Chimera Sets Its Payout Through 2012, But Expands Its Accounting Snafu And Related Risks

Aug.13.12 | About: Chimera Investment (CIM)

Last week, on August 7, 2012, Chimera Investment Corporation (NYSE:CIM) announced that it plans to initiate a regular quarterly dividend of $0.09 per share for both the third and fourth quarter of 2012. On the same day, CIM filed with the SEC, noting that each of the Company's Annual Reports (10-Ks) since 2008, and all Quarterly Reports (10-Qs) since the third quarter of 2008, need to be restated.

The market reacted positively to the news, with Chimera shares appreciating around ten percent on the date of the announcement. It appears that much of the bump was due to Chimera's plans to maintain its previously announced Q2 dividend rate of nine cents, but the market may be overlooking some of the statements included in these announcements.

For example, Chimera noted that portions of the quarterly payout might be a return of capital (which could lower an investor's cost basis), and this rate is only guaranteed until the end of 2012, at which point the Board of Directors will review the policy. Given the considerable accounting problems and share losses Chimera has sustained, one may wonder what else the Board of Directors will review, and also whether shareholders shall allow for current board-member continuity next year.

Chimera again noted that it does not expect the restatements to affect previously reported GAAP or economic book values, actual cash flows, past dividends and taxable income. Nonetheless, Chimera now reports that it estimates, for the total period in question, its interest income will decrease by approximately $411 million, from $1.88 billion to $1.46 billion (a 21.8% decrease) and that net income is expected to decrease by approximately $695 million, from $1.06 billion to $367 million (a 65.5% decrease).

Chimera is a hybrid non-agency mortgage REIT. Mortgage REITs ("mREITs") buy mortgage paper as an investment, or in order to re-securitize them and sell them to another mREIT or some other entity that is investing in real estate loans. Non-agency and/or hybrid mREITs like Chimera and peers such as MFA Financial (NYSE:MFA) and Invesco Mortgage Capital (NYSE:IVR) hold mortgage paper without government agency backing, as well as agency-backed paper. Chimera is related to Annaly Capital Management, Inc. (NYSE:NLY), the largest agency-only mREIT, and is managed by FIDAC, a wholly owned subsidiary of Annaly.

Chimera has lagged the performance of its non-agency mREIT peers over the last several quarters, with much of the underperformance tied to their accounting mess. Both MFA and IVR shares are up over the last 12 months and since the start of 2012, with each dramatically outperforming the S&P 500 (NYSEARCA:SPY). Alternatively, Chimera is still down for the year. See a 2012-to-date comparison chart for the above-mentioned mREITs, as well as the S&P 500: Click to enlarge

The company continued to comment that the accounting problems are related to the application of generally accepted accounting principles ("GAAP") to its non-Agency residential mortgage-backed securities portfolio. Since the third quarter of 2011, Chimera has reported issues relating to accounting of other than temporary impairment ("OTTI") on non-agency residential mortgage-backed securities that are rated as junk.

While Chimera has not particularized what caused this issue, much of the problem likely comes from the fact that a good chunk of junk-rated non-agency RMBS paper that existed before 2008 was not initially considered junk. Rather, much of that paper originated and traded with exceptionally high credit ratings, where the credit quality subsequently deteriorated to junk.

Beyond the abovementioned reductions to net income and interest income, Chimera also reported that it expects OTTI losses for the total term to increase by approximately $293 million from $190 million to $484 million. Additionally realized losses on sales are expected to decrease by approximately $9 million, from $29 million to $20 million.

Earlier in 2012, Chimera announced that it appointed Ernst & Young as its accounting firm beginning with the quarter ending March 31, and that the services provided by Deloitte & Touche will conclude after the completion of Deloitte's audit services for the fiscal year ending December 31, 2011. I have contacted Chimera requesting any additional information they may be able to provide, but received no response.

Since the start of these problems, I have wondered whether this accounting issue would be isolated to Chimera or become ubiquitous within the world of non-agency mREITs. No others have yet changed their accounting methodology. This would appear to indicate that there is either an undisclosed accounting issue common amongst the non-agency mREIT industry or that Chimera utilized an atypical accounting method since 2008, and that in 2011 it discovered its unique system was improper.

Many potential accounting treatments are interchangeable, making it hard to guess the extent of changes Chimera and its accountants may implement. Several options could exist. Nonetheless, the accounting will likely be revised to use newer information about securities, where the information has substantially changed for the worse.

Here, because of the expanding extent of accounting restating, coupled with Chimera's utter lack of reliable financial reporting, there is a growing probability that Chimera will end up getting sued by shareholders that opt to bring a derivative lawsuit. A shareholder derivative suit is a lawsuit brought by a shareholder on behalf of a corporation against a third party, and may even include the company's executives, officers and directors. Chimera would likely defend such a claim by stating that the decision was within the realm of reasonable business judgment and/or that the determinations were made by its consulting accountants, though such is presently unclear due to the general lack of information the company has provided.

Despite Chimera's guaranteed distribution rate for the next two quarters, given that the company may resort to returning capital in order to provide that rate, and that it has admittedly voided all of its previously reported finances, legitimate fundamental analysis of Chimera is not possible. Further, there is the potential for officers and directors to soon leave, or be removed, and a growing risk of litigation. Given the limited information available and significant potential risks, investors should continue to consider shares of CIM highly risky and limit ownership to a reasonably small portion of their total portfolio.

Disclosure: I am long CIM, NLY.