 31, 2002 For the Quarter Ended December 31, 2006 For the Quarter Ended September 30, 2006 For the Quarter Ended June 30, 2006 For the Quarter Ended March 31, 2006 Net Interest Income/ Average Equity 8.32% 8.45% 16.92% 13.85% 21.72% 8.81% 7.93% 9.20% 7.45% Gain/Loss on Sale of Mortgage– Backed Securities and Interest Net Investment Advisory Loss on other-than- Temporarily Impaired Income From Equity G & A and Service Rate Swaps/ Securities/ Investment/ Expenses/ Average Equity Fees/Average Equity Average Equity Average Equity Average Equity 0.94% 1.71% 0.62% — — 0.67% 0.76% 1.08% 1.59% 0.34% (3.30%) 0.34% 3.64% 2.15% 1.08% 1.44% (0.30%) (1.91%) (2.61%) (5.15%) — — — (0.84%) 0.20% (2.00%) — 1.63% — 1.55% — 1.45% — 1.43% 0.52% (1.86%) — 0.08% (2.08%) — (2.19%) — (1.95%) (4.91%) (7.28%) Impairment of Intangible for Customer Minority Relationships/ Average Equity Interest/ Return on Average Average Equity Equity (0.01%) (0.12%) — — — — — (0.05%) — (0.46%) (0.31%) 4.68% — (0.57%) — 16.04% — 16.04% — 22.44% 8.13% — 7.72% — 2.09% — (2.98%) Income Taxes/ Average Equity (0.38%) 0.67% 0.29% — — (0.20%) (0.41%) (0.33%) (0.57%) FINANCIAL CONDITION INVESTMENT SECURITIES, AVAILABLE FOR SALE All of our Mortgage-Backed Securities at December 31, 2006, 2005, and 2004 were adjustable-rate or fixed-rate mortgage-backed securities backed by single-family mortgage loans. All of the mortgage assets under- lying these mortgage-backed securities were secured with a first lien position on the underlying single-family properties. All of our mortgage- backed securities were FHLMC, FNMA or GNMA mortgage pass-through certificates or CMOs, which carry implied “AAA” ratings. We mark-to- market all of our earning assets to fair value. All of our agency debentures are callable and carry “AAA” ratings. We mark-to-market all of our agency debentures to fair value. We accrete discount balances as an increase in interest income over the life of discount investment securities and we amortize premium balances as a decrease in interest income over the life of premium investment secu- rities. At December 31, 2006, 2005, and 2004 we had on our balance sheet a total of $78.4 million, $21.5 million and $1.1 million, respective- ly, of unamortized discount (which is the difference between the remaining principal value and current historical amortized cost of our investment securities acquired at a price below principal value) and a total of $219.1 million, $242.1 million and $427.0 million, respectively, of unamortized premium (which is the difference between the remaining principal value and the current historical amortized cost of our invest- ment securities acquired at a price above principal value). We received mortgage principal repayments of $5.1 billion for the year ended December 31, 2006, $7.1 billion for the year ended December 31, 2005, and $6.5 billion for the year ended December 31, 2004. The over- all prepayment speed for the year ended December 31, 2006, 2005 and 2004 was 17%, 27%, and 29% respectively. During the year ended December 31, 2006, the CPR declined to 17%, from 27%, due to a decline in refinancing activity. During the year ended December 31, 2004, the annual prepayment speed was 29%. Given our current portfolio com- position, if mortgage principal prepayment rates were to increase over the life of our mortgage-backed securities, all other factors being equal, our net interest income would decrease during the life of these mortgage- backed securities as we would be required to amortize our net premium balance into income over a shorter time period. Similarly, if mortgage principal prepayment rates were to decrease over the life of our mortgage- backed securities, all other factors being equal, our net interest income would increase during the life of these mortgage-backed securities as we would amortize our net premium balance over a longer time period. The table below summarizes our Investment Securities at December 31, 2006, 2005, 2004, 2003, and 2002 and September 30, 2006, June 30, 2006, and March 31, 2006. INVESTMENT SECURITIES (dollars in thousands) At December 31, 2006 At December 31, 2005 At December 31, 2004 At December 31, 2003 At December 31, 2002 At September 30, 2006 At June 30, 2006 At March 31, 2006 Principal Amount Net Premium Amortized Cost/ Amortized Cost Principal Amount $30,134,791 $15,915,801 $19,123,902 $12,682,130 $11,202,384 $28,297,950 $23,822,683 $16,288,848 $140,709 $220,637 $425,792 $299,810 $273,963 $139,717 $141,671 $173,428 $30,275,500 $16,136,438 $19,549,694 $12,981,940 $11,476,347 $28,437,667 $23,964,354 $16,462,276 100.47% 101.39% 102.23% 102.36% 102.45% 100.49% 100.59% 101.06% Fair Value $30,217,009 $15,929,864 $19,428,895 $12,934,679 $11,551,857 $28,348,027 $23,474,006 $16,176,348 Fair Value/ Principal Amount 100.27% 100.09% 101.59% 101.99% 103.12% 100.18% 98.54% 99.31% Weighted Average Yield 5.63% 4.68% 3.43% 2.96% 3.25% 5.58% 5.42% 5.03% 13 2006 ANNUAL REPORT Annaly Capital Management, Inc. The tables below set forth certain characteristics of our investment securities. The index level for adjustable-rate Investment Securities is the weighted average rate of the various short-term inter- est rate indices, which determine the coupon rate. ADJUSTABLE-RATE INVESTMENT SECURITY CHARACTERISTICS (dollars in thousands) At December 31, 2006 At December 31, 2005 At December 31, 2004 At December 31, 2003 At December 31, 2002 At September 30, 2006 At June 30, 2006 At March 31, 2006 Principal Amount Weighted Average Weighted Average Term to Coupon Rate Next Adjustment Weighted Average Lifetime Cap Weighted Average Asset Yield Principal Amount at Period End as % of Total Investment Securities $8,493,242 $9,699,133 $13,544,872 $9,294,934 $7,007,062 $8,291,239 $7,964,221 $7,785,082 5.72% 4.76% 4.23% 3.85% 4.10% 5.57% 5.36% 4.99% 19 months 22 months 24 months 23 months 11 months 17 months 16 months 20 months 9.76% 10.26% 10.12% 9.86% 10.37% 9.64% 9.75% 10.27% 5.57% 4.74% 3.24% 2.47% 2.33% 5.47% 5.26% 5.07% 28.18% 60.94% 70.83% 73.29% 62.55% 29.30% 33.43% 47.79% FIXED-RATE INVESTMENT SECURITY CHARACTERISTICS (dollars in thousands) At December 31, 2006 At December 31, 2005 At December 31, 2004 At December 31, 2003 At December 31, 2002 At September 30, 2006 At June 30, 2006 At March 31, 2006 Principal Amount $21,641,549 $6,216,668 $5,579,030 $3,387,196 $4,195,322 $20,006,711 $15,858,461 $8,503,766 Weighted Average Coupon Rate Weighted Average Asset Yield Principal Amount at Period End as % of Total Investment Securities 5.83% 5.37% 5.24% 5.77% 6.76% 5.82% 5.73% 5.43% 5.65% 4.60% 3.89% 4.29% 4.78% 5.62% 5.50% 4.99% 71.82% 39.06% 29.17% 26.71% 37.45% 70.70% 66.57% 52.21% At December 31, 2006 and 2005, we held investment securities with coupons linked to various indices. The following tables detail the portfolio characteristics by index. ADJUSTABLE-RATE INVESTMENT SECURITIES BY INDEX—December 31, 2006 One- Month Libor Six- Twelve- Month Month Libor Libor Six-Month Auction Average Twelve- Month Moving Average National Financial Average 11th District Cost of Mortgage Month CD Rate Funds Rate Six- One-Year Treasury Index Two-Year Treasury Index Three- Year Five- Year Treasury Treasury Index Index Monthly Federal Cost of Funds Weighted Average Term to Next Adjustment Weighted Average Annual Period Cap Weighted Average Lifetime Cap at December 31, 2006 Investment Principal Value as Percentage of Investment Securities at December 31, 2006 1 mo. 35 mo. 36 mo. 2 mo. 1 mo. 1 mo. 5 mo. 3 mo. 13 mo. 9 mo. 17 mo. 31 mo. 1 mo. 6.70% 1.88% 2.00% 1.00% 0.16% 0.00% 2.00% 1.75% 1.00% 2.00% 2.03% 1.97% 0.00% 7.32% 10.39% 10.70% 12.95% 10.53% 12.07% 10.90% 9.75% 10.81% 11.91% 13.17% 12.56% 13.41% 8.29% 2.71% 9.89% 0.00% 0.07% 0.41% 0.00% 0.06% 6.34% 0.00% 0.10% 0.03% 0.28% ADJUSTABLE-RATE INVESTMENT SECURITIES BY INDEX—December 31, 2005 One- Month Libor Six- Twelve- Month Month Libor Libor Six-Month Auction Average Twelve- Month Moving Average National Financial Average 11th District Cost of Mortgage Month CD Rate Funds Rate Six- One-Year Treasury Index Two-Year Treasury Index Three- Year Five- Year Treasury Treasury Index Index Monthly Federal Cost of Funds 1 mo. 42 mo. 22 mo. 2 mo. 2 mo. 1 mo. 17mo. 3 mo. 18 mo. 14 mo. 21 mo. 34 mo. 1 mo. 7.29% 2.00% 2.00% 1.00% 0.16% 0.00% 2.00% 1.00% 1.90% 2.00% 2.03% 1.96% 0.00% 7.98% 10.78% 10.33% 13.03% 10.61% 12.07% 10.90% 11.74% 10.54% 11.93% 13.12% 12.51% 13.40% 6.33% 6.42% 24.46% 0.01% 0.19% 0.94% 0.01% 0.03% 21.55% 0.01% 0.25% 0.06% 0.68% Weighted Average Term to Next Adjustment Weighted Average Annual Period Cap Weighted Average Lifetime Cap at December 31, 2005 Investment Principal Value as Percentage of Investment Securities at December 31, 2005 14 Annaly Capital Management, Inc. 2006 ANNUAL REPORT TRADING SECURITIES AND TRADING SECURITIES SOLD, NOT YET PURCHASED Trading securities and trading securities sold, not yet purchased are included in the balance sheet as a result of consolidating the financial statements of an affiliated investment fund. Trading securities owned and trading account securities sold, but not yet purchased consisted of securi- ties at fair values as of December 31, 2006. The resulting realized and unrealized gains and losses are reflected in the statements of operations. The fair value of the trading securities was $18.4 million and the trading securities sold, not yet purchased was $41.9 million at December 31, 2006. assets decline. Potential immediate sources of liquidity for us include cash balances and unused borrowing capacity. Unused borrowing capacity will vary over time as the market value of our investment securities varies. Our balance sheet also generates liquidity on an on-going basis through mortgage principal repayments and net earnings held prior to payment as dividends. Should our needs ever exceed these on-going sources of liq- uidity plus the immediate sources of liquidity discussed above, we believe that in most circumstances our investment securities could be sold to raise cash. The maintenance of liquidity is one of the goals of our capital investment policy. Under this policy, we limit asset growth in order to preserve unused borrowing capacity for liquidity management purposes. BORROWINGS To date, our debt has consisted entirely of borrowings collateralized by a pledge of our investment securities. These borrowings appear on our bal- ance sheet as repurchase agreements. At December 31, 2006, we had established uncommitted borrowing facilities in this market with 30 lenders in amounts which we believe are in excess of our needs. All of our investment securities are currently accepted as collateral for these borrowings. However, we limit our borrowings, and thus our potential asset growth, in order to maintain unused borrowing capacity and thus increase the liquidity and strength of our balance sheet. For the year ended December 31, 2006, the term to maturity of our bor- rowings ranged from one day to three years, with a weighted average original term to maturity of 194 days at December 31, 2006. For the year ended December 31, 2005, the term to maturity of our borrowings ranged from one day to three years, with a weighted average original term to maturity of 163 days at December 31, 2005. For the year ended December 31, 2004, the term to maturity of our borrowings ranged from one day to three years, with a weighted average original term to maturity of 211 days at December 31, 2004. At December 31, 2006, the weighted average cost of funds for all of our borrowings 5.14% and the weighted average term to next rate adjustment was 125 days. At December 31, 2005, the weighted average cost of funds for all of our borrowings was 4.16% and the weighted average term to next rate adjustment was 79 days. At December 31, 2004, the weighted average cost of funds for all of our borrowings was 2.46% and the weighted average term to next rate adjustment was 111 days. LIQUIDITY Liquidity, which is our ability to turn non-cash assets into cash, allows us to purchase additional investment securities and to pledge additional assets to secure existing borrowings should the value of our pledged Borrowings under our repurchase agreements increased by $13.9 billion to $27.5 billion at December 31, 2006, from $13.6 billion at December 31, 2005. The increase in borrowings was the result of our deployment of additional capital raised during 2006, which permitted us to increase our borrowings. We anticipate that, upon repayment of each borrowing under a repur- chase agreement, we will use the collateral immediately for borrowing under a new repurchase agreement. We have not at the present time entered into any commitment agreements under which the lender would be required to enter into new repurchase agreements during a specified period of time, nor do we presently plan to have