In general, we are still bullish on mortgage real estate investment trusts (“mREITs”), particularly agency-focused mREITs. We think the current economic and interest rate picture is positive for mREITs. A weak economy is actually a good environment for mREITs, which benefit from low interest rates and a steep yield curve. See our recent article "High Yield in a Slow-Growth World: Mortgage REITs" for more details.
That said, there is one mREIT in particular that we have never been able to justify recommending to investors: Chimera Investment Corporation (NYSE:CIM). This article highlights some of the reasons why.
Founded in 2007, Chimera is a real estate investment trust that is externally managed by FIDAC (Fixed Income Discount Advisory Company). FIDAC is a wholly-owned subsidiary of Annaly Capital Management, Inc. (NYSE:NLY). CIM acquires and manages residential mortgage-backed securities, residential mortgage loans, and real estate securities.
CIM is a non-agency focused mortgage REIT. As shown in the table below, over 70% of CIM's portfolio is allocated in non-agency RMBS.
Whereas agency mortgages are guaranteed by government sponsored entities (implying limited credit risk), non-agency securities do not carry a similar implied guarantee. As such, non-agency securities are inherently more risky as they are exposed to the credit risk of the underlying borrowers. Because of this added risk, non-agency focused mREITs generally operate with less leverage than their agency-focused peers.
DELAYED 10-Q FILING
In early November, CIM confirmed what we have been suspecting for quite some time. The company delayed filing its quarterly report with the SEC due to uncertainty around the value of some of its holdings.
From CIM's press release on 11/14/11:
As previously disclosed, on November 10, 2011, the company, in conjunction with the review by its outside independent accounting firm, is conducting an analysis of the treatment under GAAP of other-than-temporary impairments ("OTTI") related to the company’s investments in securities rated less than AA, non-rated non-Agency securities and other subordinate securities. Prior to September 30, 2011, the company evaluated certain of its investments in securities for OTTI under ASC 320 Investments-Debt and Equity Securities. The company had determined that its investments in securities rated less than AA, as well as non-rated non-Agency securities and other subordinate securities, should be evaluated for impairment under ASC 325-40 Investments-Other – Beneficial Interest in Securitized Transactions.
Translation: CIM may have been overstating the value of some investments.
The dog of the mREIT industry
We don’t purport that the market is always right, but when a certain stock drastically underperforms its peers, there is usually a reason. As shown in the chart below, CIM [blue line] has drastically underperformed the S&P [purple line] over the past 6 months. Conversely, agency-focused REITs, like Annaly Capital [yellow line] and American Capital Agency (NASDAQ:AGNC) [green line], have outperformed the market over the past few months.
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Despite its attractive yield, CIM has cut its dividend in three of the past four quarters... not a good sign!
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Dividend growth investors love stocks with rising yields. However, yields typically only rise for one of two reasons: Rising dividends or a falling stock price. It’s not hard to tell which camp CIM falls into. As shown in the chart below, CIM’s yield continues to increase as the stock price falls.
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As shown in the table below, the majority of the assets in the company’s portfolio have a weighted average fair value below the company’s weighted average cost basis for these assets. However, given the recent noise around the company's delayed filing and suspect valuation techniques, the real story may be even worse.
Note: Senior, non-retained securities have been re-securitized and sold to third parties. As such, CIM receives no future economic benefit from these securities and there is no future recourse to CIM.
A portfolio made of junk
CIM's investment guidelines place no restrictions on the credit rating of the assets the company is able to hold in its portfolio. As shown in the table below, its portfolio is most heavily weighted in non-investment grade credits. In addition, the company has recently increased its concentration in these risky assets.
Note: The table above reflects the credit rating of the company’s consolidated non-Agency RMBS portfolio. At June 30, 2011 approximately 14% of the AAA, AA, and A securities balance reflected in the table above include senior, non-retained, non-Agency RMBS (which CIM receives no economic benefit for). In addition, as the company securitizes or re-securitizes assets, it expects the Below B or not rated percentages in the portfolio to increase as the company typically retains the subordinated tranches of these types of transactions.
Most of CIM's investments were originated at the peak of the credit boom in 2006 and 2007 (see table below). This should raise concerns with investors since structures and terms of MBS originated in 2006-2007 are inferior to earlier vintages.
For all the reasons discussed in this article, CIM has historically traded at a steep discount to book value. In addition, it trades at a lower valuation than any of its mREIT peers (see table below).
Despite the attractive dividend yield, we remain reluctant to invest in CIM as we feel that there are better mREIT investments with stronger risk/reward profiles (particularly agency-focused REITs like NLY and AGNC). That said, we think mREITs will produce decent risk-adjusted returns for investors over the next few years and we continue to believe that the best strategy for investing in this space is to own a portfolio of mREITs to diversify your risk.