Why I'm Long Mortgage REIT Chimera

It's hard to find value these days in the market. However, I believe the whole agency REIT space is still attractively valued. I think CIM is a special case where it will provide the same yield as agencies but with an optionality on returning leverage.

IPOed at the worst possible time. When Chimera (CIM) first IPOed on 11/15/07, the vehicle was supposed to achieve return on equity (ROE) in the low teens by investing in non-agency residential mortgage-backed securities (RMBS) and other loans, while funding purchases with repos and lines of credit, resulting in a ROE model that looks something like:

Asset yield 6.5%
Cost of funds 5.0%
Spread 1.5%

Leverage 7x
Levered yield 10.5%
Equity yield 6.5%
Mgmt Fees,G&A 3%

ROE 14%

CIM raised 500mm in IPO. They were supposed to build the portfolio over a period of six months.

Then, the world fell apart... CIM's leverage got as high as 4x by 08Q1, but they had to sell some securities to mitigate funding risks and ended the quarter with 3.4x leverage. As the credit markets blew up in the next few quarters, non-agency paper continued to lose value, while funding them with repos became harder and harder as institutions tightened their quality of acceptable collateral (non-agencies weren't making the cut).

Furthermore, banks were also reluctant to lend as many uncommitted lines of credit became useless. It was the perfect storm, forcing Chimera to sell assets at a huge loss. Book value declined by about 80% as they realized close to $150mm in losses from investments sold from Q1-Q3 and received low marks on the rest of the portfolio... stock went from $20 to $2.

The bottom? No leverage = no margin calls. For most of 09Q1 and 09Q2, according to several publicly traded mortgage REITs, non-agency paper could be bought on an UNLEVERED basis for yield-to-maturity of mid-to-high teens after adjusting for loss provisions. This means if these RMBS PMs have done their modeling correctly (and that's a big if, which I will address later), shareholders would be able to "clip" 15%+ percentage coupons. I put "clip" in quotes because a good portion of the return will be from amortization of discount, which will complicate cash flow around dividend payments. CIM said on their 09Q1 call that it wasn't an issue yet, but the non-agency book has tripled since then. CIM will probably need to further tap the Annaly (NLY) repo line.

The stock went from $20 to $2. How can you trust management? Look, they got caught in a vise because of macro conditions; many people did during 2008. T-bills were trading at negative yields for crying out loud; I don't think anybody expected that. CIM's paper, of course, is on the polar opposite side of the risk spectrum. So if chances are that I will never see in my life time appreciation of t-bills like that again, then chances are that I will never see destruction in structured products like that again either. For that reason, I'm willing to give them a pass.

Mike Farrell's (CEO of Annaly) conservatism and recent macro data makes me sleep better at night. Although low, delinquencies are rising in the portfolio. Since Mike Farrell is staunchly in the "no greenshoots" camp, you would think PMs at Chimera model loss assumptions very conservatively. Against his bearish outlook, the stabilization of median home price and employment data in recent months might give CIM's portfolio more margin of safety and possible upside.

Barney Frank is the wild card. Cramdown, according to CIM, will not "increase the cumulative losses", but "alter the way losses are distributed throughout the capital structure" (08Q4 earnings call). To read about recent cramdown threats by Frank, click here. I hate politics. It gives me a headache. Please help me monitor this risk if you get involved.

How does the stock double or triple? This is the hard part. The company needs to leverage a teens ROA a few times; the problem is funding. Borrowing a poker term, your outs for possible funding sources are 1) repo 2) re-REMIC 3) TALF II. None of them looks that good for now. For that reason, until the company can show it can increase leverage, it's probably not worth more than $4 (slight under 15% yield on 2010 dividends).

Their best chance for re-leverage currently is to do a re-REMIC, which is hard to sell right now. However, I do believe people's appetite for structured products will return if the yields are attractive enough, which will result in a higher funding cost to CIM. But if CIM can continue to purchase assets with such attractive yields, there will be plenty of spread left for CIM despite the higher cost. And if they can't buy assets at attractive yields, then that means their owns assets have appreciated. Book value will jump and you will make money either way.

