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In the following article, I will take a close look at Chimera (CIM). Chimera is a mREIT and has ongoing business relationship with Annaly Capital Management. Like Annaly, Chimera also invests in mortgage backed securities (MBS). Chimera trades around $3, with a market capitalization of $3.1 billion.

Chimera is a hybrid mREIT, meaning that the company invest in both agency backed MBS's and non-agency MBS's. Agency backed MBS's are mortgages guaranteed through Freddie Mac (OTCQB:FMCC), Fannie Mae (OTCQB:FNMA) and Ginnie Mae, and backed by the U.S. government, while non-agency MBSs have a default risk. A majority of these MBSs are rated junk because of the default risk.

Non-agency MBS entities are separated into four categories: Prime, Alternative A (Alt-A), Option adjustable Rate Mortgages (Option ARMs), and sub-prime. The sub-prime market imploded in 2007 and 2008, and led to the economic crisis from which the U.S. economy is still recovering. A majority of hybrid mREITs now find themselves investing in more agency backed MBS entities. This has resulted in a more diversified portfolio with reduced volatility. Hybrid mREITs are investing in agency backed securities out of necessity. Since the crash of the sub-prime market, few sub-prime MBSs have been issued.

I want to break down the business model for the typical mREIT. mREITs have external management teams that invest in securitized mortgages. Companies use low interest loans to purchase MBS that pay a higher rate, and the mREIT's earnings come from the difference between the two rates. mREITs are subject to several risks, such as mortgage-default risk and yield spread contraction. Default risk is specific to hybrid mREITs, like Chimera, that invest in non-agency backed MBSs. mREITs use short term leverage to exploit the difference between short and long term interest rates. When the yield spread contracts, this can be disastrous for the mREIT's profits. mREITs are highly leveraged, and their debt to equity ratios are much higher than the market average. I like mREIT's that have a double digit yield and a single digit PE. Chimera fits this profile, with a PE of 5.16, and a dividend yield of 15.6%.

A subsidiary of Annaly acts as an investment advisor for Chimera, causing confusion among investors who might be tempted to view the two companies as one company with two different classes of stock. This is not the case, as Chimera has close ties to Annaly and they share the same management team. Yet, these two companies are very different. Annaly invests in agency backed MBS's, while Chimera's business model focuses on non-agency MBS.

Annaly outperformed Chimera during the first quarter of 2012, however, both stocks are down. Annaly's share price is down 10%, while Chimera is down 28%. Chimera approaches investing differently than Annaly. Chimera invests in distressed non-agency backed MBSs. As I stated before, these MBSs are the equivalent of junk bonds. Agency backed MBSs that Annaly purchases are the equivalent of treasury bonds and are considered risk free investments. Ongoing economic improvement will benefit Chimera's portfolio. I believe that Chimera will produce positive returns going forward. During the first quarter of 2012, Chimera's stock price jumped 17%.

Chimera operates as an investment fund, and 75% of the company's portfolio is invested in non-agency MBSs. Since non-agency MBSs have a higher interest rate than agency backed MBSs, Chimera is not heavily leveraged. The company's current leverage ratio is around 1.85. As a side note, Chimera also has the same external management team as Annaly. Chimera is required to distribute at least 90% of its income as dividends to maintain the tax advantage status as a REIT. This places a limitation on the company's ability to retain earnings. Chimera is trading at book value, and at a discount to agency focused peers, due to the risk of default on non-agency backed MBSs. Companies like Annaly Capital Management and Anworth Mortgage (ANH) are safer players because of limited credit risk and slower prepayments, but a hybrid that trades at or below book value like Chimera is a strategic risk I am willing to take.

mREITs are among the top investment choices for income investors because their yields are much higher than the average yield in the equity markets. For investors looking for alternative to risk free investments, mREITs offer opportunities for higher yields. The value of mREITs is not connected to the traditional equity markets, so investors don't see large swings in value. Chimera's value is linked to interest and prepayment rates.

The company's profits could come under pressure if Congress enacts policies that would allow masses of underwater home owners to refinance their mortgages. Chimera would see large amounts of assets paid off early and would have to reinvest funds in cheaper mortgages with lower interest rates. I don't think this is likely, especially with a stronger housing market and the upcoming presidential election. Any pending legislation is likely to get upended, but this risk still needs to be addressed.

With interest rates expected to remain steady over the next 12 to 14 months, I don't expect a lot of volatility in Chimera's stock price. I anticipate that the stock will stay in the $2.50 to $4 range over the next 12 months.

With a 15% dividend, and limited downside risk, Chimera offers a good payout for income investors. I feel that agency backed mREITs are a safer investment. However, I think the limited downside of Chimera more than makes up for the potential risk of defaults and contracting interest rate spreads. Opportunities to buy Chimera at book value or less would be a wise investment for market participants who are looking for high yields without taking on unnecessary risk.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Chimera: A Compelling mREIT Buy Candidate For 2012