A Real Estate Investor's Approach Towards Chimera Investment Corp.

Includes: CIM
by: Jan Brzeski

I recently wrote two articles on Seeking Alpha looking at Annaly Capital's (NYSE:NLY) balance sheet and income statement. I analyzed the company the way we would analyze a real estate investment, focusing on the income it generates, the dependability of that income stream, and the way that Annaly has financed its portfolio of investments. Finally, we examined how various scenarios, including a change in medium term (5 year maturity) interest rates might impact the company's shareholder's equity, which would probably in turn impact the company's share price--assuming everything else remained the same.

One of member of the Seeking Alpha community asked what I thought of Chimera Investment Corp (NYSE:CIM). This article aims to take the same approach we used in the articles on Annaly and apply it to Chimera.

I am Not a Professional Stock Market Investor or Analyst
I should note that all of my articles about public companies should be viewed as "naive" analysis. I have not tracked any REIT or mortgage REIT consistently, ever. I have never invested in a REIT or mortgage REIT stock, either long or short. I have not listened in on any earnings conference calls or seen presentations by the management of any REIT.

Annother reason some Seeking Alpha readers may view my articles as naive is that I am not writing for the professional investor who has detailed knowledge of the inner workings of REITs and mortgage REITs. I am writing for amateur investors who are looking for income, who are trying to avoid trouble, and who may or may not know how these businesses really work. I will spend more time explaining basic concepts and definitions than the average Seeking Alpha contributor, because I don't want to leave anyone behind and I want my writing to be accessible to the widest possible audience of people who are trying to be informed investors.

Where I Might Be Able to Add Value
I am well-versed in the tools and techniques used to evaluate real estate investments from a "value investing" standpoint. My expertise includes analyzing investments in loans secured by real estate, because to analyze such loans propertly, we start with an analysis of the value of the underlying real estate.

In reading much of the discussion about Annaly Capital and other REITs on Seeking Alpha, I am struck that many contributors seem to have more of a trader's approach to looking at the companies they write about. Most articles focus on what I would call the noise and chatter and second-order effects that might move the stock this week or next week.

Focusing on the Basics
My experience as a real estate and mortgage investor suggests that it is the big things that drive the performance, and risk, of an investment. So this article will absolutely overlook lots of things that are relevant to the prospects of Chimera. But by focusing on the big things that jump off the pages of the company's SEC filings, from a value-oriented real estate investor's standpoint, I will try to shed some light on the business and hopefully provide an impetus for a useful discussion of the company and the stock.

Chimera's Balance Sheet: Assets
The primary reference document for this article is Chimera's Q2 2011 form 10Q filed with the SEC. The see the document, click here.

The company has assets of $10.1 billion. About $5 billion of that is "Agency RMBS" which refers to bonds issued by Fannie Mae and Freddie Mac. Both agencies have been taken over by the U.S. Treasury and carry an implied, but not explicit, U.S. Government guaranty.

In addition, the company shows about $4.6 billion of "non-Agency RMBS." A little more than half of this amount is "senior" and the balance is "subordinated."

What is non-Agency RMBS?
RMBS stands for residential mortgage backed securities.These are bonds whose underlying assets are home loans. As homeowners make their monthly payments, the bond issuer collects these payments and distributes the income to the bondholders. Non-Agency RMBS means that the bonds do not carry a guaranty from Fannie Mae or Freddie Mac. If the underlying mortgages owned by the bonds go into default and the bond issuer cannot make payments promised in the bond prospectus, nobody is going to step in and save the bondholders or make up the shortfall. Non-Agency RMBS is, almost certainly in almost every conceivable case, riskier than Agency RMBS.

The Difference Between "Senior" and "Subordinated"
In the context of real estate loans, a senior loan is a first lien on the property. In case of default, the senior lender must be paid off before any junior lenders, or subordinated lenders, get their money back.

In the context of mortgage backed securities, these securities are frequently sliced into horizontal tranches with differing amounts of seniority or subordination. The subordinated tranche has higher returns but is also more likely to suffer principal losses if the underlying mortgages do not perform. To access a paper describing the process of slicing RMBS into tranches with varying risk, click here. I am not endorsing the author of this paper, and I have no relationship with the company that produced it, I simply found it when searching for relevant background information on this topic.

