A Deeper Look Into Annaly And Chimera

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Includes: CIM, NLY
by: Erich Sauer

Annaly Capital Management (NYSE:NLY) and Chimera Investment Group (NYSE:CIM) have been a topic of heavy discussion on SA and other financial websites lately. Many of the articles have included a sensational headline about "unsustainable dividends" and then one paragraph on each company that mentions the high dividend yield and payout ratios above 1.0, which, very simply, means that dividend payments over a certain period have been higher than EPS over that same period.

However, both of these companies are very complex, and deserve to be examined in more detail before pronouncing their dividends unsustainable. My hope with this article is to give you a bit of insight into the way these companies operate to enable you to make an informed decision about whether or not to invest.

NLY and CIM are both mortgage Real Estate Investment Trusts. They make money by borrowing short-term at low rates, and investing in longer-term mortgage securities which carry higher rates, and they do this with leverage. NLY had leverage of 5.5:1 at the end of Q3 2011, and CIM had leverage of 1.2:1. NLY is the largest mortgage REIT on the NYSE, and invests in agency mortgage-backed securities, which carry either an explicit or implicit guarantee on principal repayment by the United State government.

CIM is a subsidiary of NLY, managed by FIDAC (another NLY subsidiary), and invests in non-agency mortgage backed securities. CIM's securities carry more credit risk than those of NLY, which is the reason for the lower leverage. Both companies operate under the stated objective of providing returns to shareholders, primarily through dividends, and secondarily through capital market appreciation.

Since dividends are the primary means by which these companies create value for shareholders, investors are right to focus on those dividends. However, to truly determine the sustainability of dividends, we must look deeper than simply comparing EPS to dividend payouts. We need to understand the factors that drive these businesses' earnings, and we also must understand how they are using their cash.

ANNALY

NLY reported a loss of $922M, or $0.98 per share for the quarter ended September 30, 2011. Immediately, this does not look good for its ability to continue paying dividends. However, included in this earnings calculation was an unrealized loss of $1.5B on interest rate swaps, and an unrealized gain of $1.1B on available-for-sale securities. The fact that unrealized gains and losses such as these will continually have an effect on earnings, without having an effect on NLY's cash position, makes EPS a very poor indicator of NLY's ability to pay dividends.

A much better indicator of NLY's ability to pay dividends can be found on the cash flow statement. For the quarter, NLY actually had an increase in cash of $3.07B, after paying $544M in dividends. As a REIT, NLY must pay out 90% of its earnings as dividends in order to avoid corporate taxes. Naturally, this leaves the company with little in the way of retained earnings, and it must frequently issue new shares when it needs to raise cash.

As long as the proceeds from new share issues are used to purchase securities, shareholders need not view the issue of new shares in a negative light. What would be troubling is if NLY were to issue shares solely to be able to pay its dividend. The proceeds from new shares in the past quarter were $2.4B, which means the dividend was well covered by cash from other sources. Investors in NLY will want to continue to monitor the cash flow statement in future quarters to assure themselves the dividend is safe.

The success of NLY's ongoing operations is tied to the spread it is able to earn between its borrowing costs and the returns on securities it owns. Spreads for the previous 5 quarters can be seen in the table below.

Period

Spread

Quarter Ended September 30, 2011

2.08%

Quarter Ended June 30, 2011

2.45%

Quarter Ended March 31, 2011

2.17%

Quarter Ended December 31, 2010

1.85%

Quarter Ended September 30, 2010

2.11%

The spread in the most recent quarter has obviously fallen compared to the previous two, but it is not so low as to cause immediate concern. Going forward, NLY will benefit from an environment with stable interest rates. Rising interest rates harm NLY by increasing the rate for its short term borrowings, compressing the spread. NLY benefits to an extent from falling rates, but this benefit is limited because the mortgage securities it holds exhibit a characteristic called "negative convexity."

The ability of borrowers to pre-pay a mortgage is essentially a call option. Because of this option, the prices of mortgage securities do not rise as much as the prices of non-callable bonds in response to the decrease in interest rates. As rates fall, prepayments increase, leaving NLY with cash that it must now invest at lower yields. Luckily for NLY shareholders, the Fed on Wednesday announced that it would be maintaining interest rates at current low levels until at least late 2014. This will give NLY the stable rate environment it needs to be successful.

CHIMERA

Similar to NLY, CIM's income statement is fairly complex. It contains many of the same unrecognized gains and losses on derivative contracts that make EPS a poor predictor of dividend performance, with a notable exception that bears mention. CIM recognized an "other-than-temporary" impairment loss of $41.2M in the quarter ended September 30, 2011. Other-than-temporary sounds like a euphemism for "permanent," so the loss is something to keep in mind. As long as the real estate market remains weak, similar impairments may occur in the future.

CIM's cash flow statement is stated in terms of 9 months ended September 30, 2011. For those nine months, CIM paid out $451.5M in dividends, and net cash actually increased by $2.65M. Total cash on hand at September 30, 2011, was $9.82M, which is fairly troubling. CIM is operating with very little margin for error. Results from operations will need to be strong if CIM is going to be able to continue to pay its dividend.

CIM's interest spreads are shown in the table below.

Period

Spread

Quarter Ended September 30, 2011

4.88%

Quarter Ended June 30, 2011

5.75%

Quarter Ended March 31, 2011

6.14%

Quarter Ended December 31, 2010

4.99%

Quarter Ended September 30, 2010

4.13%

The behavior of CIM's spreads illustrates quite well how falling interest rates affect a mortgage REIT. The table below shows the components of the spread in more detail.

Period

Cost of Funds

Average Yield on Assets

Quarter Ended September 30, 2011

2.33%

7.21%

Quarter Ended June 30, 2011

2.44%

8.19%

Quarter Ended March 31, 2011

2.70%

8.84%

Quarter Ended December 31, 2010

4.01%

9.00%

Quarter Ended September 30, 2010

4.58%

8.23%

CIM's cost of borrowing fell significantly in the quarter ended March 31, 2011, which is what caused the spreads in the next two quarters to be quite high. By the end of the most recent quarter, however, borrowers had taken advantage of their prepayment option and spreads were slightly lower than they were before the drop in rates. As with NLY, investors in CIM will want to keep an eye on the spread in upcoming quarters to continue to evaluate the safety of the dividend.

In conclusion, I think NLY's dividend does in fact look sustainable, especially given the Fed's intention to keep interest rates low until 2014. CIM's dividend is somewhat more risky. This increased risk is currently reflected in the market prices, as NLY currently sports a yield of 13.64% based on Wednesday's closing price and annualization of the most recent dividend, and CIM sports a yield of 14.67%. In my opinion, and extra 1.03% yield is not enough compensation for the extra risk presented by CIM, and if I were to choose to invest any additional funds, I would do so in NLY.

Disclosure: I am long NLY, CIM.