liquidity facilities with commercial banks. Under our repurchase agreements, we may be required to pledge addi- tional assets to our repurchase agreement counterparties (i.e., lenders) in the event the estimated fair value of the existing pledged collateral under such agreements declines and such lenders demand additional collateral (a “margin call”), which may take the form of additional securities or cash. Similarly, if the estimated fair value of investment securities increase due to changes in market interest rates of market factors, lenders may release collateral back to us. Specifically, margin calls result from a decline in the value of the our Mortgage-Backed Securities securing our repur- chase agreements, prepayments on the mortgages securing such Mortgage-Backed Securities and to changes in the estimated fair value of such Mortgage-Backed Securities generally due to principal reduction of such Mortgage-Backed Securities from scheduled amortization and result- ing from changes in market interest rates and other market factors. Through December 31, 2006, we did not have any margin calls on our repurchase agreements that we were not able to satisfy with either cash or additional pledged collateral. However, should prepayment speeds on the mortgages underlying our Mortgage-Backed Securities and/or market interest rates suddenly increase, margin calls on our repurchase agree- ments could result, causing an adverse change in our liquidity position. The following table summarizes the effect on our liquidity and cash flows from contractual obligations for repurchase agreements, the non-cancelable office lease and employment agreements at December 31, 2006. CONTRACTUAL OBLIGATIONS (dollars in thousands) Repurchase agreements Interest expense on repurchase agreements Long-term operating lease obligations Employment contracts Total Within One Year $26,114,020 148,416 532 13,432 $26,276,400 One to Three Years — $ 122,532 1,064 — $123,596 Three to Five Years $1,200,000 113,272 — — $1,313,272 More than Five Years $200,000 38,299 — — $238,299 Total $27,514,020 422,519 1,596 13,432 $27,951,567 15 2006 ANNUAL REPORT Annaly Capital Management, Inc. STOCKHOLDERS’ EQUITY During the year ended December 31, 2006, we declared dividends to common shareholders totaling $102.6 million or $0.57 per share, of which $39.0 million was paid on January 26, 2007. During the year ended December 31, 2006, we declared and paid dividends to Series A Preferred shareholders totaling $14.6 million or $1.97 per share, and Series B Preferred shareholders totaling $5.0 million or $1.08. During the year ended December 31, 2005, we declared and paid dividends to com- mon shareholders totaling $127.1 million or $1.04 per share, of which $12.4 million was paid on January 27, 2006. During the year ended December 31, 2005 we declared and paid dividends to Series A Preferred shareholders totaling $14.6 million or $1.97 per share. On August 16, 2006, the Company entered into an underwriting agree- ment pursuant to which it sold 40,825,000 shares of its common stock for net proceeds before expenses of approximately $476.7 million. This transaction settled on August 22, 2006. On April 6, 2006, the Company entered into an underwriting agreement pursuant to which it sold 39,215,000 shares of its common stock for net proceeds before expenses of approximately $437.7 million. On April 6, 2006, the Company entered into a second underwriting agreement pur- suant to which it sold 4,600,000 shares of its 6% Series B Cumulative Convertible Preferred Stock for net proceeds before expenses of approxi- mately $111.5 million. Each of these transactions settled on April 12, 2006. The 6% Series B Cumulative Preferred Stock has been treated under GAAP as temporary equity. For the purpose of computing ratios relating to equity measures, the Series B Preferred Stock has been includ- ed in equity. On August 3, 2006 we entered into an ATM Equity Offeringsm Sales Agreement with Merrill Lynch & Co. and Merrill Lynch, Pierce, Fenner & Smith Incorporated (or Merrill Lynch), relating to the sale of shares of our common stock from time to time through Merrill Lynch. Sales of the shares, if any, will be made by means of ordinary brokers’ transaction on the New York Stock Exchange. During the quarter ended December 31, 2006 we sold 500,000 shares of our common stock under this program. On August 3, 2006, we also entered into an ATM Equity Sales Agreement with UBS Securities LLC (or UBS Securities), relating to the sale of shares of our common stock from time to time through UBS Securities. Sales of the shares, if any, will be made by means of ordinary brokers’ transaction on the New York Stock Exchange. During the quarter ended December 31, 2006, we did not sell any shares of our common stock under this pro- gram. We refer to share issuance programs under these two agreements as the ATM Programs. During the year ended December 31, 2006, 1,598,500 shares of the Company’s common stock were issued through the ATM Programs and Equity Shelf Program, totaling net proceeds of $20.9 million. During the year ended December 31, 2006, 22,160 options were exercised under the long-term compensation plan for an aggregate exercise price of $183,000. During the year ended December 31, 2005, 2,381,550 shares of the Company’s common stock were issued through the ESP, totaling net pro- ceeds of $40.1 million. During the year ended December 31, 2005, 16,128 options were exercised under the long-term compensation plan for an aggregate exercise price of $253,000. In addition, 24,253 common shares were sold through the dividend reinvestment and direct purchase program for $440,000 during the year ended December 31, 2005. During the year ended December 31, 2004, 2,103,525 shares were issued through the Equity Shelf Program totaling net proceeds of $37.5 million. During the year ended December 31, 2004, 57,000 options were exer- cised under the long-term compensation plan for an aggregate exercise price of $856,000. In addition, 127,020 shares were purchased in the dividend reinvestment and direct purchase program at $2.3 million. On January 21, 2004, the Company entered into an underwriting agree- ment pursuant to which the Company raised net proceeds of approxi- mately $363.6 million in an offering of 20,700,000 shares of common stock. On March 31, 2004, the Company entered into an underwriting agreement pursuant to which the Company raised net proceeds of approximately $102.9 million through an offering of 4,250,000 shares of 7.875% Series A Cumulative Redeemable Preferred Stock, which settled on April 5, 2004. On October 14, 2004, the Company entered into an underwriting agreement pursuant to which the Company raised net pro- ceeds of approximately $74.5 million through an offering of 3,162,500 shares of 7.875% Series A Cumulative Redeemable Preferred Stock, which settled on October 19, 2004. The FIDAC acquisition was completed on June 4, 2004. We issued 2,201,080 common shares to the shareholders of FIDAC, based on the December 31, 2003 closing price of $18.40. We continue to operate as a self-managed and self-advised real estate investment trust, with FIDAC operating as our wholly-owned taxable REIT subsidiary. We will not pay any consideration under the earn out provisions contained in the merger agreement pursuant to which we acquired FIDAC. With our “available-for-sale” accounting treatment, unrealized fluctuations in market values of assets do not impact our GAAP or taxable income but rather are reflected on our balance sheet by changing the carrying value of the asset and stockholders’ equity under “Accumulated Other Comprehensive Income (Loss).” By accounting for our assets in this man- ner, we hope to provide useful information to stockholders and creditors and to preserve flexibility to sell assets in the future without having to change accounting methods. As a result of this mark-to-market accounting treatment, our book value and book value per share are likely to fluctuate far more than if we used historical amortized cost accounting. As a result, comparisons with com- panies that use historical cost accounting for some or all of their balance sheet may not be meaningful. The table below shows unrealized gains and losses on the Investment Securities and interest rate swaps in our portfolio. UNREALIZED GAINS AND LOSSES (dollars in thousands) Unrealized gain Unrealized loss Net unrealized (loss) gain Net unrealized (loss) gain as % of investment securities principal amount Net unrealized (loss) gain as % of investment securities amortized cost 2006 $112,596 (188,708) ($76,112) (0.25%) (0.25%) 2005 $5,027 (211,601) ($206,574) (1.30%) (1.28%) AT DECEMBER 31, 2004 $23,021 (143,821) ($120,800) (0.63%) (0.62%) 2003 $24,886 (72,147) ($47,261) (0.37%) (0.37%) 2002 $90,507 (14,996) $75,511 0.67% 0.67% 16 Annaly Capital Management, Inc. 2006 ANNUAL REPORT Unrealized changes in the estimated net market value of investment secu- rities have one direct effect on our potential earnings and dividends: posi- tive mark-to-market changes increase our equity base and allow us to increase our borrowing capacity while negative changes tend to limit bor- rowing capacity under our capital investment policy. A very large negative change in the net market value of our investment securities might impair our liquidity position, requiring us to sell assets with the likely result of realized losses upon sale. The net unrealized loss on available for sale securities and interest rate swaps was $76.1 million, or 0.25% of the amortized cost of our investment securities as of December 31, 2006, $206.6 million, or 1.28% of the amortized cost of our investment securi- ties as of December 31, 2005 and $120.8 million, or 0.62% of the amor- tized cost of our investment securities as of December 31, 2004. Mortgage-Backed Securities with a carrying value of $7.0 billion were in a continuous unrealized loss position over 12 months at December 31, 2006 in the amount of $138.2 million. Mortgage-Backed Securities with a carrying value of $6.4 billion were in a continuous unrealized loss posi- tion for less than 12 months at December 31, 2006 in the amount of $30.2 million. Mortgage-Backed Securities with a carrying value of $4.6 billion were in a continuous unrealized loss position over 12 months at December 31, 2005 in the amount of $111.1 million. Mortgage-Backed Securities with a carrying value of $8.4 billion were in a continuous unre- alized loss position for less than 12 months at December 31, 2005 in the amount of $100.5 million. The decline in value of these securities is sole- ly due to increases in interest rates. All of the Mortgage-Backed Securities are “AAA” rated or carry an implied “AAA” rating. During the years ended December 31, 2006 and 2005, the Company recorded an impairment loss of $52.3 million and $83.1 million. The remaining investments are not considered other-than-temporarily impaired since the Company currently has the ability and intent to hold the investments for a period of time or to maturity, if necessary, sufficient for a forecasted market price recovery up to or beyond the cost of the investments. Also, the Company is guar- anteed payment on the par value of the securities. LEVERAGE Our debt-to-equity ratio at December 31, 2006, 2005, and 2004 was 10.4:1, 9.0:1, and 9.8:1, respectively. We generally expect to maintain a ratio of debt-to-equity of between 8:1 and 12:1, although the ratio may vary from this range from time to time based upon various factors, including our management’s opinion of the level of risk of our assets and liabilities, our liquidity position, our level of unused borrowing capacity and over-collateralization levels required by lenders when we pledge assets to secure borrowings. Our target debt-to-equity ratio is determined under our capital invest- ment policy. Should our actual debt-to-equity ratio increase above the tar- get level due to asset acquisition or market value fluctuations in assets, we will cease to acquire new assets. Our management will, at that time, pres- ent a plan to our board of directors to bring us back to our target debt-to- equity ratio; in many circumstances, this would be accomplished over time by the monthly reduction of the balance of our Mortgage-Backed Securities through principal repayments. ASSET/LIABILITY MANAGEMENT AND EFFECT OF CHANGES IN INTEREST RATES We continually review our asset/liability management strategy with respect to interest rate risk, mortgage prepayment risk, credit risk and the related issues of capital adequacy and liquidity. Our goal is to provide attractive risk-adjusted stockholder returns while maintaining what we believe is a strong balance sheet. We seek to manage the extent to which our net income changes as a func- tion of changes in