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Chimera Investment Corporation (NYSE:CIM)

Q3 2011 Earnings Call

November 21, 2011 10:00 a.m. ET

Executives

Matthew Lambiase - President and Chief Executive Officer

Christian Woschenko - Head, Investments

Alexandra Denahan - Chief Financial Officer

William Dyer - Head of Underwriting

Jay Diamond - Managing Director, FIDAC, Member of Chimera’s Board of Directors

Choudhary Yarlagadda - Head of Structuring at FIDAC

Analysts

Bose George - Keefe, Bruyette & Woods

Jason Weaver - Sterne Agee

Steven DeLaney - JMP Securities

Daniel Furtado - Jefferies

Arren Cyganovich - Evercore Partners

Operator

Good morning and welcome to the Third Quarter Earnings Call for Chimera Investment Corporation. At this time, I would like to inform you that this event is being recorded and that all participants are in a listen-only mode. (Operator Instructions) At the request of the company, we will open the conference up to questions and answers after the presentation.

Unidentified Company Representative

This earnings call may contain certain forward-looking statements within the meaning of Section 27-A of the Securities Act of 1933 and Section 21-E 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, our business and investment strategy; our projected financial and operating results; our ability to maintain existing financing arrangements, obtain future financing arrangements and the terms of such arrangements; general volatility of the securities markets in which we invest; the implementation, timing and impact of and changes to various government programs affecting the capital markets and the economy. Our expected investments; changes in the value of our investments; interest rate mismatches between our investments and our borrowings used to funds such purchases; changes in interest rates and mortgage prepayment rates; effects of interest rate caps on our adjustable rate investments; rates of default or decreased recovery rates on our investments; prepayments of the mortgage and other loans underlying our mortgage-backed or other asset-backed securities; the degree to which our hedging strategies may or may not protect us from interest rate volatility; impact of and changes in governmental regulations; tax law, and rates; accounting guidance and similar matters; availability of investment opportunities in real estate-related and other securities; availability of qualified personnel; estimates relating to our ability to make distributions to our stockholders in the future; our understanding of our competition and market trends in our industry, interest rates, the debt securities markets or the general economy.

For a discussion of the risks and uncertainties which could cause actual results to differ from those contained in the forward-looking statements, see risk factors in our most recent annual report on Form 10-K 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 unanticipated events or circumstances after the date of such statements.

Operator

I will now turn the conference over to Mr. Matthew Lambiase, President and Chief Executive Officer. Please proceed, sir.

Matthew Lambiase

Thank you, Andrew. Good morning and welcome to the third quarter 2011 Chimera Investment Corporation earnings call. This is Matt Lambiase, President and CEO, and joining me on the call this morning I have Alex Denahan, our CFO; Chris Woschenko, the Head of Investments; Bill Dyer, our Head of Underwriting; Choudhary Yarlagadda, the Head of Structuring at FIDAC; and Jay Diamond, the Managing Director at FIDAC and a member of Chimera’s Board of Directors. We are here to answer questions after the prepared comments.

On November 18, the company filed its third quarter 2011 10-Q. We made the filing later than usual because in conjunction with the review by our independent auditors we determined that ASC 325 should be applied to determine the GAAP treatment of other than temporary impairments or OTTI related to our securities rated less then AA, as well as non-rated non-agency RMBS and other subordinated RMBS that are not of high credit quality. And that, that analysis had not been completed.

The analysis is now complete and after my comments Alex will give a detailed explanation of ASC 325, as well as a discussion on how the OTTI changes will be reflected in our GAAP reporting going forward. However, I think it’s important for investors to understand that this analysis is a non-cash change in our GAAP accounting results. This does not affect our previously announced book value or taxable income in any period. Chimera pays its dividends based upon its taxable income not GAAP income. So the results of the change of evaluation to ASC 325 will have no impact on the company's prior or future dividend distribution.

Now this morning there are two items influencing our operating environment that I would like to discuss. First, as you know the financial markets continue to be turbulent and the recent news of sovereign debt deals in Europe’s welcome but probably not sufficient to calm the markets of the doubts of capital adequacy of its European banks. European banks may be forced to raise large amounts of capital and require to sell assets in the near future. In our opinion it’s most likely that they will see non-core, non-European assets like U.S. dollar denominated mortgage backed securities, CMBS or corporate bonds. When this happens, there may be a significant opportunity for those companies that have the ability like Chimera and the liquidity to take advantage of the selling.

