This article was available to subscribers on 06/21/2016.
Updates Since 06/21/2016
Brexit rocked the markets since this piece was published. With the exception of stated share prices from that date, I believe the rest of the work remains highly relevant to investors. When this article was written, I had no position in any of the mREITs. I very recently initiated a position in MTGE.
Chimera Investment Corporation (NYSE:CIM) is a moderately unique mortgage REIT. Its portfolio is at least a little different from any other mortgage REIT, but some comparisons can be made in a manner that is close enough to give a relative feeling of the fair value of the stock. CIM has been on an incredible run since it bottomed out earlier in February around $11.32. By any measure, the market was being too bearish at that point, and pretty much every mortgage REIT has a strong return since then. Since CIM invests in assets with more credit risk, the its gains are a combination of higher values for credit-sensitive assets and higher valuations relative to book value for mortgage REITs.
Unique Valuation Issue - Being a Sponsor
When most investors look at methods like price-to-book, they may want to use the trailing value for GAAP book value. I try to update those trailing values, but I usually start with GAAP book value. For Chimera Investment Corporation, the situation is a little more difficult.
Chimera Investment Corporation sponsors "Mortgage Loan Securitizations". When the company does this, it is able to pool a large number of loans together to create a thoroughly diversified batch. The batch is then cut into different pieces, with the major difference being the seniority and the yields on the pieces. The lower pieces in the totem pole take on more risk because they have to absorb losses before the senior pools. CIM likes to sponsor the production of these assets and retains the lowest piece on the totem pole. This is the "first loss tranche". If none of the borrowers default, or very few default, CIM should earn excellent returns on this position.
Unique Valuation Issue - Consolidation
The thing about owning that first loss tranche is that it results in consolidating the entire pool onto your balance sheet.
Hypothetical example: CIM could have a pool of $1 billion on its balance sheet. The company may have sold $900 million in senior claims, but it is required to consolidate the entire $1 billion. This would give CIM an asset of $1 billion and a liability of $900 million.
If investors believe a mortgage REIT carries all assets and liabilities at fair value, this would seem like a non-issue. If the fair market value of the entire pool moves up to $1.1 billion, but the entire gain is a result of the market-loving senior tranches (which were already sold), an investor might think the new asset value is $1.1 billion and the new liability value is $1 billion. In that case, no change in equity, so no big deal, right? The problem is that the loans that were sold from the pool are carried at "historical amortized cost", which is explicitly not the same as "fair value". In the situation that was just described, the asset value would go up to $1.1 billion and the liability value would remain at $900 million. Under these rules, CIM has a gain of $100 million that brings equity from $100 million to $200 million.
It would also be possible for the market to become much more bullish about the first loss tranche position, while becoming less excited about the senior positions. Then, the entire value of the consolidated position might remain at $1 billion and the liability would remain at $900 million. It would look like nothing had happened, but the fair value of CIM's position could have increased to $150 million without it showing up, because the result was masked by the consolidation.
CIM Handles This Very Well
I have to give CIM's management credit. They try to be very clear about this challenge. They put together a presentation on the difference between GAAP book value and economic book value.
I don't think the presentation would classify as easy reading for most investors, but this is a strong effort put forth by management to demonstrate why it is important for them to also report "economic book value".
What is "Economic Book Value"?
Economic book value is the value management reaches after they make adjustments to their consolidation that adjust for splitting up the fair value of each part of each pool they sponsored.
At the end of Q1 2016, the GAAP book value was $15.52 per share. The economic book value, on the other hand, was only $14.46 per share. The reconciliation from GAAP book value to economic book value can be seen for both Q1 2016 and Q4 2015 in the chart below from CIM's Q1 10-Q (page 57):
What to Use
Investors should never throw the GAAP values out the window, but I do believe the adjustments management makes are very important here. While I've seen many companies provide "low-value adjustments", where they attempt to create absurd metrics so they can look better, CIM is providing a real service to investors by indicating the fair value of the positions it actually owns. For most mortgage REITs, the GAAP book value is the best place to start, but for comparable values, I think the economic book value provided by management gives investors a value that is comparable to what a mortgage REIT without consolidation would report.
At the time of my writing, CIM shares trade at $15.62. This is an 8% premium to the trailing book value. To be fair, I believe credit-sensitive assets are having a great quarter, and I suspect the economic book value will be higher now than it was at the start of the second quarter.
The problem is what happens to CIM if the economy hits another rough patch. To get support to share prices from a buyout offer, a mortgage REIT needs to trade at no less than a 25% discount to book value (based on my estimates from watching the last several deals), and the deal is much more likely at a discount of 35%. If another mortgage REIT were to acquire CIM, it would probably start the discussions by applying a discount to the economic book value, not the GAAP book value.
Even if economic book value rocketed up by a full 8% (seems unlikely, but I don't have a model done), it would mean CIM was trading at economic book value, and the potential floor would be about 25-35% lower. Further, it is entirely possible for an mREIT to at least temporarily fall right through the floor. The problem becomes even worse since the mortgage REIT relies on first loss tranches. If the market is in a panic and prices for mortgage REITs are falling, then the economic book value is likely to get smashed.
In a nutshell, if things turn bad for the sector once again, it would be feasible for CIM to see economic book value decline towards $13-14. Even assuming it only hit $14, a buyout offer at 80% of book value would be $11.20 per share. This is a "worst-case scenario", but it is materially more risk than some of the mortgage REITs seem to demonstrate in the current environment. Further, assuming a buyout offer at 80% of book value and only $.46 in decline of book value is, in my opinion, hardly a worst-case scenario. There are mREITs right now trading at less than 80% of book value.
Theory on Strong Pricing
I believe a substantial amount of retail investors are flowing into the sector, and that they are overwhelmingly favoring mortgage REITs that have strong dividend yields and less cuts in the payout. I believe these investors have no clue what they are buying when they purchase shares. CIM was smart enough to make public comments about expecting to be able to sustain its dividend throughout the year. Remember that sustaining a dividend doesn't mean the portfolio can really sustain it indefinitely; it simply means continuing to pay the dividend in the short term. Meanwhile, CIM may well be trading above economic book value, so it would make sense for the company to be issuing new shares and using the proceeds to fund new mortgage loan securitizations, such as the one announced in the link at the top of the article.
I'm going to do some more work on CIM to provide a deeper look into the portfolio and hedges that are in place. In my opinion, American Capital Mortgage Investment (NASDAQ:MTGE) is a dramatically more attractive total return vehicle, based on current prices and my rough estimates of current book values.
By my estimate, Orchid Island Capital (NYSE:ORC) is also trading at high valuations, and an investor holding both ORC and CIM has a portfolio that is fairly similar to that of MTGE. Specifically, if an investor were to spend $10,000 on MTGE, he would have ownership in roughly the same assets and hedges as an investor spending $3,850 on ORC and $6,150 on CIM. The major difference is that the investor in MTGE would have substantially less debt (and more equity) on the balance sheet. I'll go deeper into that later when I have adequate material out demonstrating each portfolio.
My outlook is bullish on MTGE, bearish on CIM, and bearish on ORC. While the combined portfolios are fairly similar, the amount of equity acquired is vastly different.
Pitch for Subscribers
Since the Mortgage REIT Forum is a new, exclusive research platform, the first 100 subscribers will be able to lock in their subscription rates at only $240/year. My investment ideas emphasize finding undervalued mortgage REITs, triple net lease REITs, and preferred shares. With the market at relatively high levels, there is also significant work on finding which securities are overvalued to protect investors from losing a chunk of their portfolio.
Disclosure: I am/we are long MTGE.
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.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.