Annaly, Chimera And CreXus May Soon Combine Into One Diversified Mortgage REIT

Includes: CIM, CXS, NLY, STWD
by: Zvi Bar

Last week, at a time when most companies had already reported their 2012 results, or were about to do so, Chimera Investment Corp. (NYSE:CIM) filed its 2011 10-K annual report. The mortgage REIT had not filed any reports in several quarters, and in February, the New York Stock Exchange (NYSE) gave the company a third and final extension for continued listing and trading of the company's stock on its exchange. Chimera is yet to file any results for 2012, but is expected to do so within the next two months.

In many ways, Chimera could not do much more harm to itself with even a terrible result for 2011 than it had already caused through its failure to report. At this point, stating anything was better than the continued silence, as the mere action of filing a 10-K for 2011 will allow Chimera to stay listed on the NYSE. A delisting would have likely sent many investors running from the still speculative mREIT.

For 2011, Chimera reported net interest income of $570 million and an other-than-temporary impairment ("OTTI") loss of $419 million. The mortgage REIT also reported that its OTTI losses for 2010 totaled $295 million, and $290 million in 2009. More OTTI losses are likely within 2012, with the precise sum still yet to be disclosed.

Chimera is a hybrid non-agency mortgage REIT. Mortgage REITs (mREITs) buy mortgage paper as an investment, or in order to re-securitize them and sell them to another mREIT or some other entity that is investing in real estate loans. Non-agency and/or hybrid mREITs like Chimera hold mortgage paper without government agency backing, but Chimera also holds agency-backed paper. Chimera is related to Annaly Capital Management (NYSE:NLY), the largest agency-only mREIT, and is managed by FIDAC, a wholly-owned subsidiary of Annaly.

With each filing extension Chimera announced between late 2011 and early 2013, the company commented that its accounting problems are related to the application of generally accepted accounting principles (GAAP) to its non-agency residential mortgage-backed securities portfolio. Chimera also indicated that its accounting issues relate to OTTI treatment regarding non-agency residential mortgage-backed securities that are rated as junk.

Much of Chimera's accounting problem likely originated from its ownership of non-agency RMBS paper that existed before 2008, and which initially traded with exceptionally high credit ratings before being downgraded to junk. The company's repackaging and selling portions of those downgraded securities further complicated Chimera's accounting.

Chimera's problematic accounting issues had made legitimate fundamental analysis of Chimera impossible. This recent filing and the probable filing of 2012 results in the near future should change this. Beyond giving analysts numbers on which to base estimates, the removal of some uncertainty through the very act of filing has removed a tremendous fog of uncertainty that surrounded Chimera. While many questions clearly remain, at the very least, the potential for the mREIT to be delisted is now minimized. Instead, of a delisting, now the market is transitioning to the heightened potential for Chimera to become acquired by Annaly.

Annaly Capital Management Inc. recently agreed to purchase the shares of CreXus Investment Corp. (NYSE:CXS) it doesn't already own for about $872 million, valuing the company at $996 million. Annaly owns 12.4 percent of CreXus and the commercial mREIT is managed by FIDAC, a wholly-owned subsidiary of Annaly. Chimera is similarly managed by FIDAC and Annaly has a similar ownership interest in it.

The terms of the agreement allow CreXus to pursue alternatives to the deal though March 16, and CreXus has indicated that a special committee and independent advisers will "actively solicit" other options. On March 15, CXS announced that it would pay a quarterly dividend of $0.25, which is a 21.8% reduction from the $0.32 it paid last quarter. It is unclear whether this dividend cut is due to reduced spreads at CreXus, or because Annaly and CreXus wish to keep some more of its cash within the business, pre-acquisition.

At the time Annaly made its initial bid for CreXus, Wellington Denahan, Annaly's chairman and CEO, commented that:

"Since our inception in 1997, Annaly has maintained the capacity to diversify its asset base to include real estate related assets in addition to Agency mortgage-backed securities if we determined that compelling other long-term investment opportunities exist relative to the Agency market. While we remain committed to the Agency market, given the current environment, we believe it is prudent to diversify a portion of our investment portfolio. Therefore, we may allocate up to 25% of our shareholders' equity to real estate assets other than Agency mortgage-backed securities.

A powerful step in this direction is the proposed acquisition of CreXus. We believe that wholly owning the commercial real estate platform we currently manage through FIDAC is complementary to our existing business and return profile and should provide stable and diversified risk-adjusted returns to our shareholders."

This statement indicated that Annaly might make other acquisitions beyond CreXus and commercial mortgage paper. Annaly's CFO and Treasurer, Kathryn Fagan, commented on its relationship with CreXus and Chimera during the company's last conference call, noting that:

"Annaly's participation has been as an equity owner in those companies, and part of the reason for the CreXus transaction is that we do need to remove some of the conflicts I guess, of being able to expand those positions on our own balance sheet while we have these public companies out there that we manage."

Fagan's statement indicated that if Annaly should choose to accumulate non-agency RMBSs, much like it is accumulate CMBSs through the CreXus acquisition, it will likely have a similar conflict that would potentially obligate Annaly to first acquire Chimera.

This coming week, CreXus should indicate whether it has received any other offers. It is entirely possible that another interested buyer may emerge. For example, in 2011 Starwood Property Trust (NYSE:STWD) made an unsolicited bid of $14 per share for CreXus back in 2011, which CXS turned down. Starwood may still be interested in the assets, as might others.

Both Chimera and Annaly (through FIDAC's management) may end up having some civil liability, or at least the need to defend claims relating to their possible mismanagement and faulty prior accounting relating to Chimera's assets. Chimera "paid FIDAC a management fee of $52.0 million, $40.9 million and $25.7 million for the years ended December 31, 2011, 2010 and 2009, respectively." FIDAC was paid a management fee of 1.5% of shareholder equity until November of 2012, when the fee was halved. Issues relating to prior actions will likely not emerge until Chimera files its 2012 reports.

After those reports are filed, and provided Annaly does successfully acquire CreXus, a bid for Chimera appears of ever growing probability.

Disclosure: I am long CIM, NLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.