Chimera Investment Corp. (NYSE:CIM) is a REIT that invests directly, or indirectly, in mortgage-backed securities (MBS), the majority of which are residential (RMBS). Chimera sports a high yield as many view the assets it is investing in as risky; after all, they are partly responsible for the near collapse of our financial system.
Chimera’s investment portfolio as of September 30 is as follows:
- Non-agency MBS: $4.9 billion
- Senior notes: $1.065 billion
- Subordinated:$1.867 billion
- Senior non-retained*:$1.968 billion
- Agency MBS: $1.884 billion
- Securities held for investment: $389 million
- Total*:$5.205 billion
*For the purpose of this analysis the $1.968 billion of senior non-retained securities are excluded. It is my understanding that these notes are ones that have been re-securitized and sold to third parties. They are of no future benefit to the company and there is no further future recourse to Chimera from them. As such, there is no further value added from these assets.
In the most recent quarter, these $5.205 billion in investments had an average yield of 9.02%. The average cost of funds for the most recent quarter was 4.58%. These figures resulted in a spread of 4.44% in the most recent quarter as compared to 5.56% in June 2010. This 4.44% yield on investment resulted in a 17.39% return on average equity for the quarter ending September 30th, 2010.
The 4.44% yield on $5.205 billion in investments should result in earnings of $231.1 million. These earnings should increase in the near future as the most recent spread was partly depressed due to the management investing proceeds from previous offerings late in the 3Q where their full effect could not be noticed. These depressed earnings produced a return of $0.069 for each current share outstanding for this quarter.
Chimera also makes money from securitizing RMBS that it owns and selling them to other investors. Chimera typically sells the senior notes and retains the subordinate tranches. The result of this will typically be a lowering of the dollar amount in senior notes that are retained by the company (listed above) while increasing the amount of subordinated notes (also listed above). In the most recent quarter Chimera sold $920.4 million of such securities for net proceeds of $74.5 million; however, this did not contribute to earnings in either of the first two quarters.
Chimera also achieves earnings through the accretion of the securities that it has purchased at a discount. This can be a significant sum in some cases. The net accretion for June and September respectively was $65 million and $69.1 million. Chimera mentioned in its 3Q 10-Q that there is still $2.2 billion remaining of discounts to be accreted. The $69.1 million results in EPS of $0.078.
Lastly, Chimera is able to sell some of the RMBS it invests in for a profit. In the most recent quarter Chimera sold $206 million of such assets for a gain of $2 million which is negligible in terms of EPS.
Chimera will have deductions from these earnings as well. Other than temporary impairments to the valuation of its investments will force non-cash expenses to be taken on the income statement. Over the past four quarters they have average about $12.557 million.
Chimera has also been purchasing interest rate swaps to help it hedge against movements in interest rates. In most recent quarters these have also averaged a loss of about $12.410 million.
There is also the management fee that Chimera pays FIDAC to help manage its portfolio of real estate. This management fee was most recently $11.318 million in the most recent quarter.
Lastly, there are “other gains or losses” that contribute or reduce the company’s earnings. The average loss over the past four quarters has been $2.561 million.
If you tally all of this together we see that Chimera has earnings potential that should average a minimum $114.675 million per quarter. This represents $0.13 per share per quarter or $0.52 annualized. Since Chimera is a REIT its value is based more on a metric called “core earnings” rather than GAAP earnings. core earnings calculates earnings slightly differently to emulate the actual income that a REIT has available to pay out to shareholders. Chimera’s core earnings for the 3Q were $139 million which is about $0.16 per share.
Lots of investors feel that Chimera’s continuous dilutive offerings are bad for current investors; however, past performance has shown that the company has been able to put these proceeds to good use. Even though the current earnings this quarter were satisfactory, they were lower than the previous quarter. According to the management, this was a result of the cash received from the previous offerings being deployed late in the quarter. So despite near-term negatives from dilution, the long-term picture looks better.
Chimera’s agency portfolio has returns that guaranteed by Fannie Mae and Freddie Mac so these investments should be relatively safe in their return.
Chimera’s non-agency investment portfolio:
The weighted average life of the securities in this portfolio fall into two categories: 47% of the securities have a WAL from 1-5 years while most of the remainder exhibit WALs higher than 5 years. The weighted average Life takes into consideration prepayment speeds, interest rates, and other factors. This measure basically means that about 47% of the principal value outstanding will be paid back within five years and the remainder will take longer than 5 years to recover This makes sense given that prepayment typically increases during periods of low-interest rates as more borrowers refinance at lower rates. As rates rise it can be expected for the weighted average life of this portfolio to extend.
The average FICO for Chimera’s non-agency investment portfolio is 715.6 which is still in the range of good credit. The average loan balance is $421,300 with 83% being owner occupied. Owner occupied buildings are supposed to be less likely to default than other types of mortgage owners all other things being equal. These mortgages have an intense concentration in California with 57.3% of the mortgages originating there which is part of why Chimera is viewed as so risky.
Lastly, the portfolio has an average amortized loan to value of 72.9%. This represents that average amount that was borrowed for the properties which means that owners have an average of 27.1% equity in their homes at the time of loan origination. Most of these loans were originated in 2007. It is true that home prices have fallen significantly since then, especially in California; hopefully this 27% equity has provided a buffer to homeowners from being turned upside-down on their mortgages.
While this may be the case for some, there are parts of the country where even this 27% equity + 3 years of interest/principal payments would still not be enough to prevent from being upside-down on the mortgage. This may very well be the case with several of the properties owned in California This is a dangerous situation because it gives mortgage owners an incentive to stop paying their mortgage and homeowners will find it difficult to refinance if they owe more on their house than it is currently worth.
Rising Interest Rates
So what effect would rising interest rates have on Chimera’s portfolio?
Chimera has estimated that a 0.25% rise in interest rates would result in increased Net Income by about 4.42% while reducing the overall carrying value of their portfolios by 1.46%. After a 0.75% rise in interest rates, Net Income is expected to rise by 11.46% and the portfolio’s value is expected to fall by 4.29%. These figures make sense because more than half of Chimera’s investments are in Adjustable Rate Mortgages whose rates should reset to higher rates in a rising rate environment. The reduction of the portfolio also makes sense as it is typically for fixed income investments to suffer in the event of rising interest rates as the discount rate used to value their cash flow grows.
An environment of rising rates provides the potential for earnings growth as well as what should occur from fewer defaults in the economy (which may be likely if the economy is growing quickly enough to warrant rising rates).
In conclusion, it seems that Chimera is a riskier REIT to invest in but it rewards investors who are willing to take that risk. Chimera tries to manage its downside by being completely transparent with shareholders as well as keeping leverage levels within a reasonable level (Chimera is currently leverage 1.3:1, compare that to the 6:1 ratio displayed by some other REITs in more conservative investments). Also, Chimera’s track record has shown that the management seems to be able to create profits despite the tough conditions within the real estate markets.
Chimera may be risky but I do not believe that this risk merits the current 17% yield found on the stock. A look at Chimera's past performance displays that this is a company that knows what it is doing in the current environment. I think if Chimera can continue to display operating results similar to the ones that it has been attaining then we will see a significant upward trend in the shares of this stock. Even in an environment of rising interest rates, Chimera is set to benefit from increased income through its ARM investments. Ultimately, the current yield should more than make up for the risk investors are taking.
Disclosure: Author is long CIM. Author has little to no experience as a a real-estate investor and has adopted this approach as an attempt to learn more about the industry. Any stocks mentioned are merely examples selected for research and any investor should conduct their own due diligence before taking anything in this article as a serious recommendation. As always, feedback is welcome.