Since the first quarter of this year, Chimera has adopted a conservative low leverage strategy which allows us great flexibility in the current market. We deliberately remove repo leverage from our credit investments and now 100% of our recourse borrowings are backed by U.S. agency mortgage backed securities. Because the Company is operating at 1.2 to 1 recourse leverage ratio, we have the ability to either increase our leverage or sell highly liquid U.S. agency mortgage backed securities in order to buy distressed assets in the future should the opportunity arise.

Second, there has been a major change in the jumbo prime lending landscape. On October 1, Fannie Mae and Freddie Mac reduced the conforming loan balance and now $625,000 is the largest amount that they will guarantee. In the past few years, it’s been very difficult for private capital to compete with the efficiencies of the U.S. agencies, and now lowering the conforming loan balance should create opportunities for companies like Chimera who wish to purchase and securitize new jumbo prime mortgages.

We believe recently originated mortgages represent some of the best credit and underwriting standards seen in the industry in a very long time. Mortgage borrowers today submit to a thorough credit review, and are also required to put significant money down in order to secure a loan. In late 2007 and early 2008, the company underwrote, purchased and securitized over $750 million jumbo prime mortgages, and those mortgages were tightly underwritten and have had excellent performance to date.

The destruction of the mortgage securitization market and the encroachment of Fannie Mae and Freddie Mac into the jumbo prime mortgage space, made it difficult to consummate profitable securitization since 2008. However, we believe this will be changing in the near future and Chimera, which maintained its underwriting and structuring abilities, will be able to capitalize on the new opportunity. Sourcing recently originated jumbo mortgages, securitizing them, should create high yielding, long duration investments, backed by well-underwritten credit that will benefit Chimera into the future.

I believe the company is currently very well positioned. We continue to produce high real returns by operating at low leverage and maintaining significant liquidity. Chimera will be able to take advantage of asset sales out of European banks, if the prices are attractive. And as we look to the future, we continue to lay the foundation of our new jumbo prime mortgage securitization platform. We expect to see more jumbo securitizations in 2012, and we want to be a meaningful participant in that developing market. The historical rates of return on the jumbo prime securitization business are attractive, and we believe Chimera has both the capital and expertise to develop a meaningful franchise in the quarters ahead

And with that I will turn it over to Alex to discuss the recent accounting developments.

Alexandra Denahan

As Matt stated, during our quarterly review we determined that the application of ASC 325-40, investments and other beneficial interest in securitized financial assets, should be applied rather than ASC 320-10, investments in debt and equity securities. And evaluating our non-agency RMBS that are not of high credit quality for OTTI and the related interest income recognition. The company considers a non-agency RMBS to be not of high credit quality when it does not have an actual or implied rating of AA or higher at the time of acquisition.

The difference between the two methodologies as explained in further details in footnote 17 of our 10-Q, lies primarily in the impact of timing of cash flows on recognition of impairments, and the determination of yields. It does not affect the actual cash flows we receive from those assets or the severity of losses on those assets or how those losses compare to our expectations. Notably, this analysis had no effect on the fair value of those assets, thus our book value was not affected.

We will prospectively correct these immaterial misstatements over the coming four quarters in Chimera’s financial statements. The cumulative net effect on Chimera’s previously reported financial statements is a decline in GAAP net income of approximately $16.2 million over the previous six quarters or less than 2% of previously reported GAAP net income. We have removed the reference to core income from our press release as the application of this standard does not permit the company to disclose data in a manner that would facilitate a meaningful calculation of core income from the GAAP financial statements.

As a REIT, we are required to distribute 90% of our taxable income and going forward we encourage users of our financial statements to consider the quarterly dividend we declare to be a proxy for estimated taxable income. We expect the application of this standard may increase volatility in our GAAP reported earnings by taking impairments in one quarter followed by increasing accretion in future periods. We encourage you to review the disclosure in our Form 10-Q for more detailed information surrounding this change.

We will now turn the call back over to Andrew to answer any questions you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Bose George of KBW. Please go ahead.

Bose George - Keefe, Bruyette & Woods

Good morning. I had a couple of things. First, it looks like the discount accretion for the years that number has been restated higher. I was just wondering does that change also tie into the OTTI accounting change or is that something different?

Alexandra Denahan

Right. So the change in the OTTI impairment will essentially cause us to write down a bond in a current period to a lower cost basis and then future periods accrete a higher amount of discount. So you will see an impairment today being picked up as accretable discount in future periods.

Bose George - Keefe, Bruyette & Woods

So did you, sort of, retroactively write down bonds and then as a result there was just more accretion that went through the earnings in the last couple of quarters?

