Chimera Revisited: Dump, Hold Or Reinvest?

| About: Chimera Investment (CIM)

In the article I wrote last week there was a lot of discussion about Chimera Investment Corporation (NYSE:CIM), which is a Residential Mortgage Backed Securities fund.

There have been a number of negative articles posted on this company since early November when it delayed its earnings announcement and took a nominal write-off due to some "uncertainty" about the value of its holdings.

Since I went long on this fund in late March, the market value of the fund has gone from about $4.20 to $2.60:

(Click to enlarge)

So, the question of the day is: Should I dump it from my little RMBS portfolio, sit on it for awhile longer and see if it turns around, or take some of my dividend cash and buy more, since it is beaten down and has probably formed a technical base right around where it is?

The above article does an excellent job of summarizing the portfolio valuation and recent dividend performance of this fund, but I will point out a couple of other items from the most recent quarterly report:

First of all, even though this entire industry is still glowing in the dark from the meltdown of 2008, this is an extremely profitable business. CIM had interest income of about $177M in the first quarter, compared to interest expense of $7.1M, which is a 95% profit margin doing what CIM does, which is originating the funding for mostly non-agency-guaranteed mortgage loans. Their average interest rate spread, which is the difference between interest rate of the money they borrow and the money that they loan out was 5.58% for the quarter ending September of 2011.

The write-offs they have been taking are explained in their most recent Management Discussion: They transferred a lot of assets that they accumulated in 2009 and 2010 to some "resecuritization trusts". The trusts issued notes, the senior of which Chimera kept, and the subordinate of which they sold, and although the value of the trusts were still on Chimera's books at their original asset values, at this point they are essentially just the note holders. The write-offs that they are taking are to get their GAAP book value more in line with their "economic book value".

How much money are we talking about? Unfortunately, a lot. The difference between their "GAAP" and "economic" book values are on the order of $2B or about $0.26 per share. However, according to the management discussion, there are no effects of all of this on the rest of the $9B portfolio or other ongoing operations.

I would also throw out this quote from the management:

"Our estimate of fair value is as of a point in time and subject to significant judgment. Other market participants may derive a different fair value for each asset than we calculate. Should we sell the assets in our portfolio, we may realize materially different proceeds from the sale than we have estimated as of the reporting date."

What they're saying is exactly right: We do not know how the other companies in this industry are handling the topic that no one wants to talk about, which is how to value on the financial statements the value of real estate assets that are no longer performing.

A couple of other ideas for consideration:

Here is the dividend history:

(Click to enlarge)

When I bought this fund in March, with the price at $4.20 and a dividend of $0.14 I had the expectation that the dividends would remain stable, and so when I made that decision I "expected" my dividend yield for this year would be 13.33%. As it turned out, I "only" collected 12.6% on my investment, and the nominal market value aside, I am still delighted that I did not have that money sitting in a 2% CD, or in my online brokerage cash account which is paying less than 0.5%. If I were to clean out this account and buy more CIM today, with the expectation that the dividend remain $0.13 per share, I would be looking at 20% annualized, and so if it was a good decision to go long expecting to go 13.33% in March, it is even more attractive today.

So the first question is: What is the likelihood that the 13 cent per share dividend will remain the same? I suppose for the answer to that question you have to go back to the Management Discussion of Risks: Risk that interest rates will go either up or down and affect either repayment rates or borrowing costs, risk that the economy will tank again and a lot of people will stop paying their mortgages, which is particularly important with this fund, which is 80% non-government-backed loans. There are some others. Side question: Is there enough discount in the share price at the moment to insulate me from the risk that the dividend will be cut again?

The second question is: Do you believe that the management is competently managing this difference between book value and "economic value". Well, the company is run by a wholly owned subsidiary of Annaly (NYSE:NLY) and although the share price NLY is also beaten down a little, NLY still has a PE of around 8.6, compared to CIM which is about 5, so to the extent that the PE ratio is a measurement of the confidence of the marketplace in the management, CIM is trading at a discount. Also, as was pointed out in the comments on my previous article, CIM has seen about $600K in insider buying in November, so at least the management is confident.

The third question: What is the fund worth? The book value per share, net of the "restatement" is about $3 per share, so at the very least there is a 15% upside at the current stock price of $2.60.

If you wish to value the stock at some function of its ability to pay you money, and discount the current 20% dividend yield to somewhere around 17% which is where Cypress Investments (NYSE:CYS) is at the moment, you're looking at $3.05 per share on the immediate upside. If you discount the dividend down to 13%, which is what my expectation was last March, you're looking at $4.

The short percentage of CIM is about 5% compared to about 4.6% of NLY, and 11.9% of Invesco Mortgage Capital (NYSE:IVR), so perhaps the market considers this fund beaten down enough. We are still not in the realm of Bank of America (NYSE:BAC) whose short percentage is about 2.5%.

A Fourth question: To what extent will the other companies in this industry do the same thing that CIM did, and deal in a forthright way with the valuation of the assets in their portfolio? I will leave that one unanswered for the moment.

The ex-dividend date for CIM for this quarter should be around December 21st, The fund was upgraded today by Thompson Investments.

I believe in the Benjamin Graham theory that you should hang on to an investment as long as the underlying reason you bought it in the first place is still valid, and in this case since the underlying theory was "high dividends" I can't see selling it. Whether I double down in CIM at the bottom or invest in a similar fund like this is still in question. IVR's current annualized dividend yield is just under 24%,, since it was also beaten down in the last year, and is tempting. AGNC is 95% government-backed loans and yielding just under 20%, and the dividend has been more consistent.

Keep in mind that the world is chaotic, and there are no guarantees on anything, and past performance is not necessarily an indicator of future results, which in this case might be a good thing.

Disclosure: I am long IVR, CYS, AGNC, CIM, TWO.

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