interest rates by matching adjustable-rate assets with variable-rate borrowings. In addition, we have attempted to mitigate the potential impact on net income of periodic and lifetime coupon adjust- ment restrictions in our portfolio of investment securities by entering into interest rate swaps. At December 31, 2006, we entered into swap agree- ments with a total notional amount of $9.3 billion. We agreed to pay a weighted average pay rate of 5.17% and receive a floating rate based on one month LIBOR. At December 31, 2005, we entered into swap agree- ments with a total notional amount of $479.0 million. We agreed to pay a weighted average pay rate of 4.88% and receive a floating rate based on one month LIBOR. The interest rate swap had not settled as of December 31, 2005. We may enter into similar derivative transactions in the future by entering into interest rate collars, caps or floors or purchas- ing interest-only securities. Changes in interest rates may also affect the rate of mortgage principal prepayments and, as a result, prepayments on mortgage-backed securities. We will seek to mitigate the effect of changes in the mortgage principal repayment rate by balancing assets we purchase at a premium with assets we purchase at a discount. To date, the aggregate premium exceeds the aggregate discount on our mortgage-backed securities. As a result, pre- payments, which result in the expensing of unamortized premium, will reduce our net income compared to what net income would be absent such prepayments. OFF-BALANCE SHEET ARRANGEMENTS We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the pur- pose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Further, we have not guaranteed any obliga- tions of unconsolidated entities nor do we have any commitment or intent to provide funding to any such entities. As such, we are not materi- ally exposed to any market, credit, liquidity or financing risk that could arise if we had engaged in such relationships. CAPITAL RESOURCES At December 31, 2006, we had no material commitments for capital expenditures. INFLATION Virtually all of our assets and liabilities are financial in nature. As a result, interest rates and other factors drive our performance far more than does inflation. Changes in interest rates do not necessarily correlate with infla- tion rates or changes in inflation rates. Our financial statements are pre- pared in accordance with GAAP and our dividends based upon our net income as calculated for tax purposes; in each case, our activities and bal- ance sheet are measured with reference to historical cost or fair market value without considering inflation. OTHER MATTERS We calculate that our qualified REIT assets, as defined in the Internal Revenue Code, are 100% of our total assets at December 31, 2006 and 2005 as compared to the Internal Revenue Code requirement that at least 75% of our total assets be qualified REIT assets. We also calculate that 99.3% and 93.3%, respectively, of our revenue qualifies for the 75% source of income test, and 100% of our revenue qualifies for the 95% source of income test, under the REIT rules for the years ended December 31, 2006 and 2005. We also met all REIT requirements regard- ing the ownership of our common stock and the distribution of our net income. Therefore, as of December 31, 2006, 2005 and 2004, we believe that we qualified as a REIT under the Internal Revenue Code. We at all times intend to conduct our business so as not to become regu- lated as an investment company under the Investment Company Act of 1940, as amended (the “Investment Company Act”). We rely on the exclusion provided by Section 3(c)(5)(C) of the Investment Company Act. Section 3 ( c)(5)( C), as interpreted by the staff of the SEC, requires us to invest at least 55% of our assets in “mortgages and other liens on and interests in real estate” (or Qualifying Real Estate Assets) and a least 80% or our assets in Qualifying Real Estate Assets plus real estate related assets. The assets that we acquire, therefore, are limited by the provisions of the Investment Company Act and the rules and regulations promulgated under the Investment Company Act. We calculate that as of December 31, 2006, 2005 and 2004, we were in compliance with this requirement. 17 2006 ANNUAL REPORT Annaly Capital Management, Inc. MANAGEMENT REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING DATED: FEBRUARY 26, 2007 Management of the Company is responsible for establishing and main- taining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rules 13a-15(f) under the Securities Exchange Act as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s Board of Directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purpos- es in accordance with generally accepted accounting principles and includes those policies and procedures that: • pertain to the maintenance of records that in reasonable detail accu- rately and fairly reflect the transactions and dispositions of the assets of the Company; • provide reasonable assurance that transactions are recorded as neces- sary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expen- ditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and Because of its inherent limitations, internal control over financial report- ing may not prevent or detect misstatements. As a result, even systems determined to be effective can provide only reasonable assurance regard- ing the preparation and presentation of financial statements. Moreover, projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or proce- dures may deteriorate. The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006. In making this assessment, the Company’s management used criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on management’s assessment, the Company’s management believes that, as of December 31, 2006, the Company’s internal control over finan- cial reporting was effective based on those criteria. There have been no changes in the Company’s internal controls over financial reporting that occurred during the quarter ended December 31, 2006 that have materi- ally affected, or are reasonably likely to affect its internal control over financial reporting. • provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. The Company’s independent registered public accounting firm, Deloitte & Touche LLP, have issued an audit report on management’s assessment of the Company’s internal control over financial reporting. PERFORMANCE ANALYSIS The following graph provides a comparison of our cumulative total stockholder return and the cumulative stockholder return of the Standard & Poor’s Composite-500 Stock Index, or S&P 500, and the Bloomberg REIT Mortgage Index, or BBG REIT Index, an industry index of 32 tax-qualified mort- gage REITs. The comparison is for the period from December 31, 2001 to December 31, 2006 and assumes the reinvestment of any dividends. The ini- tial price of our common stock shown in the graph below is based upon the price to public of $16.00 on December 31, 2001. Upon written request, we will provide stockholders with a list of the REITs included in the BBG REIT Index. The historical information set forth below is not necessarily indicative of future performance. 200 150 100 50 Annaly S&P 500 Index BBG REIT Index 191 164 110 189 138 132 168 116 115 157 144 100 100 134 123 78 12/31/01 12/31/02 12/31/03 12/31/04 12/31/05 12/31/06 12/31/01 12/31/02 12/31/03 12/31/04 12/31/05 12/31/06 Annaly S&P 500 Index BBG REIT Index 100 100 100 134 78 123 144 100 157 164 110 191 116 115 168 138 132 189 18 Annaly Capital Management, Inc. 2006 ANNUAL REPORT REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF ANNALY CAPITAL MANAGEMENT, INC. NEW YORK, NEW YORK We have audited the accompanying consolidated statements of financial condition of Annaly Capital Management, Inc. and subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consol- idated statements of operations and comprehensive income (loss), stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. We also have audited management’s assessment, included in the accompanying Management Report On Internal Control Over Financial Reporting included on page 18, that the Company maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management’s assessment, and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements included exam- ining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understand- ing of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide rea- sonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including the possibility of collu- sion or improper management override of controls, material misstatements due to error or fraud may not be pre- vented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Annaly Capital Management, Inc. and subsidiaries, as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, management’s assessment that the Company maintained effective internal control over financial report- ing as of December 31, 2006, is fairly stated, in all material respects, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control— Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. New York, New York February 26, 2007 19 2006 ANNUAL REPORT Annaly Capital Management, Inc. ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, 2006 AND 2005 (dollars in thousands, except per share data) ASSETS Cash and cash equivalents Mortgage-Backed Securities, at fair value Agency debentures, at fair value Trading securities, at fair value Receivable for Mortgage-Backed Securities sold Accrued interest receivable Receivable for advisory and service fees Intangible for customer relationships, net Goodwill Interest rate swaps, at fair value Other assets Total assets LIABILITIES AND STOCKHOLDERS’ EQUITY Liabilities: Repurchase agreements Payable for Mortgage-Backed Securities purchased Trading securities sold, not yet purchased, at fair value Accrued interest payable Dividends payable Other liabilities Accounts payable Interest rate swaps, at fair value Total liabilities Minority interest in equity of consolidated affiliate 6.00% Series B Cumulative Convertible Preferred Stock: 4,600,000 and 0 authorized, issued and outstanding, respectively Stockholders’ Equity: 7.875% Series A Cumulative Redeemable Preferred Stock: 7,637,500 authorized 7,412,500 shares issued and outstanding Common stock: par value $.01 per share; 500,000,000 authorized, 205,345,591 and 123,684,931 shares issued and outstanding, respectively Additional paid-in capital Accumulated other comprehensive loss Accumulated deficit Total stockholders’ equity Total liabilities, minority interest, Series B Preferred Stock and stockholders’ equity SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. December 31, 2006 December 31, 2005 $91,782 30,167,509 49,500 18,365 200,535 146,089 3,178 11,184 22,966 2,558 2,314 $30,715,980 $27,514,020 338,172 41,948 83,998 39,016 — 18,816 20,179 28,056,149 5,324 111,466 177,088 2,053 2,615,016 (76,112) (175,004) 2,543,041 $4,808 15,929,864 — — 13,449 71,340 3,497 15,183 23,122 — 2,159 $16,063,422 $13,576,301 933,051 — 27,994 12,368 305 8,837 543 14,559,399 — — 177,088 1,237 1,679,452 (207,117) (146,637) 1,504,023 $30,715,980 $16,063,422 20 Annaly Capital Management, Inc. 2006 ANNUAL REPORT ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS) YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004 (dollars in thousands, except per share amounts) December 31, 2006 December 31, 2005 December 31, 2004 FOR THE YEAR ENDED Interest income Interest expense Net interest income Other (loss) income: Investment advisory and service fees (Loss) gain on sale of Investment Securities Gain on termination of interest rate swaps Income from trading securities Loss on other-than-temporarily impaired securities Total other (loss) income Expenses: Distribution fees General and administrative expenses Total expenses Impairment of intangible for customer relationships Income before income taxes and minority interest Income taxes Income (loss) before minority interest Minority interest Net Income (loss) Dividends on preferred stock Net income available (loss related) to common shareholders Net income available (loss related) to common shareholders per average common share: Basic Diluted Weighted average number of common shares outstanding: Basic Diluted Net income (loss) Comprehensive income (loss): Unrealized gain (loss) on available-for sale securities Unrealized loss on interest rate swaps Reclassification adjustment for net losses (gains) included in net income or loss Other comprehensive income (loss) Comprehensive income (loss) SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. $1,221,882 1,055,013 166,869 22,351 (3,862) 10,674 3,994 (52,348) (19,191) 3,444 40,063 43,507 2,493 101,678 7,538 94,140 324 93,816 19,557 $74,259 $0.44 $0.44 167,666,631 167,746,387 $93,816 91,873 (6,404) 45,536 131,005 $224,821 $705,046 568,560 136,486 35,625 (53,238) — — (83,098) (100,711) 8,000 26,278 34,278 — 1,497 10,744 (9,247) — (9,247) 14,593 ($23,840) ($0.19) ($0.19) 122,475,032 122,475,032 ($9,247) (222,110) (543) 136,336 (86,317) ($95,564) $532,328 270,116 262,212 12,512 5,215 — — — 17,727 2,860 24,029 26,889 — 253,050 4,458 248,592 — 248,592 7,745 $240,847 $2.04 $2.03 118,223,330 118,459,145 $248,592 (68,324) — (5,215) (73,539) $175,053 21 2006 ANNUAL REPORT Annaly Capital Management, Inc. ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004 (dollars in thousands, except per share data) BALANCE, DECEMBER 31, 2003 Net Income Other comprehensive loss Comprehensive income Exercise of stock options Net proceeds from direct purchase and dividend reinvestment Net proceeds from follow-on offering Common shares issued in FIDAC transaction Net proceeds from preferred offering Net proceeds from equity shelf program Preferred dividends declared, $1.45 per share Common dividends declared, $1.98 per share Preferred Stock Common Stock Par Value Additional Paid-in Capital Other Accumulated Comprehensive Income (loss) $ 961 $1,194,159 ($ 47,261) (73,539) 1 1 207 22 21 855 2,285 363,385 40,478 37,473 $177,077 BALANCE, DECEMBER 31, 2004 $ 177,077 $1,213 $1,638,635 ($120,800) Net loss Other comprehensive Loss Comprehensive loss Reduction in estimated legal cost of preferred offering Exercise of stock options Net proceeds from direct purchase and dividend reinvestment Net proceeds from equity shelf program Preferred dividends declared, $1.97 per share Common dividends declared, $1.04 per share (86,317) 11 253 440 40,124 24 BALANCE, DECEMBER 31, 2005 $177,088 $1,237 $1,679,452 ($207,117) Net income Other comprehensive income Comprehensive income Exercise of stock options Option expense Net proceeds from follow-on offerings Net proceeds from equity shelf program Preferred Series A dividends declared $1.97 per share Preferred Series B dividends declared $1.08 per share Common dividends declared, $0.57 per share 131,005 183 1,285 913,200 20,896 800 16 BALANCE, DECEMBER 31, 2006 $177,088 $2,053 $2,615,016 ($76,112) SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. Retained (Deficit) Earnings $1,361 248,592 (7,745) (237,863) $4,345 (9,247) (14,593) (127,142) ($146,637) 93,816 (14,594) (4,966) (102,623) ($175,004) Total $1,149,220 175,053 856 2,286 363,592 40,500 177,077 37,494 (7,745) (237,863) $1,700,470 (95,564) 11 253 440 40,148 (14,593) (127,142) $1,504,023 224,821 183 1,285 914,000 20,912 (14,594) (4,966) (102,623) $2,543,041 22 Annaly Capital Management, Inc. 2006 ANNUAL REPORT ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 2006, 2005, AND 2004 (dollars in thousands) December 31, 2006 December 31, 2005 December 31, 2004 FOR THE YEAR ENDED $93,816 ($9,247) $248,592 Cash flows from operating activities: Net income (loss) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Amortization of Mortgage Backed Securities premiums and discounts, net Amortization of intangibles Loss (gain) on sale of Investment Securities Gain on termination of interest rate swaps Stock option expense Net realized gain on trading investments Unrealized depreciation on trading investments Market value adjustment on long-term repurchase agreements Loss on other-than-temporarily impaired securities Impairment of intangibles (Increase) decrease in accrued interest receivable Increase in other assets Purchase of trading investments Proceeds from sale of trading securities Purchase of trading securities sold, not yet purchased Proceeds for securities sold, not yet purchased (Decrease) increase in advisory and service fees receivable Increase (decrease) in interest payable Increase in accrued expenses and other liabilities Net cash provided by operating activities Cash flows from investing activities: Purchase of Mortgage-Backed Securities Proceeds from sale of Investment Securities Principal payments of Mortgage-Backed Securities Purchase of agency debentures Proceeds from called agency debentures Cash from FIDAC acquisition Net cash (used in) provided by investing activities Cash flows from financing activities: Proceeds from repurchase agreements Principal payments on repurchase agreements Proceeds from exercise of stock options Proceeds from termination of interest rate swaps Proceeds from direct purchase and dividend reinvestment Net proceeds from follow-on offerings Net proceeds from preferred stock offering Net proceeds from equity shelf program and ATM Equity Sales Agreement Minority interest Dividends paid Net cash provided by (used in) financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year Supplemental disclosure of cash flow information: Interest paid Taxes paid Noncash financing activities: Net change in unrealized loss on available-for-sale securities and interest rate swaps, net of reclassification adjustment Dividends declared, not yet paid Noncash investing and financing activities: Noncash acquisition of FIDAC SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. 63,625 1,589 3,862 (10,674) 1,285 (1,200) 1,180 (149) 52,348 2,493 (76,224) (238) (44,200) 28,838 (16,096) 55,073 319 56,004 9,978 221,629 (23,196,076) 3,040,984 5,115,693 — — — (15,039,399) 292,418,807 (278,481,088) 183 10,674 — 914,000 111,466 20,912 5,324 (95,534) 14,904,744 86,974 4,808 $91,782 $999,009 $7,242 $131,005 $39,016 — 154,309 571 53,238 — 56 — — (2,514) 83,098 — 10,555 (425) — — — — (1,138) (7,727) 753 281,529 (7,416,869) 3,231,219 7,053,867 — 130,000 — 2,998,217 245,514,548 (248,646,126) 197 — 440 — — 40,148 — (189,998) (3,280,791) (1,045) 5,853 $4,808 $576,287 $11,740 ($86,317) $12,368 — 179,602 130 (5,215) — 317 — — (1,133) — — (27,964) (1,749) — — — — (795) 20,732 4,400 416,917 (14,147,323) 596,962 6,495,911 (250,000) 845,000 2,526 (6,456,924) 152,739,827 (147,045,071) 539 — 2,286 363,592 177,077 37,494 — (230,131) 6,045,613 5,606 247 $5,853 $249,384 $3,462 ($73,539) $60,632 $40,500 23 2006 ANNUAL REPORT Annaly Capital Management, Inc. ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES Annaly Capital Management, Inc. (the “Company”) was incorporated in Maryland on November 25, 1996. The Company changed its name from Annaly Mortgage Management, Inc. to Annaly Capital Management, Inc. effective August 2, 2006. The Company commenced its operations of purchasing and managing an investment portfolio of mortgage-backed securities on February 18, 1997, upon receipt of the net proceeds from the private placement of equity capital. An initial public offering was completed on October 14, 1997. The Company is a real estate investment trust (REIT) under the Internal Revenue Code of 1986, as amended. The Company acquired Fixed Income Discount Advisory Company (“FIDAC”) on June 4, 2004. FIDAC is a registered investment advisor and is a tax- able REIT subsidiary of the Company. On June 27, 2006, the Company made a majority equity investment of 90% in an affiliated investment fund (the “Fund”). At December 31, 2006, the Fund was invested 100% in equity investments. A summary of the Company’s significant accounting policies follows: The consolidated financial statements include the accounts of the Company, FIDAC and the Fund. All intercompany balances and transac- tions have been eliminated. The minority shareholder in the Fund is reflected as minority interest in the consolidated financial statements. Cash and Cash Equivalents—Cash and cash equivalents include cash on hand and money market funds. Mortgage-Backed Securities and Agency Debentures—The Company invests primarily in mortgage pass-through certificates, collateralized mortgage obligations and other mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans (collectively, “Mortgage- Backed Securities”). The Company also invests in agency debentures issued by Federal Home Loan Bank (“FHLB”), Federal Home Loan Mortgage Corporation (“FHLMC”), and Federal National Mortgage Association (“FNMA”). The Mortgage-Backed Securities and agency debentures are collectively referred to herein as “Investment Securities.” Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities, requires the Company to classify its Investment Securities as either trad- ing investments, available-for-sale investments or held-to-maturity invest- ments. Although the Company generally intends to hold most of its Investment Securities until maturity, it may, from time to time, sell any of its Investment Securities as part of its overall management of its portfolio. Accordingly, SFAS No. 115 requires the Company to classify all of its Investment Securities as available-for-sale. All assets classified as available- for-sale are reported at estimated fair value, based on market prices from independent sources, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders’ equity. Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been lower than carrying value, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its invest- ment in the issuer for a period of time sufficient to allow for any antici- pated recovery in fair value. Unrealized losses on Investment Securities that are considered other than temporary, as measured by the amount of decline in fair value attributable to other-than-temporary factors, are rec- ognized in income and the cost basis of the Investment Securities is adjusted. The loss on other-than-temporarily impaired securities was $52.3 million during the year ended December 31, 2006 and $83.1 mil- lion during the year ended December 31, 2005. There were no impair- ment losses recognized in 2004. SFAS No. 107, Disclosure About Fair Value of Financial Instruments, requires disclosure of the fair value of financial instruments for which it is practi- cable to estimate that value. The fair value of Mortgage-Backed Securities and agency debentures available-for-sale and interest rate swaps is equal to their carrying value presented in the consolidated statements of finan- cial condition. The fair value of trading securities and trading securities sold, not yet purchased is equal to their estimated fair value presented in the consolidated statements of financial condition. The fair value of cash and cash equivalents, accrued interest receivable, receivable for securities sold, receivable for advisory and service fees, repurchase agreements, with less than a one year maturity date, and payable for mortgage-backed securities purchased, dividends payable, accounts payable, and accrued interest payable, generally approximates cost as of December 31, 2006 due to the short term nature of these financial instruments. Interest income is accrued based on the outstanding principal amount of the Investment Securities and their contractual terms. Premiums and dis- counts associated with the purchase of the Investment Securities are amortized into interest income over the projected lives of the securities using the interest method. The Company’s policy for estimating prepay- ment speeds for calculating the effective yield is to evaluate historical per- formance, consensus prepayment speeds, and current market conditions. Investment Securities transactions are recorded on the trade date. Purchases of newly-issued securities are recorded when all significant uncertainties regarding the characteristics of the securities are removed, generally shortly before settlement date. Realized gain and losses on sale of Investment Securities are determined on the specific identification basis. Derivative Financial Instruments/Hedging Activity— The Company hedges interest rate risk through the use of derivative financial instruments, com- prised of interest rate caps and interest rate swaps (collectively, “Hedging Instruments”). The Company accounts for Hedging Instruments in accor- dance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, (“SFAS 133”) as amended and interpreted. The Company carries all Hedging Instruments at their fair value, as assets, if their fair value is positive, or as liabilities, if their fair value is negative. As the Company’s interest rate swaps are designated as cash flow hedges under SFAS No. 133, the change in the fair value of any such derivative is recorded in other comprehensive income or loss for hedges that qualify as effective. At December 31, 2006 the Company did not have any interest rate caps. The ineffective amount of all Hedging Instruments, if any, is recognized in earnings each year. To date, the Company has not recog- nized any change in the value of its interest rate swaps in earnings as a result of the hedge or a portion thereof being ineffective. Upon entering into hedging transactions, the Company documents the relationship between the Hedging Instruments and the hedged liability. The Company also documents its risk-management policies, including