Chimera's Liabilities
Chimera has liabilities of about $6.7 billion, mostly in the form of repurchase agreements and securitized debt, both of which are a type of borrowing secured by the company's assets. Shareholder equity is $3.4 billion. The ratio of debt to equity is about 2.0 ($6.7 billion / $3.4 billion).

Income Statement
Interest income in the quarter ended June 30, 2011 was $194 million. On an annualized basis, this is $776 million. Compared with the company's assets of $10.1 billion, Chimera is earning a blended interest rate of about 7.7% on its investments.

Interest expense in the same quarter was $7.5 million, or $30 million when converted to an annual number. Compared with the company's liabilities of $6.7 billion, the blended cost of Chimera's borrowing is about 0.45%, or 0.5% rounded.

If Chimera Were a Leveraged Mortgage Fund, What Would Management Fees Be?

With the information covered so far, we can figure out what it costs Chimera's investors to have the services of the company. We will use the same technique discussed in the "Tying It All Together" section of my first article on Annaly Capital (click here to link to that article).

The difference between Chimera's blended yield on its investments and its cost of borrowing is 7.7% - 0.5% = 7.2%.

If Chimera invested its $3.4 billion of shareholders equity at 7.7%, then borrowed another $6.7 billion and earned a spread of 7.2% on that, ignoring operating costs, its cash-on-cash return would be approximately 7.7% + (2.0 x 7.2%) = 25.1%.

Note that in the Annaly Capital article, my math was incorrect. I neglected to add in the return that Annaly receives on its shareholder's equity and only counted the spread it earns on its borrowed capital. Because Annaly's leverage is higher, the impact of that oversight in the numbers was not as large as it would be if we made that mistake in looking at Chimera--which we won't do.

Chimera's actual dividend yield is about 18.3% as of the date of this article. Therefore, we can estimate that the operating costs of running Chimera, including compensation of the company's employees, amount to 25.1%-18.3%=6.8% of total assets under management. That corresponds to 6.8%/25.1%=27% of gross returns.

Suppose Chimera were a hedge fund operating on the "2 and 20" model. The first 2% of returns would go to the manager to cover overhead, leaving 25.1%-2%=23.1% returns. Of this return, the manager would earn an incentive fee of 20% of the 23.1% returns, or about 4.6%. The manager's total compensation would be about 2%+4.6%=6.6%. In fact, that is about what Chimera's management appears to be earning.

Of course this analysis is very rough. It does not account for the fact that Chimera may be setting aside some of its earnings (to the extent allowable under the REIT structure) as retained earnings, which would benefit shareholders. Of the theoretical 6.8% of gross possible returns that is "leaking" out and not getting paid to company shareholders, not all of that money is going to Chimera's staff in the form of compensation.

In this first article on Chimera Investment Corp, we looked at the company's assets, liabilities and shareholder's equity. We also looked at the company's income statement. We made some broad observations based on the relationship between its assets and its interest income, on the one hand, and its liabilities and interest expense, on the other hand.

Chimera is actually managed by a subsidiary of Annaly Capital, according to Chimera's filings with the SEC. Compared with Annaly, Chimera invests in riskier bonds, in that a substantial portion of Chimera's assets do not carry any U.S. government guaranty, either explicit or implied.

Because its investments carry more default risk, Chimera earns a higher interest rate on its assets than does Annaly, and it can generate high dividend payouts with a lower amount of leverage on its balance sheet. Chimera's debt-to-equity ratio is about 2 to 1, while Annaly's is about 6 to 1.

A Request to the Seeking Alpha Community for Input
In the next article in Chimera, we will take a closer look at Chimera's non-Agency assets. In addition, in researching Chimera it is clear that the company's shareholders suffered a huge loss in 2008, its first full year as a public company. The company's stock is also down significantly this year.

If any commenters can shed light on what happened in 2008, and what happened so far this year, I would be interested to know. As mentioned previously, I have not covered the company or paid attention to its stock until recentl. I am simply taking a snapshot of it today, through my own lens as a real estate investor and manager of a portfolio of real estate-backed loans.

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