Chimera: Is That Monster Dividend Worth The Risk?

| About: Chimera Investment (CIM)

Income starved investors will find Chimera Investment (NYSE:CIM) a very tempting investment thanks to its 14.5% or so dividend yield but one has to wonder how many investors have considered the risks that comes with any investment paying such a sky-high dividend yield. After all, investing is often a game where there are winners and losers, not winners and more winners that continue into perpetuity. In other words, it's often a case of buyer beware and doing your homework to understand just how a complex investment generates outsized returns or income and the risks involved in generating those returns or income.

What is Chimera Investment?

For tax purposes, Chimera Investment is a real estate investment trust (REIT) which means it must distribute at least 90% of its earnings to shareholders in the form of dividends. But unlike other REITs which invest in physical real estate, Chimera Investment invests in residential mortgage-backed securities (NASDAQ:RMBS), residential mortgage loans, real estate-related securities and other types of asset classes.

Moreover, Chimera Investment is externally managed by Fixed Income Discount Advisory Company (FIDAC), which is a wholly-owned subsidiary of Annaly Capital Management (NYSE:NLY) - a large-cap mortgage REIT that has a market cap of almost $17 billion and a 13% dividend yield that also has another mortgage REIT called Crexus Investment (NYSE:CXS) with a nearly 11% dividend yield as a subsidiary.

Other mortgage REITs with good size market caps available to investors seeking income would include American Capital Agency (NASDAQ:AGNC) with a yield of almost 15%, CYS Investments (NYSE:CYS) with a yield that's over 14%, Hatteras Financial (NYSE:HTS) with a yield around 12.5%, MFA Financial (NYSE:MFA) with a yield approaching 12% and Two Harbors Investment (NYSE:TWO) with a yield of around 14.5%.

Understanding How Mortgage REITs Like Chimera Investment Work

Before deciding on which mortgage REIT to invest in, it would be wise to take some time to understand just how mortgage REITs work and exactly what they are investing in to generate those incredible yields.

To begin with, mortgage REITs need to generate income off the spread between the interest earned from their investments (e.g. mortgages) and the cost to borrow the capital in order to acquire those investments. More often than not, mortgage REITs will also throw in leverage by borrowing at low short-term lending rates to go long. Of course, that can be a risky endeavor as no-one believes that interest rates will remain at their current low levels forever.

Finally, investors need to have an understanding of conditional prepayment rates (CPRs) which is the percentage of principal that gets prepaid on an annualized basis. A high conditional prepayment rate in the current environment means a mortgage REIT will need to reinvest in new mortgages at lower rates and eventually, its dividend will move lower.

Chimera Investment

With the above in mind, how does Chimera Investment stack up for current or would-be investors? First of all, investors need to understand that Chimera Investment solely exists to allow Annaly Capital Management to invest in riskier instruments that aren't guaranteed by government entities or groups likes Freddy Mac or Fannie Mae. That alone means that Chimera Investment is riskier than other mortgage REITs.

On the dividend front, Chimera Investment's quarterly dividend hit the $0.17 per quarter level during the first quarter of 2010 and it stayed at that level for the next five quarters (Note: $0.18 was paid in the fourth quarter). For 2011, Chimera Investment's dividends were $0.17 (Q1), $0.14 (Q2), $0.13 (Q3) and $0.13 (Q4) and so far this year they have been $0.11 (Q1), $0.11 (Q2) and $0.09 (Q3). In other words and despite the added risk that the stock takes on by the nature of its investments, dividends are falling and most likely this trend will continue into the indefinite future.

Moreover and while Chimera Investment's share price held steady in 2010, it started to fall in 2011 and its now down about 40% since the start of that year as of late August. This means that despite the high dividend, investors have most likely suffered losses over the past year and a half.

But, investors need to be aware that Chimera Investment will be restating earnings from 2008 through 2011 as a result of a year long accounting investigation into the way it accounted for earnings from bonds bought at a discount. While a restatement sounds pretty bad (think of all those Chinese stocks that have imploded because of such announcements), the company was quick to point out that the restatement does not impact previously reported GAAP or economic book values, cash flows, dividends and taxable income. If there is any bright side to the announcement, it's that Chimera Investment can finally put the issue behind it once the restatement occurs and both it along with shareholders can move on from there.

On the other hand, the restatement also calls into question just what is the true value of the assets it holds and whether these assets can continue paying a strong income stream to investors. In fact, the restatement could even call into question the true level of risk that investors faced in mortgage REITs in general.

The Final Verdict: Chimera Investment

While income seeking investors should consider having mortgage REITs as a small portion of their portfolio, I would not be particularly keen on having Chimera Investment in my portfolio. Granted the company is moving in the right direction by resolving the asset restatement issue but it's also obvious that this stock is one of the more risky of the mortgage REITs out there. Given that most income seeking investors probably have capital preservation concerns, there are plenty of other mortgage REITs out there with better performances and are investing in less risky assets.

With that said, Chimera Investment is putting the accounting restatement issue behind it, meaning it might also be a good time for value investors with a high tolerance for risk to make a move. After all, the worst might be over and Chimera Investment is still paying a juicy but albeit falling dividend yield.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.