Chimera (CIM) has announced that Ernst & Young LLP will now be the Independent registered accounting firm and the audit services provided by the current auditor Deloitte & Touche LLP will be concluded after the end of the fiscal year ending 31 December 2011. The company is also reviewing its treatment of its portfolio of non-Agency backed residential mortgage-backed securities and, as a result, more time would be required for the completion of reporting formalities for the quarter ended 31 March 2012 and finalizing of the accounts for the fiscal ended 31 December 2011.
The company has clarified that any changes because of the review will only result in a non-cash charge in the GAAP accounts and key metrics such as book value, cash flow, income and dividends will remain unchanged. The stock price declined on the announcement because this is the second consecutive quarter in which Chimera has delayed the announcement of the quarterly results. The previous delay was attributed to the treatment investment impairments that were other than temporary. The company also declared a cash dividend of $.11 per share for the first quarter of the year 2012.
I would like to point out that the replacement of an auditor and the delay in the publication of financial results could have more serious ramifications. Something like two months have gone by this announcement was made and there has been no further news. Many listed companies have already announced its results for the first quarter of 2012 and here we are still waiting for Chimera's results for the year 2011. It is extremely difficult to make investment decisions based on out of date financials. But historical evidence also suggests that the change in auditors and delay in the publication of financials often means bad news which will only become evident when the results are available. I am not suggesting that this is the case with Chimera but I would certainly regard the announcement as a red flag. I would guess that some investors are selling and sitting on the cash to reinvest later if they still like the stock and the price comes down when the results are published.
To help you make up your mind, I would like to analyze the company in a little more detail. To recap, Chimera is what is known as a hybrid mREIT which means that its investment portfolio includes both agency backed mortgage-backed securities (MBS) and non-agency backed MBS. Agency backed MBS means that the securities are based on mortgages that are guaranteed by agencies backed by the federal government such as Freddie Mac and Fannie Mae.
Non-agency backed mortgages often fall into the junk investment category because of the higher risk of default. 75% of the portfolio is made up of non-agency backed markets securities and this has both advantage and disadvantage. The advantage is that because of the higher default risk, the securities offer higher yields and helped to limit the leverage. However, this very default risk means that Chimera will always trade at a discount to its peers such as Annaly (NLY) and American Capital Agency (AGNC), which only invest in agency backed mortgage securities.
All mREITs make profits by capitalizing on the difference between low short-term borrowing interest rates and the higher long-term deal from mortgage-backed securities. This enables them to exploit leverage by borrowing cheap and investing in higher yield securities. Sounds simple but there are several factors that need to be considered to maintain profitability. As we could see, default risk management is crucial but so is maintaining the spread between borrowing costs and yields because the high leverage of many of these companies make them extremely vulnerable to the contraction of margins.
Another factor that could dent profits would be a large volume of mortgage prepayments say if the government were to make policies that allow large-scale prepayments. This would create large fund inflows for the mREITs that would have to be reinvested in mortgage-backed securities that offer lower returns. You should also remember that Chimera has a limited capability to build capital cushions through retained earnings. To retain its tax-exempt status, 90% of its earnings have to be distributed as dividends.
Let us now look at some trends that might help us determine the outlook for the industry. I expect interest rates to remain stable at or around current levels till the end of 2014. The Fed has committed to near 0% short-term rates which mean the borrowing will continue to be dirt cheap. There are indications of an upturn in long-term interest rates but this will benefit the industry by pushing up the spread. For companies that invest in non-agency backed securities, default risk has been an overriding concern over the last few years. However there are indications that foreclosures are bottoming out and delinquency rates will continue to drop as the US economy improves. The industry looks to continue to be profitable at least until the end of the year 2014.
Mind you, there are considerations that make an investment in Chimera or comparable companies such as CYS Investments (CYS) or Hatteras Financial (HTS) look attractive under present conditions. The mouthwatering yield of over 15% is amongst the best deals that you would get in the market, particularly if you are investing for income. I would expect this dividend to be maintained provided there is no substantial deterioration in asset quality because of the spread protection that will be available for the next couple of years. You can add to this the fact that the stock currently quotes at a discount to book value.
I do not recommend buying Chimera at this time. I am still concerned about the delayed financials and uncomfortable about making an investment in the absence of the basis on which to put a value on the company and to assess the sustainability of the dividend. I also believe that you should not invest in a company that is having accounting issues until they have been satisfactorily resolved. I would prefer to wait and see. However, I would hold on to an existing position in the stock in the consolation of being compensated by the dividend yield.