objectives and strategies, as they relate to its hedging activities. The Company assesses, both at inception of a hedge and on an on-going basis, whether or not the hedge is “highly effective,” as defined by SFAS 133. The Company discontinues hedge accounting on a prospective basis with changes in the estimated fair value reflected in earnings when (i) it is determined that the derivative is no longer effective in offsetting cash flows of a hedged item (including hedged items such as forecasted trans- actions); (ii) it is no longer probable that the forecasted transaction will occur; or (iii) it is determined that designating the derivative as a Hedging Instrument is no longer appropriate. When the Company enters into an interest rate swap, it agrees to pay a fixed rate of interest and to receive a variable interest rate, generally based on the London Interbank Offered Rate (“LIBOR”). The Company’s interest rate swaps are designated as cash flow hedges against the benchmark interest rate risk associated with the Company’s borrowings. All changes in the unrealized gains/losses on any interest rate swap are recorded in accumulated other comprehensive income or loss and are reclassified to earnings as interest expense is recognized on the Company’s hedged borrowings. If it becomes probable that the forecasted transaction, which in this case refers to interest payments to be made under the Company’s short-term borrowing agreements, will not occur by the end of the originally specified time period, as documented at the 24 Annaly Capital Management, Inc. 2006 ANNUAL REPORT inception of the hedging relationship, then the related gain or loss in accumulated other comprehensive income or loss would be reclassified to income or loss. Realized gains and losses resulting from the termination of an interest rate swap are initially recorded in accumulated other comprehensive income or loss as a separate component of stockholders’ equity. The gain or loss from a terminated interest rate swap remains in accumulated other com- prehensive income or loss until the forecasted interest payments affect earnings. If it becomes probable that the forecasted interest payments will not occur, then the entire gain or loss would be recognized in earnings. Credit Risk—The Company has limited its exposure to credit losses on its portfolio of Mortgage-Backed Securities by only purchasing securities issued by FHLMC, FNMA, or GNMA. The payment of principal and interest on the FHLMC and FNMA Mortgage-Backed Securities are guar- anteed by those respective agencies, and the payment of principal and interest on the GNMA Mortgage-Backed Securities are backed by the full faith and credit of the U.S. government. All of the Company’s Investment Securities have an actual or implied “AAA” rating. Trading Securities and Trading Securities sold, not yet purchased—Trading securities and trading securities sold, not yet purchased, are included in the balance sheet as a result of consolidating the financial statements of the Fund, and are carried at fair value at December 31, 2006. The real- ized and unrealized gains and losses from trading securities are recorded in the income from trading securities balance in the accompanying con- solidated statements of operations. Trading account securities sold, not yet purchased represent obligations of the Fund to deliver the specified security at the contracted price, and thereby create a liability to purchase the security in the market at prevail- ing prices. Repurchase Agreements—The Company finances the acquisition of its Investment Securities through the use of repurchase agreements. Repurchase agreements are treated as collateralized financing transactions and are carried at their contractual amounts, including accrued interest, as specified in the respective agreements. Cumulative Convertible Preferred Stock—The Company classifies its Series B Cumulative Convertible Preferred Stock on the consolidated statements of financial condition using the guidance in SEC Accounting Series Release No. 268, Presentation in Financial Statements of “Redeemable Preferred Stocks,” and Emerging Issues Task Force (“EITF”) Topic D-98, Classification and Measurement of Redeemable Securities. The Series B Cumulative Convertible Preferred Stock contains fundamental change provisions that allow the holder to redeem the preferred stock for cash if certain events occur. As redemption under these provisions is not solely within the Company’s control, the Company has classified the Series B Cumulative Convertible Preferred Stock as temporary equity in the accompanying consolidated statement of financial condition. The Company has analyzed whether the embedded conversion option should be bifurcated under the guidance in SFAS No. 133 and EITF Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, and has determined that bifurcation is not necessary. Income Taxes—The Company has elected to be taxed as a REIT and intends to comply with the provisions of the Internal Revenue Code of 1986, as amended (the “Code”), with respect thereto. Accordingly, the Company will not be subjected to federal income tax to the extent of its distributions to shareholders and as long as certain asset, income and stock ownership tests are met. The Company and FIDAC have made a joint election to treat FIDAC as a taxable REIT subsidiary. As such, FIDAC is taxable as a domestic C corporation and subject to federal and state and local income taxes based upon its taxable income. Use of Estimates—The preparation of the consolidated financial statements in conformity with Generally Accepted Accounting Principles or GAAP, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the report- ed amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Intangible Assets—The Company’s acquisition of FIDAC was accounted for using the purchase method. Under the purchase method, net assets and results of operations of acquired companies are included in the consoli- dated financial statements from the date of acquisition. In addition, the cost of FIDAC was allocated to the assets acquired, including identifiable intangible assets, and the liabilities assumed based on their estimated fair values at the date of acquisition. The excess of purchase price over the fair value of the net assets acquired was recognized as goodwill. Intangible assets are periodically (but not less frequently than annually) reviewed for potential impairment. Intangible assets with an estimated useful life are expected to amortize over a 8.7 year weighted average time period. During the year ended December 31, 2006, the Company recog- nized $2.5 million in impairment losses on intangible assets relating to customer relationships. During the years ended December 31, 2005 and 2004, the Company did not have impairment losses. Stock Based Compensation—On December 16, 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (Revised 2004)—Share-Based Recent Payment (“SFAS No. 123R”). SFAS No. 123R, which replaces SFAS No. 123, requires the Company to measure and rec- ognize in the financial statements the compensation cost relating to share- based payment transactions. The compensation cost should be reassessed based on the fair value of the equity instruments issued. We adopted SFAS No. 123R effective January 1, 2006 under the modified prospec- tive transition method. Accordingly, prior period amounts have not been restated. Under this application, the Company is required to record com- pensation expense for all awards granted or modified on or after January 1, 2006 and for the unvested portion of all outstanding awards that remain outstanding at the date of adoption. The adoption of SFAS No. 123R resulted in total stock-based compensation expense of approxi- mately $1.3 million for the year ended December 31, 2006. The Company elected to recognize compensation expense on a straight- line basis over the requisite service period for the entire award (that is, over the requisite service period of the last separately vesting portion of the award). We estimate fair value using the Black-Scholes valuation model. The assumptions used to value the options granted during the year ended December 31, 2006 are as follows: Expected volatility of 26.50%, expected dividends of 5.57%, expected term in years of 6.8 and risk-free rate of 4.6%. Assumptions used to estimate the compensation expense are determined as follows: • Expected term (estimated time of outstanding) is estimated using the historical exercise behavior of employees • Expected volatility is measured using the weighted average of histori- cal daily changes in the market price of our common stock over the expected term of the award • Expected dividend yield is based on projected dividend yield over the expected term of the award • Risk-free interest rate is equivalent to the implied yield on zero- coupon U.S. Treasury bonds with a remaining maturity equal to the expected term of the awards; and, • Forfeitures are based substantially on the history of cancellations of similar awards granted by the Company in prior years. Prior to the adoption of SFAS No. 123R, we used the intrinsic value method prescribed in APB 25 and also followed the disclosure require- ments of SFAS No. 123, as amended by SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure (“SFAS No. 148”) which required certain disclosures on a pro forma basis as if the fair value method had been followed for accounting for such compensation. 25 2006 ANNUAL REPORT Annaly Capital Management, Inc. (dollars in thousands, except per share data) December 31, 2005 December 31, 2004 FOR THE YEAR ENDED Net (loss) income available to common shareholders, as reported Deduct: Total stock-based employee compensation expense determined under fair value based method Pro-forma net (loss) income available to common shareholers Net (loss) income per share available to common shareholders, as reported: Basic Diluted Pro-forma net (loss) income per share available to common shareholders: Basic Diluted ($23,840) $240,847 (357) (149 ) ($24,197) $240,698 ($0.19) ($0.19) ($0.20) ($0.20) $2.04 $2.03 $2.03 $2.03 Recent Accounting Pronouncements—SEC Staff Accounting Bulletin No. 108 —In September 2006 the SEC issued Staff Accounting Bulletin (SAB) No. 108 “Considering the effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements (SAB 108)”, which expresses the Staff’s views regarding the process of quantifying financial statement misstatements. SAB 108 is effective for annual financial state- ments covering the fiscal year ending after November 15, 2006. Registrants are required to quantify the impact of correcting all misstate- ments, including both the carryover and reversing effects of prior year misstatements, on the current year financial statements. The techniques most commonly used in practice to accumulate and quantify misstate- ments are generally referred to as the “rollover” (current year income statement perspective) and “iron curtain” (year-end balance perspective) approaches. The financial statements would require adjustment when either approach results in quantifying a misstatement that is material, after considering all relevant quantitative and qualitative factors. The adoption of SAB 108 on December 31, 2006 has no effect on the Company’s consolidated financial statements. In April 2006, the FASB issued FSP FIN 46(R)-6, Determining the Variability to be Considered When Applying FASB Interpretation No. 46(R)(“FIN 46(R)-6”). FIN 46(R)-6 addresses the approach to determine the variability to consider when applying FIN 46(R). The variability that is considered in applying Interpretation 46(R) may affect (i) the determi- nation as to whether an entity is a variable interest entity (“VIE”), (ii) the determination of which interests are variable in the entity, (iii) if neces- sary, the calculation of expected losses and residual returns on the entity, and (iv) the determination of which party is the primary beneficiary of the VIE. Thus, determining the variability to be considered is necessary to apply the provisions of Interpretation 46(R). FIN 46(R)-6 is required to be prospectively applied to entities in which the Company first become involved after July 1, 2006 and would be applied to all existing entities with which the Company is involved if and when a “reconsideration event” (as described in FIN 46) occurs. The adoption did not have a material impact on the consolidated financial statements of the Company. In February 2006, the FASB issued FAS No. 155, Accounting for Certain Hybrid Instruments (“FAS 155”), an amendment of FASB Statements No. 133 and 140. Among other things, FAS 155: (i) permits fair value re-measure- ment for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; (ii) clarifies which interest-only strips and principal-only strips are not subject to the requirements of FAS 133; (iii) establishes a requirement to evaluate inter- ests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; (iv) clarifies that concentra- tions of credit risk in the form of subordination are not embedded derivatives; and (v) amends FAS 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another deriva- tive financial instrument. FAS 155 is effective for all financial instruments acquired or issued by the Company after December 31, 2006. On September 25, 2006, the FASB met and proposed a scope exception under FAS 155 for securitized interests that only contain an embedded derivative that is tied to the prepayment risk of the underlying pre- payable financial assets, and for which the investor does not control the right to accelerate the settlement. If a securitized interest contains any other embedded derivative (for example, an inverse floater), then it would be subject to the bifurcation tests in FAS 133, as would securities pur- chased at a significant premium. The FASB plans to issue their final posi- tion in early 2007. In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 (“FIN 48”), and related implementation issues. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the Company’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a threshold and meas- urement attribute for recognition in the financial statements of an asset or liability resulting from a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and tran- sition. FIN 48 is effective as of the beginning of fiscal years that begin after December 15, 2006. There is no impact to the Company from implementing this new standard. In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements. SFAS No. 157 requires companies to disclose the fair value of its financial instruments according to a fair value hierarchy (i.e., levels 1, 2, and 3, as defined). Additionally, companies are required to provide enhanced disclosure regarding instruments in the level 3 cate- gory (which require significant management judgment), including a rec- onciliation of the beginning and ending balances separately for each major category of assets and liabilities. SFAS No. 157 is effective for the Company on January 1, 2008. The Company is currently evaluating the impact adoption of SFAS No. 157 may have on its consolidated financial statements. Proposed Accounting Pronouncements—The FASB has added an item to its current proposed amendment relating to the accounting treatment under SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities of transactions where assets purchased from a particular counterparty are financed via a repurchase agreement with the same counterparty. Currently, the Company records such assets and the related financing in the consolidated statement of financial condition, and the corresponding interest income and interest expense in the Company’s consolidated statement of operations and comprehensive (loss) income. For assets representing available-for-sale investment securities, as in the Company’s case, any change in fair value is reported through other com- prehensive income under SFAS No. 115, with the exception of impair- ment losses, which are recorded in the consolidated statement of opera- tions and comprehensive (loss) income as realized losses. However, a transaction where assets are acquired from and financed under a repurchase agreement with the same counterparty may not quali- fy for a sale treatment by a seller under an interpretation of SFAS No. 140, which would require the seller to continue to carry such sold assets on their books based on their “continuing involvement” with such assets. Depending on the ultimate outcome of the FASB deliberations, the result may be that the Company would be precluded from recording the assets purchased in the transaction described above as well as the related financ- ing in the Company’s consolidated statement of financial condition and would instead be treating the Company’s net investment in such assets as a derivative. This potential change in accounting treatment would not affect the eco- nomic substance of the transactions but would affect how the transactions would be reported in the Company’s financial statements. The Company’s cash flows, liquidity and ability to pay a dividend would be unchanged, and the Company does not believe the Company’s taxable income or net equity would be affected. 26 Annaly Capital Management, Inc. 2006 ANNUAL REPORT 2. MORTGAGE-BACKED SECURITIES The following tables present the Company’s available-for-sale Mortgage-Backed Securities portfolio as of December 31, 2006 and 2005: December 31, 2006 (dollars in thousands) Mortgage-Backed Securities, gross Unamortized discount Unamortized premium Amortized cost Gross unrealized gains Gross unrealized losses Estimated fair value (dollars in thousands) Adjustable rate Fixed rate Total December 31, 2005 (dollars in thousands) Mortgage-Backed Securities, gross Unamortized discount Unamortized premium Amortized cost Gross unrealized gains Gross unrealized losses Estimated fair value (dollars in thousands) Adjustable rate Fixed rate Total Federal Home Loan Mortgage Corporation $10,675,235 (21,332) 82,707 10,736,610 35,174 (73,125) $10,698,659 Amortized Cost $8,546,363 21,679,517 $30,225,880 Federal National Mortgage Association Government Total National Mortgage Mortgage-Backed Association Securities $19,085,218 (56,517) 133,164 19,161,865 74,498 (92,548) $19,143,815 $324,338 (204) 3,271 327,405 366 (2,736) $325,035 $30,084,791 (78,053) 219,142 30,225,880 110,038 (168,409) $30,167,509 Gross Unrealized Gain Gross Unrealized Loss Estimated Fair Value $12,764 97,274 $110,038 ($61,483) (106,926) ($168,409) $8,497,644 21,669,865 $30,167,509 Federal Home Loan Mortgage Corporation Federal National Mortgage Association Government Total National Mortgage Mortgage-Backed Association Securities $5,689,898 (4,043) 92,228 5,778,083 3,174 (80,733) $5,700,524 Amortized Cost $9,844,261 6,292,177 $16,136,438 $9,881,672 (17,345) 144,726 10,009,053 1,853 (124,330) $9,886,576 $344,231 (62) 5,133 349,302 — (6,538) $342,764 $15,915,801 (21,450) 242,087 16,136,438 5,027 (211,601) $15,929,864 Gross Unrealized Gain Gross Unrealized Loss Estimated Fair Value $3,973 1,054 $5,027 ($120,480) (91,121) ($211,601) 9,727,754 6,202,110 $15,929,864 Actual maturities of Mortgage-Backed Securities are generally shorter than stated contractual maturities. Actual maturities of the Company’s Mortgage- Backed Securities are affected by the contractual lives of the underlying mortgages, periodic payments of principal, and prepayments of principal. The following table summarizes the Company’s mortgage-backed securities on December 31, 2006 and 2005 according to their estimated weighted-average life classifications: (dollars in thousands) Less than one year Greater than one year and less than five years Greater than or equal to five years Total DECEMBER 31, 2006 DECEMBER 31, 2005 Fair Value $379,967 21,788,975 7,998,567 $30,167,509 Amortized Cost $382,268 21,851,659 7,991,953 $30,225,880 Fair Value $508,851 12,648,106 2,772,907 $15,929,864 Amortized Cost $514,560 12,824,736 2,797,142 $16,136,438 The weighted-average lives of the mortgage-backed securities at December 31, 2006 and 2005 in the table above are based upon data provided through subscription-based financial information services, assuming constant principal prepayment rates to the reset date of each security. The prepayment model considers current yield, forward yield, steepness of the yield curve, current mortgage rates, mortgage rate of the outstanding loans, loan age, margin and volatility. Mortgage-Backed Securities with a carrying value of $7.0 billion were in a continuous unrealized loss position over 12 months at December 31, 2006 in the amount of $138.2 million. Mortgage-Backed Securities with a carrying value of $6.4 billion were in a continuous unrealized loss posi- tion for less than 12 months at December 31, 2006 in the amount of $30.2 million. Mortgage-Backed Securities with a carrying value of $4.6 billion were in a continuous unrealized loss position over 12 months at December 31, 2005 in the amount of $111.1 million. Mortgage-Backed Securities with a carrying value of $8.4 billion were in a continuous unre- alized loss position for less than 12 months at December 31, 2005 in the amount of $100.5 million. The decline in value of these securities is sole- ly due to increases in interest rates. All of the Mortgage-Backed Securities are “AAA” rated or carry an implied “AAA” rating. During the years ended December 31, 2006 and 2005, the Company recorded impairment losses of $52.3 million and $83.1 million, respectively. The remaining invest- ments are not considered other-than-temporarily impaired since the Company currently has the ability and intent to hold the investments for a period of time or to maturity, if necessary, sufficient for a forecasted market price recovery up to or beyond the cost of the investments. Also, the Company is guaranteed payment on the par value of the securities. 27 2006 ANNUAL REPORT Annaly Capital Management, Inc. The adjustable rate Mortgage-Backed Securities are limited by periodic caps (generally interest rate adjustments are limited to no more than 1% every nine months) and lifetime caps. The weighted average lifetime cap was 9.8% at December 31, 2006 and 10.3% at December 31, 2005. During the year ended December 31, 2006, the Company realized $3.9 million in net losses from sales of Investment Securities. During year ended December 31, 2005, the Company realized $53.2 million in net gains from sales of Mortgage-Backed Securities. 3. AGENCY DEBENTURES At December 31, 2006, the Company owned agency debentures with a carrying value of $49.6 million, including the unrealized loss of $120,000. At December 31, 2005, the Company did not own agency debentures. 4. REPURCHASE AGREEMENTS The Company had outstanding $27.5 billion and $13.6 billion of repur- chase agreements with weighted average borrowing rates of 5.14% and 4.16%, and weighted average remaining maturities of 125 days and 79 days as of December 31, 2006 and December 31, 2005, respectively. Investment Securities pledged as collateral under these repurchase agree- ments had an estimated fair value of $28.6 billion at December 31, 2006 and $14.3 billion at December 31, 2005. At December 31, 2006 and December 31, 2005, the repurchase agreements had the following remaining maturities: (dollars in thousands) December 31, 2006 December 31, 2005 Within 30 days 30 to 59 days 60 to 89 days 90 to 119 days Over 120 days Total $22,778,703 $10,575,945 2,285,317 200,000 — 1,250,356 — — 2,250,000 1,750,000 $27,514,020 $13,576,301 The Company did not have an amount at risk greater than 10% of the equity of the Company with any counterparties as of December 31, 2006. The Company had an amount at risk greater than 10% of the equity of the Company with the following counterparty at December 31, 2005. (dollars in thousands) UBS Securities LLC Amount at Risk (1) $179,959 Weighted Average Days to Maturity 121 (1) Equal to the sum of fair value of securities sold plus accrued interest income minus the sum of repurchase agreements plus accrued interest expense. The Company has entered into repurchase agreements which provide the counterparty with the right to call the balance prior to maturity date. The repurchase agreements totaled $1.4 billion and the market value of the option to call is $1.4 million. Management has determined that the call option is not required to be bifurcated under the provisions of FASB No. 133 as it is deemed clearly and closely related to the debt instrument, therefore the option value is not recorded in the consolidated financial statements. 5. INTEREST RATE SWAPS In connection with the Company’s interest rate risk management strategy, the Company hedges a portion of its interest rate risk by entering into derivative financial instrument contracts. As of December 31, 2006, such instruments are comprised of interest rate swaps, which in effect modify the cash flows on repurchase agreements. The use of interest rate swaps creates exposure to credit risk relating to potential losses that could be recognized if the counterparties to these instruments fail to perform their obligations under the contracts. In the event of a default by the counter- party, the Company could have difficulty obtaining its Mortgage-Backed Securities pledged as collateral for swaps. The Company does not antici- pate any defaults by its counterparties. The Company’s swaps are used to lock-in the fixed rate related to a por- tion of its current and anticipated future 30-day term repurchase agree- ments. The table below presents information about the Company’s swaps outstanding at December 31, 2006. (dollars in thousands) Notional Amount Weighted Average Pay Rate Weighted Average Receive Rate Net Estimated Fair Value/ Carrying Value $9,328,000 5.17% 5.35% ($17,621) In 2006, the Company had a $10.7 million realized gain on the termina- tion of interest rate swaps with a notional value of $1.2 billion. At December 31, 2005, there were no swap contracts that had settled. 