Alexandra Denahan

Sure. We re-evaluated every CUSIP in the portfolio from 2007 forward that this may have applied to, to determine the impact in each quarter and rolled it forward through every quarter. And that change, as I said earlier, was approximately $16 million.

Bose George - Keefe, Bruyette & Woods

Okay. And then just switching to the REIT taxable income, the $0.13 that you guys had for the quarter. I was just wondering how that was calculated just when we think of that as a sort of the core number. I just wanted to make sure I figure out how that was calculated?

Alexandra Denahan

When the taxable income number that we declare when we declare a dividend, we run our actual cash flows for tax and calculate our estimate of taxable income. Now, tax is slightly different than GAAP, or in this case, more different than GAAP than it used to be. And so we declared the dividend based on our estimate of taxable income. As we have stated...

Bose George - Keefe, Bruyette & Woods

Is there, kind of some, easy way for us to do it off the GAAP financials, because I wasn’t fully able to reconcile the GAAP financials with the REIT taxable income number?

Alexandra Denahan

Unfortunately, we used to disclose, what was credit losses actually principal write-downs in the financials. And we no longer, using 325, will disclose that line item. So it is difficult for us to tell you to back out a GAAP line items to get to a proxy for core. It’s no longer there for you. And that’s why we rather point you to what we declare in the dividend, simply because that should be -- we have to declare 90% of our income. So that should be a very good proxy for what our tax is.

Bose George - Keefe, Bruyette & Woods

Okay. But just in terms of forecasting it, I guess, it makes -- it does make it somewhat challenging for us, right. Since we -- because the interest income won’t capture that and some portion of the loss we have to include but it’s kind of hard, I guess, for us to figure out that number. Is that fair?

Alexandra Denahan

Right. That’s a fair statement. Unfortunately, the changes in GAAP are not necessarily more transparent, and so we are losing a data point that used to allow you to get there.

Operator

The next question comes from Jason Weaver of Sterne Agee. Please go ahead.

Jason Weaver - Sterne Agee

Hi, thank you for taking my question. Just had one clarification that I was struggling to figure out. Your entire purchase discount on the non-agency allocation, is that what your level accreting into your income per quarter?

Alexandra Denahan

We are accreting that discount based on the loss adjusted yields. So we do not accrete to par, we accrete to an expectation of recovery on an asset.

Jason Weaver - Sterne Agee

You don’t disclose that though, do you?

Alexandra Denahan

No, we do not.

Operator

The next question comes from Steve DeLaney of JMP Securities. Please go ahead.

Steven DeLaney - JMP Securities

Good morning. I noticed there was a relatively large decline sequentially in the discount accretion from about $79 million to $49 million. But the CPR, we think of the accretion as maybe being highly correlated with prepaids, but CPR was flat at 14. Is there anything onetime in the third quarter accretion figure of $49 million, that is connected to the accounting change?

Alexandra Denahan

In general, if you look at the buckets on the assets, the agency portfolio picked up slightly so we are amortizing a little faster on that. And then if you look at the individual categories of asset classes on the non-agency portfolio, they in general slowed. So we accreted less discount on the non-agencies and amortized faster on the agency. So you did see a quarter-over-quarter decline of close to 3 pennies in accretion. And that’s simply due to that we had slowing prepayments associated with broader market implications.

Steven DeLaney - JMP Securities

Okay. So it really was just the speed and not anything related to the accounting change, specifically?

Alexandra Denahan

No, no. It was related to the speed, and as we’ve said before, the assets are performing relatively in line with our expectations and there was no material change in the credit quality of the assets.

Matthew Lambiase

Yeah. And I think, Steve, just to go at that point. We did see the pay down slow in the quarter, and I think a lot of it had to do -- again, it’s hard to ever pinpoint one specific reason why anything pays, especially when you have as many bonds as we do. But I think the Robo signing lawsuit getting settled, and also I think that there was -- everybody knew that there was going to be new initiatives to keep people in their homes through modifications. And I think that made the servicers slow the resolution process down, and this is all a matter of timing. It’s a matter, if they slow it down now, you’re going to probably see those cash flows in the future.

Steven DeLaney - JMP Securities

Okay. Thanks, Matt. And then just one final thing, your non-agency portfolio held up from a fair value standpoint, very well in the quarter. I mean, I realized all the news on the ABX and the PrimeX and that doesn’t always relate to the quality of bonds that you own. But you had the subordinate bonds only went down about 1.4% at par to 41.9% from 43.3%. Is that September 30 mark, is that based on third party pricing. It’s level two, so I assume that it is?