Disclosure: Long CIM

Comments

[MrLucky:]

Excellent overview. Mortgage REITs are in a sweet spot right now, and not well understood by many market participants.

Sep 01 06:21 AM

[Jonathan Ch...:]

Financial Hippie is correct that CIM is presently a relatively low risk purchase with a current dividend of about 8% and potential for increase in stock price and dividend as the investment environment improves and they can expand their leverage.

Additionally, since their P/B is 1.31, they can continue to increase earnings, and earnings per share by issuing more stock without dilution of equity.

I purchased CIM right after the initial offering and had a big loss in the stock as the error in timing became apparent. I had thought they would wait to invest (considering the uncertainties at that time) and was very disappointed in their performance. I am willing to give them one more chance, especially since I have been a long tern investor in NLY and think that Mike Ferrell does a good job.

Currently long on NLY and CIM

Sep 01 07:25 AM

[Pullease:]

Keep in mind that the PPIP will be barging into that market (MBS) with $45 Billion and bidding up the whole market shortly. This has gotten no coverage. The CIM book value should scream. These MBS are one of the best bond investments extant right now. Just ask John Paulson!

Sep 01 10:03 AM

[Patrick Harden:]

I'm not entirely sure that I buy into Annaly's divide and conquer methodology on the distressed debt orgy. First of all, they were way too early in effectively calling the non-agency backed RMBS bottom with the Chimera IPO. On the heels of that disaster, Annaly now has another spinoff for the commercial side of the house in CreXus (how do you even pronounce that?).

I'm not convinced that the Annaly machine has enough experience outside of the agency arena to run either REIT, frankly. Chimera's only defensive strategy during the 2008 crisis was to launch one dilutive secondary after another -- perhaps just throwing good money after bad in an attempt to bury bad paper deep in the portfolio.

I think investors stand a better shot with Redwood Trust (RWT), which has much more relevant experience in non-agency MBS than Chimera & crew. Even one of the newly launched vulture REITs will have a cleaner balance sheet and less share dilution.

Sep 01 01:53 PM

[drbob66:]

NLY just boosted their quarterly dividend to $.69 last night (now yielding 14%)...this stock has been a monster for me this year, so I say THANKS to Mike Farrell and all the dedicated employees at Annaly for making me mucho dinero! Keep up the good work!

Sorry, Patrick, RWT looks nice, but they're only paying 6% divy at the moment. I'd buy ANH or CMO before RWT...but I have enough money in REITs right now, so I'm holding my NLY and some ANH bought earlier this year.


On Sep 01 01:53 PM Patrick Harden wrote:

> I'm not entirely sure that I buy into Annaly's divide and conquer
> methodology on the distressed debt orgy. First of all, they were
> way too early in effectively calling the non-agency backed RMBS bottom
> with the Chimera IPO. On the heels of that disaster, Annaly now
> has another spinoff for the commercial side of the house in CreXus
> (how do you even pronounce that?).
>
> I'm not convinced that the Annaly machine has enough experience outside
> of the agency arena to run either REIT, frankly. Chimera's only
> defensive strategy during the 2008 crisis was to launch one dilutive
> secondary after another -- perhaps just throwing good money after
> bad in an attempt to bury bad paper deep in the portfolio.
>
> I think investors stand a better shot with Redwood Trust (seekingalpha.com/symbo...),
> which has much more relevant experience in non-agency MBS than Chimera
> & crew. Even one of the newly launched vulture REITs will have
> a cleaner balance sheet and less share dilution.

Sep 22 06:02 PM

[claudio.lan...:]

Redwood trust is one of 20 companies that are expected to go bankrupt this year. This is along with Riteaid, and 18 others.

Sep 26 11:10 AM