6. PREFERRED STOCK AND COMMON STOCK (A) STOCK ISSUANCES On August 16, 2006, the Company entered into an underwriting agree- ment pursuant to which it sold 40,825,000 shares of its common stock for net proceeds before expenses of approximately $476.7 million. This transaction settled on August 22, 2006. On April 6, 2006, the Company entered into an underwriting agreement pursuant to which it sold 39,215,000 shares of its common stock for net proceeds before expenses of approximately $437.7 million. On April 6, 2006, the Company entered into a second underwriting agreement pur- suant to which if sold 4,600,000 shares of its 6% Series B Cumulative Convertible Preferred Stock for net proceeds before expenses of approxi- mately $111.5 million. Both of these transactions settled on April 12, 2006. On August 3, 2006, the Company entered into an ATM Equity Offeringsm Sales Agreement with Merrill Lynch & Co. and Merrill Lynch, Pierce, Fenner & Smith Incorporated (“Merrill Lynch”), relating to the sale of shares of its common stock from time to time through Merrill Lynch. Sales of the shares, if any, are made by means of ordinary brokers’ transaction on the New York Stock Exchange. During the year ended December 31, 2006, 500,000 shares of the Company’s common stock were issued pursuant to this program, totaling $6.7 million in net proceeds. On August 3, 2006, the Company entered into an ATM Equity Sales Agreement with UBS Securities LLC (“UBS Securities”), relating to the sale of shares of its common stock from time to time through UBS Securities. Sales of the shares, if any, are made by means of ordinary brokers’ trans- action on the New York Stock Exchange. During the year ended December 31, 2006, no shares of the Company’s common stock were issued pursuant to this program. During the year ended December 31, 2006, the Company declared divi- dends to common shareholders totaling $102.6 million or $.57 per share, of which $39.0 million were paid on January 26, 2007. During the year ended December 31, 2006, the Company declared and paid dividends to Series A preferred shareholders totaling $14.6 million or $1.97 per share and Series B Preferred shareholders totaling $5.0 million or $1.08 per share. During the year ended December 31, 2006, 1,098,500 shares of the Company’s common stock were issued through the Equity Shelf Program, totaling net proceeds of $14.2 million. During the year ended December 31, 2006, 22,160 options were exercised under the long-term compensation plan for an aggregate exercise price of $183,000. During the year ended December 31, 2005, the Company declared divi- dends to common shareholders totaling $127.1 million, the Company declared and paid dividends to preferred shareholders totaling $14.6 mil- lion or $1.97 per share. During the twelve months ended December 31, 2005, 2,381,550 shares of the Company’s common stock were issued through the Equity Shelf Program, totaling net proceeds of $40.1 million. During the year ended December 31, 2005, 16,128 options were exer- cised under the long-term compensation plan for an aggregate exercise price of $253,000. In addition, 24,253 common shares were sold through the dividend reinvestment and direct purchase program for $440,000 during the year ended December 31, 2005. 28 Annaly Capital Management, Inc. 2006 ANNUAL REPORT During the year ended December 31, 2004, 2,103,525 shares were issued through the Equity Shelf Program, totaling net proceeds of $37.5 million. During the year ended December 31, 2004, 57,000 options were exer- cised under the long-term compensation plan for an aggregate exercise price of $856,000. In addition, 127,020 shares were purchased in the dividend reinvestment and direct purchase program at $2.3 million. (B) PREFERRED STOCK At December 31, 2006, the Company had issued and outstanding 7,412,500 shares of Series A Cumulative Redeemable Preferred Stock, with a par value $0.01 per share and a liquidation preference of $25.00 per share plus accrued and unpaid dividends (whether or not declared). The Series A preferred stock must be paid a dividend at a rate of 7.875% per year on the $25.00 liquidation preference before the common stock is entitled to receive any dividends. The Series A preferred stock is redeemable at $25.00 per share plus accrued and unpaid dividends (whether or not declared) exclusively at the Company’s option commenc- ing on April 5, 2009 (subject to the Company’s right under limited circumstances to redeem the Series A preferred stock earlier in order to preserve its qualification as a REIT). The Series A preferred stock is senior to the Company’s common stock and is on parity with the Series B pre- ferred stock with respect to dividends and distributions, including distri- butions upon liquidation, dissolution or winding up. The Series A preferred stock generally does not have any voting rights, except if the Company fails to pay dividends on the Series A preferred stock for six or more quarterly periods (whether or not consecutive). Under such circumstances, the Series A preferred stock, together with the Series B preferred stock, will be entitled to vote to elect two additional directors to the Board, until all unpaid dividends have been paid or declared and set apart for payment. In addition, certain material and adverse changes to the terms of the Series A preferred stock cannot be made without the affirmative vote of holders of at least two-thirds of the outstanding shares of Series A preferred stock and Series B preferred stock. Through December 31, 2006, the Company had declared and paid all required quarterly dividends on the Series A preferred stock. At December 31, 2006, the Company had issued and outstanding 4,600,000 shares of Series B Cumulative Convertible Preferred Stock, with a par value $0.01 per share and a liquidation preference of $25.00 per share plus accrued and unpaid dividends (whether or not declared). The Series B preferred stock must be paid a dividend at a rate of 6% per year on the $25.00 liquidation preference before the common stock is entitled to receive any dividends. The Series B preferred stock is not redeemable. The Series B preferred stock is convertible into shares of common stock at a conversion rate that adjusts from time to time upon the occurrence of certain events, includ- ing if the Company distributes to its common shareholders in any calen- dar quarter cash dividends in excess of $0.11 per share. Initially, the con- version rate was 1.7730 shares of common shares per $25 liquidation preference. Commencing April 5, 2011, the Company has to right in cer- tain circumstances to convert each Series B preferred stock into a number of common shares based upon the then prevailing conversion rate. The Series B preferred stock is also convertible into common shares at the option of the Series B preferred shareholder at any time at the then pre- vailing conversion rate. The Series B preferred stock is senior to the Company’s common stock and is on parity with the Series A preferred stock with respect to dividends and distributions, including distributions upon liquidation, dissolution or winding up. The Series B preferred stock generally does not have any voting rights, except if the Company fails to pay dividends on the Series B preferred stock for six or more quarterly periods (whether or not consecutive). Under such circumstances, the Series B preferred stock, together with the Series A preferred stock, will be entitled to vote to elect two additional directors to the Board, until all unpaid dividends have been paid or declared and set apart for payment. In addition, certain material and adverse changes to the terms of the Series B preferred stock cannot be made without the affirmative vote of holders of at least two-thirds of the outstanding shares of Series B pre- ferred stock and Series A preferred stock. Through December 31, 2006, the Company had declared and paid all required quarterly dividends on the Series B preferred stock. 7. NET INCOME (LOSS) PER COMMON SHARE The following table presents a reconciliation of the net income (loss) and shares used in calculating basic and diluted earnings per share for the years ended December 31, 2006, 2005 and 2004. Net income (loss) Less: Preferred stock dividends Net income available (loss related) to common shareholders Weighted average shares of common stock outstanding-basic Add: Effect of dilutive stock options Weighted average shares of common stock outstanding-diluted December 31, 2006 $93,816 19,557 $74,259 167,667 79 167,746 FOR THE YEAR ENDED December 31, 2005 ($9,247) 14,593 ($23,840) 122,475 — 122,475 December 31, 2004 $248,592 7,745 $240,847 118,223 236 118,459 The Series B Cumulative Convertible Preferred Stock was anti-dilutive for the year ended December 31, 2006. Because the Company had a net loss related to common shareholders for the year ended December 31, 2005, options to purchase 2,333,593 shares of common stock were considered anti-dilutive for the year ended December 31, 2005. Options to purchase 12,500 of common stock were outstanding and considered anti-dilutive as their exercise price exceeded the average stock price for the year ended December 31, 2004. 8. LONG-TERM STOCK INCENTIVE PLAN The Company has adopted a long term stock incentive plan for executive officers, key employees and non-employee directors (the “Incentive Plan”). The Incentive Plan authorizes the Compensation Committee of the board of directors to grant awards, including non-qualified options as well as incentive stock options as defined under Section 422 of the Code. The Incentive Plan authorizes the granting of options or other awards for an aggregate of the greater of 500,000 shares or 9.5% of the diluted out- standing shares of the Company’s common stock, up to ceiling of 8,932,921 shares. Stock options are issued at the current market price on the date of grant, subject to an immediate or four year vesting in four equal installments with a contractual term of 5 or 10 years. The grant date fair value is calculated using the Black-Scholes option valuation model. 29 2006 ANNUAL REPORT Annaly Capital Management, Inc. Options outstanding at the beginning of year Granted Exercised Forfeited Expired Options outstanding at the end of year Options exercisable at the end of the year December 31, 2006 December 31, 2005 December 31, 2004 FOR THE YEAR ENDED Number of Shares 2,333,593 737,250 (22,160) (60,000) (3,688) 2,984,995 1,298,496 Weighted Average Exercise Price $16.10 11.72 8.25 15.39 13.69 $15.10 $15.28 Number of Shares 1,645,721 737,750 (16,128) — (33,750) 2,333,593 831,906 Weighted Average Exercise Price $15.66 17.08 12.21 — 17.87 $16.10 $13.84 Number of Shares 1,063,259 639,750 (57,288) — — 1,645,721 540,721 Weighted Average Exercise Price $14.28 17.39 9.40 — — $15.66 $11.62 The weighted average remaining contractual term was approximately 7.3 years for stock options outstanding and approximately 5.9 years for stock options exercisable as of December 31, 2006. As of December 31, 2006, there was approximately $2.8 million of total unrecognized compensation cost related to nonvested share-based compensation awards. That cost is expected to be recognized over a weighted average period of 2.6 years. The following table summarizes information about stock options outstanding at December 31, 2006: Range of Exercise Prices $7.94–$19.99 $20.00–$29.99 Weighted Average Exercise Price on Total Outstanding Weighted Average Remaining Contractual Life (Years) on Total Outstanding $15.08 20.53 $15.10 7.34 0.99 7.32 Weighted Weighted Average Remaining Average Exercise Contractual Life Price On Exercisable (Years) on Exercisable $15.24 20.53 $15.28 5.97 0.99 5.93 Total Options Exercisable 1,288,496 10,000 1,298,496 Total Options Outstanding 2,974,995 10,000 2,984,995 9. INCOME TAXES The Company’s aggregate future minimum lease payments are as follows: As a REIT, the Company is not subject to Federal income tax on earnings distributed to its shareholders. Most states recognize REIT status as well. The Company has decided to distribute the majority of its income and retain a portion of the permanent difference between book and taxable income arising from Section 162(m) of the Code pertaining to employee remuneration. (dollars in thousands) Total per Year 2007 2008 2009 Total remaining lease payments $532 532 532 $1,596 During the year ended December 31, 2006, the Company recorded $3.1 million of income tax expense for income attributable to FIDAC, its taxable REIT subsidiary, and the portion of earnings retained based on Code Section 162(m) limitations. During the year ended December 31, 2006, the Company recorded $4.5 million of income tax expense for a portion of earnings retained based on Section 162(m) limitations. The statutory combined federal, state, and city corporate tax rate is 45%. This amount is applied to the amount of estimated REIT taxable income retained (if any, and only up to 10% of ordinary income as all capital gain income is distributed) and to taxable income earned at the taxable sub- sidiaries. Thus, as a REIT, our effective tax rate is significantly less as we are allowed to deduct dividend distributions. During the year ended December 31, 2005, the Company recorded $8.7 million of income tax expense for income attributable to FIDAC, its taxable REIT subsidiary, and the portion of earnings retained based on Code Section 162(m) limitations. During the year ended December 31, 2005, the Company recorded $2.0 million of income tax expense for a portion of earnings retained based on Section 162(m) limitations. During the year ended December 31, 2004, the Company recorded $4.5 million of income tax expense for income attributable to FIDAC and the portion of earnings retained based on Code Section 162(m) limitations. 