Alexandra Denahan

We mark the bonds internally and then we send them out to three dealers. Now in aggregate on the portfolio, we are 0.69% higher than the average of the dealer mark. So we are very close to the average of dealer marks on the portfolio as a whole. But just keep in mind we have a tendency on the subs to mark them, what I would consider rather conservative, and so the general movement in the market you would not I think that you see the market value move on the subs but it was not as....

Matthew Lambiase

Yeah. I think the important -- the operative thing here is that we have the same system in place that we’ve always used to mark the portfolio. And there has nothing changed this quarter over any other quarter. And sometimes I remember first quarter people were yelling at us that the prices didn’t move up fast enough and now they are not falling I guess as fast as some people might have thought. The fact is the assets that we have are not rated, a large amount of them are not rated, they are staple, they are private securities. And they just, they are marked to generally the dealers when they mark them, and are marking them to a yield basis and that yield basis hasn’t really changed dramatically. And I’ll tell you, just in the level of portfolio activity we’ve been bidding on bonds and we have been buying anything and I think the first time we bought anything significantly was happened may be two weeks ago. The first bond that we purchased closed to levels on our portfolio. So, it’s the same methodology that we’ve always used.

Operator

(Operator Instructions) The next question comes from Daniel Furtado of Jefferies. Please go ahead.

Daniel Furtado - Jefferies

Good morning. Thank you for taking my question. Do you have kind of estimate for what the approximate size of the agency portfolio needs to be to satisfy REIT rules?

Alexandra Denahan

Well, on an unconsolidated basis, it needs to be -- 55% of the assets need to be whole pool qualifying. So we typically run within a very comfortable margin above that number and so we do have room if we would like to unwind an agency position to use the liquidity to purchase other assets, we have ample room to do that.

Daniel Furtado - Jefferies

And when we think of that, we think of the non-agency or should we think of that as the -- the 55% of the fair value of the non-agencies. Or when you say 55% of assets have to be whole pool qualifying, when we run that calculation ourselves and we look at your non-agency book, so we be -- we should, I would assume, be looking at the fair value of that portfolio?

Unidentified Corporate Participant

It is 55% of the total portfolio, or the fair market value of the entire portfolio.

Daniel Furtado - Jefferies

Understood. Thank you. And then, how about progress that’s been made so far. Matt, I appreciate your comments on the jumbo securitization side. What are you seeing in that front from a ground level perspective?

Matthew Lambiase

Well, I think it’s kind of an interesting market. Obviously, Fannie Mae and Freddy Mac getting out of it should open up some opportunities. I also think that the banks who have been funding these jumbo mortgages over the last two years and putting them into their portfolio, are getting kind of full. And I think that there is going to be some opportunity there for private capital to come in. We think that sourcing and developing sources, interesting sources for these mortgages is where we’ve been spending an awful lot of our time. ,And hopefully, we’ll be articulate that better in may be the next earnings call, and we really do hope that we’re going to be actively making securities in 2012. I think, we are seeing enough demand out there from people who want to have jumbo prime mortgages and we think the investors are there to buy the AAA securities. So it looks, it feels to us like that the market is going to start to open up here going forward.

Daniel Furtado - Jefferies

Great. Thank you for that. And the way that we should think about your ability to access that. I mean, when we have kind of run our own calcs on what this 55% should be, assume some of that agency portfolio burns off, and then depending on timing, I know on the non-agency side your taxable income is higher than the cash flows that are coming off that portfolio, but do we kind of fast forward into the future, where the taxable income has been net down because of realized losses and then you are able to retain some of those cash flows on the subordinate portfolio to then kind of reinvest in that in the new issuance market.

Matthew Lambiase

Well, I think right now we have quite a bit of liquidity to go after the jumbo prime market. Like I said earlier, we have the ability to either take -- lever up the agencies more if we want, because they are relatively low-levered, or we could sell them and take that capital and go after the jumbo prime market that way as well. There are also people offering warehouse lines to us to warehouse jumbo prime mortgages before securitization. So there are a lot of different ways for us to use the capital that we currently have to pursue that market. What was the first part of the question?

Daniel Furtado - Jefferies

No, I think that was pretty much it. Those are all my questions and thanks for your time.

Operator

(Operator Instructions) The next question comes from [Davey Richards of Pine River]. Please go ahead.

