Chimera: A Contrarian mREIT With Confident Insiders

| About: Chimera Investment (CIM)

Chimera Investment Management (CIM) appears to be the contrarian’s option amongst Mortgage REIT equities.

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. Agency mREITs, such as Annaly Capital Management, Inc (NLY), American Capital Agency Corp (AGNC) and Hatteras Financial Corp (HTS), buy mortgage paper that is backed by federal agencies. Non-agency mREITs like Chimera, MFA Financial (MFA) and Invesco Mortgage Capital (IVR) also hold mortgage paper without government agency backing, though these companies also can and do buy large positions in agency paper.

These non-agency mREITs are also sometimes called hybrid mREITs, where they also own agency paper. Some non-agency debt is collateralized by the underlying property, while other debt is non-recourse. There are four primary categories of non-agency mortgages:

  1. Prime mortgages: High-quality mortgages that meet rigorous underwriting requirements, similar to those used for agency mortgages. Such loans are usually non-agency because the balances are above what Fannie and Freddie allows. Prime mortgage loans have historically carried low default risk because they are usually made to high-credit quality borrowers.

  2. Alternative-A [Alt-A] mortgages: Alt-A loans are usually provided to borrowers with average or above average credit scores, and have historically required looser loan documentation requirements and allowed larger loan sizes than under agency underwriting guidelines.

  3. Option Adjustable Rate Mortgages (Option ARMs): Option ARMs are a specific hybrid type of Alt-A mortgage that has flexible repayment terms. Option ARM mortgages allow for interest-only payments and sometimes even less than interest due payments. The loan balance of an Option ARM can increase over time (negative amortization in lending jargon). Such loans are designed to start with an exceedingly below average rate of interest, usually called a teaser rate, to attract borrowers.

  4. Subprime: Subprime mortgages are provided to borrowers with low credit ratings due to a damning or limited credit history. Subprime mortgages usually require minimal income and asset verification and carry high default risk. Lenders usually charge Subprime borrowers a higher than average interest rate.

Chimera was founded in late 2007 and is in many ways a spin-off of Annaly. Chimera was created to buy non-agency paper that was then starting to lose value. Chimera was initially highly leveraged. Chimera started doing this too early, and as the real estate and equity markets began to fall in 2008 and 2009 Chimera was forced to deleverage. Chimera now has a leverage rate of about 1.9x, which is considerably below the general leverage rates for mREITs.

Hybrid and/or non-agency mREITs usually have lower leverage rates than the agency mREIT's based upon their risk characteristics. At first, Chimera held far more non-agency paper than it now holds. During 2008, the REIT was forced to deleverage. In the process, Chimera had to get rid of some of its portfolio. Since doing that, Chimera has been happy to continue holding onto those non-agency mortgages it then chose to keep.
Chimera now holds about 70% of its assets in non-agency mortgage paper. Last year, Chimera had about 80% of its assets in non-agency paper. Over the past year, Chimera has primarily acquired agency paper, increasing that stake from under 15% to over 25% of its portfolio.

Within 2011, Chimera and most other mREITs with non-agency exposure began to severely underperform agency mREITs. Chimera is now trading at slightly above $3 a share. At this price, it is considered a penny stock by most standards, and many funds are restricted from owning it. As a result, there is also no real interest in institutional promotion of Chimera.

At $3, Chimera is trading at about a 88% of it's book value, which is below the present average price to book for a mREIT. Currently, most agency mREITs are trading above their book values. Some may note that the fair value of some of Chimera's non-agency assets is below Chimera's cost-basis, but much of that should be expected based upon the income provided since purchase. Chimera has since primarily distributed that income to the shareholders, while also adding to their lower risk agency allocation. This agency paper has since gained value. At the same time, those paper losses on the non-agency positions should provide future unrealized tax write-offs.

Since the start of May, Chimera has lost approximately 25% of its price per share. As the market recently entered this recent sell-off period, several Chimera insiders chose to accumulate positions. In fact, seven Chimera insiders purchased between 9,000 and 100,000 shares during the first 2 weeks of August, at prices between $3 and $3.17. Several of these insiders have shown historical prowess at accumulating Chimera stock, often adding shares during such sell-offs or after secondary offerings.

Chimera's non-agency paper is now primarily rated below B, or non-investment grade, which also triggers many fund restrictions. This is also how Chimera obtains such a lofty yield without the using the mREIT industry standard higher leverage method. Essentially, Chimera substitutes leverage for junk-bond like default risk. The question remains, of course, how worthwhile are these junk ratings?

Do keep in mind that the vast majority of U.S. mortgage securities were highly rated before the MBS market collapsed. Chimera's non-agency paper originated between 2006 and 2008, as real estate prices and mortgages peaked. Some of the worst junk mortgages were made at this point in time. Many have defaulted and more should when the Alt-A and ARM types adjust. Most were set to reset after 3 or 5 years, so the remaining adjustments should occur between now and 2013. If yields were to spike up before non-agency defaults do, Chimera could still potentially leverage up on then devalued agency paper. To the contrary, most other mREITs would have to then deleverage.

Additionally, not all non-agency paper must default. Some mortgages will likely refinance prior to resetting, especially during this extended low-rate period. Others may simply continue to exist, especially where fixed at a reasonably low rate. In the meantime, Chimera has continued to temper its mortgage portfolio with agency paper. This, combined with Chimera’s reluctance to buy more non-agency paper or sell that which they already hold, appears to indicate that Chimera’s management does not believe they can obtain non-agency paper of the same quality. Essentially, not all junk is equal and Chimera may have some of the better junk.

Chimera offers significant yield and some very real risk. Exposure to it should be limited to a reasonable portion of any portfolio, with the understanding that the majority of its assets are not investment grade and carry a significant risk profile. Should you be interested in investing more broadly in this sector, iShares offers the FTSE NAREIT Mortgage REITs Index ETF (NYSEARCA:REM), and Van Eck offers the Market Vectors Mortgage REIT Income ETF (NYSEARCA:MORT).

Disclaimer: This article is intended to be informative and should not be construed as personalized advice, as it does not take into account your specific situation or objectives.

Disclosure: I am long NLY, CIM.