10. LEASE COMMITMENTS The Company has a noncancelable lease for office space, which com- menced in May 2002 and expires in December 2009. Office rent expense was $618,000, $573,000, and $591,000 for the years ended December 31, 2006, 2005 and 2004, respectively. The expense was net of sub-lease payments received of $91,000, $84,000, and $7,000 for the years ended December 31, 2006, 2005 and 2004, respectively. 11. INTEREST RATE RISK The primary market risk to the Company is interest rate risk. Interest rates are highly sensitive to many factors, including governmental mone- tary and tax policies, domestic and international economic and political considerations and other factors beyond the Company’s control. Changes in the general level of interest rates can affect net interest income, which is the difference between the interest income earned on interest-earning assets and the interest expense incurred in connection with the interest bearing liabilities, by affecting the spread between the interest-earning assets and interest-bearing liabilities. Changes in the level of interest rates also can affect the value of the Investment Securities and the Company’s ability to realize gains from the sale of these assets. A decline in the value of the Investment Securities pledged as collateral for borrowings under repurchase agreements could result in the counterparties demanding additional collateral pledges or liquidation of some of the existing collat- eral to reduce borrowing levels. Liquidation of collateral at losses could have an adverse accounting impact, as discussed in Note 3. The Company seeks to manage the extent to which net income changes as a function of changes in interest rates by matching adjustable-rate assets with variable-rate borrowings. The Company may seek to mitigate the potential impact on net income of periodic and lifetime coupon adjustment restrictions in the portfolio of Investment Securities by enter- ing into interest rate agreements such as interest rate caps and interest rate swaps. As of December 31, 2006, the Company entered into interest rate swaps to pay a fixed rate and receive a floating rate of interest, with total notional amount of $9.3 billion. Changes in interest rates may also have an effect on the rate of mortgage principal prepayments and, as a result, prepayments on Mortgage-Backed Securities. The Company will seek to mitigate the effect of changes in the 30 Annaly Capital Management, Inc. 2006 ANNUAL REPORT mortgage principal repayment rate by balancing assets purchased at a pre- mium with assets purchased at a discount. To date, the aggregate premi- um exceeds the aggregate discount on the Mortgage-Backed Securities. As a result, prepayments, which result in the expensing of unamortized pre- mium, will reduce net income compared to what net income would be absent such prepayments. 12. CONTINGENCIES From time to time, the Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of man- agement, the ultimate disposition of these matters will not have a material effect on the Company’s consolidated financial statements. 13. SUMMARIZED QUARTERLY RESULTS (UNAUDITED) The following is a presentation of the quarterly results of operations for the year ended December 31, 2006. (dollars in thousands, except per share data) Interest income Interest expense Net interest income Other (loss) income: Investment advisory and service fees (Loss) gain on sale of Investment Securities Gain on termination of interest rate swaps Income from trading securities Loss on other-than-temporarily impaired securities Total other (loss) income Expenses: Distribution fees General and administrative expenses Total expenses Impairment of intangible for customer relationships (Loss) Income before income taxes and minority interest Income taxes (Loss) income before minority interest Minority interest Net (loss) income Dividends on preferred stock Net (loss related) income available to common shareholders March 31, 2006 $194,882 167,512 27,370 June 30, 2006 $280,171 242,473 37,698 September 30, 2006 December 31, 2006 $339,737 295,726 44,011 $407,092 349,302 57,790 6,997 (7,006) — — (26,730) (26,739) 1,170 7,177 8,347 1,148 (8,864) 2,085 (10,949) — (10,949) 3,648 ($14,597) 5,210 (1,239) — — (20,114) (16,143) 755 8,985 9,740 1,345 10,470 1,892 8,578 — 8,578 5,163 $3,415 4,966 (446) 8,414 612 — 13,546 724 11,682 12,406 — 45,151 2,273 42,878 28 42,850 5,373 $37,477 5,178 4,829 2,260 3,382 (5,504) 10,145 795 12,219 13,014 — 54,921 1,288 53,633 296 53,337 5,373 $47,964 Weighted average number of basic common shares outstanding Weighted average number of diluted common shares outstanding 123,693,851 123,693,851 158,632,865 158,703,614 181,767,106 189,952,159 205,092,330 213,455,555 Net (loss related) income available to common shareholders per average common share: Basic Diluted ($0.12) ($0.12) $0.02 $0.02 $0.21 $0.20 $0.23 $0.23 31 2006 ANNUAL REPORT Annaly Capital Management, Inc. The following is a presentation of the quarterly results of operations for the year ended December 31, 2005. (dollars in thousands, except per share data) Interest income Interest expense Net interest income Other income (loss): Investment advisory and service fees Gain (loss) on sale of Investment Securities Loss on other-than-temporarily impaired securities Total other income (loss) Expenses: Distribution Fees General and administrative expenses Total expenses March 31, 2005 $176,289 113,993 62,296 6,309 580 — 6,889 1,610 6,664 8,274 June 30, 2005 $171,595 133,758 37,837 9,669 11,435 — 21,104 2,126 6,800 8,926 September 30, 2005 December 31, 2005 $177,474 155,043 22,431 10,945 32 — 10,977 2,414 6,455 8,869 $179,688 165,766 13,922 8,702 (65,285) (83,098) (139,681) 1,850 6,359 8,209 Income (loss) before income taxes Income taxes Net income (loss) Dividends on preferred stock Net income available (loss related) to common shareholders Weighted average number of basic common shares outstanding Weighted average number of diluted common shares outstanding 60,911 1,578 59,333 3,648 $55,685 121,270,867 121,564,320 50,015 3,022 46,993 3,648 $43,345 121,740,256 122,013,050 24,539 3,353 21,186 3,648 $17,538 123,169,910 123,330,645 (133,968) 2,791 (136,759) 3,649) ($140,408) 123,684,931 123,684,931 Net income available (loss related) to common shareholders per average common share: Basic Diluted $0.46 $0.46 $0.36 $0.36 $0.14 $0.14 ($1.14) ($1.14) The following table sets forth, for the periods indicated, the high, low, and closing sales prices per share of our common stock as reported on the New York Stock Exchange composite tape and the cash dividends declared per share of our common stock. First Quarter ended March 31, 2006 Second Quarter ended June 30, 2006 Third Quarter ended September 30, 2006 Fourth Quarter ended December 31, 2006 First Quarter ended March 31, 2005 Second Quarter ended June 30, 2005 Third Quarter ended September 30, 2005 Fourth Quarter ended December 31, 2005 First Quarter ended March 31, 2006 Second Quarter ended June 30, 2006 Third Quarter ended September 30, 2006 Fourth Quarter ended December 31, 2006 First Quarter ended March 31, 2005 Second Quarter ended June 30, 2005 Third Quarter ended September 30, 2005 Fourth Quarter ended December 31, 2005 High $12.82 $14.04 $13.25 $14.42 High $20.01 $20.01 $18.05 $12.90 Close $12.14 $12.81 $13.14 $13.91 Close $18.76 $17.93 $12.95 $10.94 Stock Prices Low $11.34 $11.57 $12.17 $13.01 Low $17.34 $17.68 $12.49 $10.90 Common Dividends Declared Per Share $0.11 $0.13 $0.14 $0.19 $0.45 $0.36 $0.13 $0.10 We intend to pay quarterly dividends and to distribute to our stockholders all or substantially all of our taxable income in each year (subject to certain adjustments). This will enable us to qualify for the tax benefits accorded to a REIT under the Code. We have not established a minimum dividend pay- ment level and our ability to pay dividends may be adversely affected for the reasons described under the caption “Risk Factors.” All distributions will be made at the discretion of our board of directors and will depend on our earnings, our financial condition, maintenance of our REIT status and such other factors as our board of directors may deem relevant from time to time. No dividends can be paid on our common stock unless we have paid full cumulative dividends on our preferred stock. From the date of issuance of our preferred stock through December 31, 2006, we have paid full cumula- tive dividends on our preferred stock. 32 Annaly Capital Management, Inc. 2006 ANNUAL REPORT CORPORATE OFFICERS BOARD OF DIRECTORS CORPORATE HEADQUARTERS Michael A. J. Farrell Chairman of the Board, President & Chief Executive Officer Wellington J. Denahan-Norris Vice Chairman, Chief Investment Officer & Chief Operating Officer Kevin P. Brady Founder & Chief Executive Officer TaxStream Jonathan D. Green President & Chief Executive Officer Rockefeller Group International, Inc John A. Lambiase Former Managing Director Salomon Brothers, Inc E. Wayne Nordberg Senior Director Ingalls & Synder, LLC Donnell A. Segalas Managing Partner & Chief Executive Officer Pinnacle Asset Management, L.P. Michael A. J. Farrell Chairman of the Board, President & Chief Executive Officer Wellington J. Denahan-Norris Vice Chairman, Chief Investment Officer & Chief Operating Officer Kathryn F. Fagan Chief Financial Officer & Treasurer R. Nicholas Singh Executive Vice President, General Counsel, Secretary & Chief Compliance Officer James P. Fortescue Executive Vice President Head of Liabilities Kristopher Konrad Executive Vice President Co-Head of Portfolio Management Rose-Marie Lyght Executive Vice President Co-Head of Portfolio Management Jeremy Diamond Managing Director Ronald D. Kazel Managing Director Annaly Capital Management, Inc. 1211 Avenue of the Americas, Suite 2902 New York, NY 10036 LEGAL COUNSEL Kirkpatrick & Lockhart Preston Gates Ellis LLP 1601 K. Street, N.W. Washington, D.C. 20006 AUDITORS Deloitte & Touche LLP Two World Financial Center New York, NY 10281-1434 STOCK TRANSFER AGENT Shareholder inquiries concerning dividend payments, lost certificates, change of address: Mellon Investors Services, LLC P.O. Box 3315 South Hackensack, NJ 07606-1163 800-301-5234 www.melloninvestor.com/isd STOCK EXCHANGE LISTING The common stock is listed on the New York Stock Exchange (symbol: NLY). The Series A preferred stock is listed on the New York Stock Exchange (symbol: NLY-A). ANNUAL SHAREHOLDERS MEETING The Annual Meeting will be held Thursday, May 24, 2007 at 9:00 a.m. at: New York Marriott Marquis 1535 Broadway New York, NY 10036 SHAREHOLDER COMMUNICATIONS Copies of the Company’s Annual Report and 2006 Form 10-K may be obtained by writing the Secretary, by calling the investor relations hot line at 1–888–8annaly, or by visiting our website www.annaly.com. ADDITIONAL INFORMATION The Company has included as exhibits to its annual report on Form 10-K for fiscal year ended 2006 certificates of the Company’s Chief Executive Officer and Chief Financial Officer certifying the quality of the Company’s public disclosure controls, and the Company has submitted to the New York Stock Exchange (NYSE) in 2006, a certificate of the Company’s Chief Executive Officer certifying that he is not aware of any violations by the Company of the NYSE corporate governance listing standards. Annaly Capital Management, Inc. 1211 Avenue of the Americas Suite 2902 New York, NY 10036 1.888.8annaly www.annaly.com