Unidentified Analyst

Actually it’s [Brad Burn] from Pine River. Just wanted to understand tax versus GAAP income, one clarification on the accretable yield for the non-agency. I think you guys clarified that, you accrete yield to the loss adjusted so it doesn’t go to par. Does tax go to accretable to par then, or something less than par on those securities? Just help us model the taxable income. I appreciate it.

Alexandra Denahan

For tax you accrete to par until you realize an actual principle write-down. So you set your assumptions on the day that you purchase the assets, and you cannot change your assumptions. And as the pay downs come in, you accrete your discount towards par until you actually have a principle write-down.

Unidentified Analyst

Okay. Great. Just wanted to make sure I understood how to model the yield differentials, so appreciate that. Thank you.

Operator

And we have a follow up from Bose George of KBW. Please go ahead.

Bose George - Keefe, Bruyette & Woods

Thanks. Just wanted to check, what was the REIT taxable income last quarter?

Alexandra Denahan

We were right around $0.13.

Bose George - Keefe, Bruyette & Woods

Okay. Then, in terms of the decline in the spread, you noted about $0.03 impact for the decline in the spread. What was the offset, since your REIT taxable income stayed roughly flat quarter-over-quarter?

Alexandra Denahan

Well, taxable income is not driven by the GAAP income. So the taxable income stayed relatively constant and you have to keep in mind that on tax, the assumptions are set on your date of purchase.

Bose George - Keefe, Bruyette & Woods

So that change in the spread really doesn’t impact REIT taxable income?

Alexandra Denahan

No.

Operator

We have a follow up from Daniel Furtado of Jefferies. Please go ahead.

Daniel Furtado - Jefferies

Sorry, Alex, I am just trying to follow-up on the Pine River question there. So you set the assumptions on day one, you accreted to par on tax until a loss is experienced on that specific CUSIP or that security. And then do you continue to accrete, like let’s say it’s 100, you have a five point loss, so you continue to accrete to 95 or does that first instance of loss allow you to re-estimate what your -- kind of bring the entire accretion back down to something lower than the actual expected -- experienced losses to-date?

Alexandra Denahan

So you take the loss into account so you essentially will not go above 95 after that point in time, but you do not change your purchase assumptions. It just removes that accretable discount from your tax book.

Operator

Next question comes from Arren Cyganovich of Evercore. Please go ahead.

Arren Cyganovich - Evercore Partners

Hi, thanks. If you could talk about your agency book a little bit, the CPR at the end of the period was 11%. So a little bit lower than some of the peers that I’ve seen, what’s in the makeup of that portfolio that has added a fairly low CPR?

Matthew Lambiase

I mean they are pretty plain vanilla securities. I mean we stick with fixed rate pass-throughs. We do have a position that’s lot of jumbo conforming paper, and the idea is we’re buying premium so we’re trying to pick pools that are going pay little bit slower.

Unidentified Corporate Participant

I think generally speaking it’s all 30-year and 15-year paper, and it’s been performing pretty well.

Arren Cyganovich - Evercore Partners

Okay. And then on the jumbo side, you mentioned the fact the GSC, I guess will have lowered 625, but I guess there was legislation passed by the Senate saying that the FHA would then have the extended limit. Is that going to impact your...

Matthew Lambiase

Yeah. I mean, it should have some impact. And we’ll see how exactly that all kind of pans out in the near future. Obviously, FHA with the insurance guarantees makes a higher coupon but we’ll see how that all kind of pans out. I think the operative thing for us is Fannie and Freddie have been pretty big in this space and having them out, I think opens up some opportunity there.

Arren Cyganovich - Evercore Partners

Okay. And then, lastly, the -- I guess, Shannon funding through your parent company. How are you going to be able to utilize that source? Is that business up and running, I know that was kind of a relatively new business?

Matthew Lambiase

Yeah, I mean, I think we’re looking at a whole bunch of different opportunities there. I mean, Shannon is really, it’s an Annaly company. Chimera doesn’t do business with affiliated parties on one-off type of basis. I think, one of the things that we could do there is potentially show rates out to their clients and close directly. But, yeah, we’re still in the process of determining how all that -- all kind of processes out and works out.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Lambiase for closing remarks.

Matthew Lambiase

Well, thank you for all participating in the third quarter 2011 earnings call for Chimera Investment Corporation, and we look forward to speaking to you early next year. Thank you.

Operator

Ladies and gentlemen, if you wish to access the replay for this call, you may do so by dialing 877-344-7529 or 412-317-0088, with an ID number of 10005697, again 10005697. This concludes our conference for today. Thank you for participating and have a nice day. All parties may now disconnect.

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