Chimera Investment Corporation (NYSE:CIM) Q2 2016 Earnings Conference Call August 4, 2016 10:00 AM ET
Matthew Lambiase – President and Chief Executive Officer
Mohit Marria – Chief Investment Officer
Rob Colligan – Chief Financial Officer
Choudhary Yarlagadda – Chief Operating Officer
Bill Dyer – Head of Underwriting
Brock Vandervliet – Nomura Securities
Good morning, and welcome to the Second Quarter 2016 Earnings Conference Call for Chimera Investment Corporation.
Any forward-looking statements made during today's call are subject to risks and uncertainties which are outlined in the risk factors section in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the forward-looking statement disclaimer in our earnings release in addition to our quarterly and annual filings.
Additionally, the content of this conference call may contain time-sensitive information that is accurate only as of the date of this earnings call. We do not undertake and specifically disclaim any obligation to update or revise this information. Please also note, this event is being recorded.
I will now like to turn the conference call over to Mr. Matthew Lambiase. Mr. Lambiase, the floor is yours, sir.
Thank you, Mike. Good morning, and welcome to Chimera Investment Corporation's second quarter 2016 earnings call. Joining me on the call this morning I have Mohit Marria, our Chief Investment Officer; Rob Colligan, our CFO; Choudhary Yarlagadda, Chief Operating Officer; and Bill Dyer, Chimera's Head of Underwriting.
I'll make a few brief comments this morning about how we positioned the company, then Mohit will discuss the activity in the portfolio, and Rob will review the financial results. Afterward we'll open up the call for questions. But before we start, I'd like to say as a team, we're excited to be celebrating our first anniversary operating as an independent internally-managed company. We've come a long way in the course of the year, and I could not be more proud of my team. The hard work and the dedication of the men and women at Chimera made the transition seamless and successful, and I believe that together we have a great future ahead of us.
In the second quarter of 2016, we materially changed Chimera's asset mix by reducing our interest rate risk and increasing our mortgage credit exposure. We purchased approximately $5 billion of seasoned performing loans and sponsored three securitizations to finance the purchase. We structured and sold senior bonds from the securitizations and retained the high-yielding subordinate bonds.
Under the new risk securitization retention rules, Chimera has committed to consolidate the loans on its balance sheet and retain our investment in the deal for at least five years. An important feature of the securitization is that all the principle pay downs from the underlying loan collateral go to retire the senior bonds first, leaving Chimera's credit investment locked out from prepayments. In a low-yield environment, having less reinvestment risk is beneficial, and having longer duration high-yielding bonds will help the company continue to produce its dividend stream into the future. In these securitizations Chimera has retained the option to call each transaction at any time after four years. This allows us to seek better financing terms in the future.
In order to fund the purchase of the credit bonds from these three securitizations, Chimera reduced its agency portfolio by roughly $2 billion, and used cash and repo borrowings to fund the balance. Our agency portfolio, as we've stated on other earnings calls, is liquid and a ready source of capital to fund more attractive investments. In the current market, with a flat yield curve, higher financing costs and faster prepayment speeds, it's an easy decision to sell agency mortgage-backed securities, because our credit investments should require less recourse leverage and produce more consistent returns over time.
Being able to produce consistent returns and to continue to pay our dividend stream is our primary objective. The addition of these new loan securitizations along with our high-yielding Springleaf loan portfolio, I believe, will go a long way to help us meet that objective. In a yield-challenged fixed income market, our investment team has been able to assemble an $8.8 billion portfolio of current low loan balance, seasoned higher coupon mortgages. We now have over 96,000 loans on our balance sheet, with an average balance of just $92,000, and an average coupon of just under 7.25%. These loans were originated on average over 10 years ago, and have been performing well. Chimera acquired this loan portfolio at a discount dollar price.
We believe that over time these assets will perform better than other assets currently available in the mortgage market due to their moderate prepayment speeds, and their improving credit profile. In the two years that we've consolidated the Springleaf loans, we've seen stable prepayments. Consider that in the last six months of very low interest rates, this portfolio has experienced a 9% constant prepayment rate, and has an average coupon over 7%. Over the same period, 30-year Fannie Mae 4% coupon bonds paid at over 17% CPR. One of the reasons that prepayment rates are moderate on this portfolio is due to their low loan balance. High upfront fixed costs make refinancing low loan balance mortgages less economical for the borrowers.
Lower prepayment speeds for our portfolio means more stable cash flow, and less principle to reinvest. We like the credit profile of these borrowers. The loans are over 10 years old and the borrowers have been through a severe credit cycle, and continue to pay. Home prices have been steady, and there's been limited new supply of homes at this price point. The home owners' average monthly mortgage payment is approximately $800, which compares favorably to renting a similar apartment. Staying in the home and continuing to pay on their 10-year-old mortgage is most likely their chief housing option. We also believe that lower energy costs have a great impact on these borrowers. They've experienced a real increase in their disposable income this year every time they gas up their car or fill up their heating oil tanks.
It's our view that the cash flows that come from these mortgages will be stable. And we have structured these mortgages into bonds that are high-yielding, long duration, bespoke investments for our portfolio. The universe of non-agency securities available to purchase has been shrinking every month since the crisis. Being able to create our own bespoke investments gives Chimera a competitive advantage over those who simply just buy bonds in the market. The Chimera team has put together an investment portfolio that is truly unique, and has proven once again that Chimera is ahead of the curve when allocating capital in the mortgage market. In 2009, we told investors about the opportunity in the Re-REMIC market, and we executed over $10 billion of those transactions. And many of those high-yielding investments still remain on our balance sheet.
Today, we believe the best opportunity in the mortgage market is in seasoned performing mortgages. And our team has purchased and securitized over 8.8 billion of them to date. The size and scale of our credit investments in these transactions will be difficult, if not impossible, to reproduce. And more importantly, they'll be on our balance sheet producing high relative income for years to come. In a very difficult fixed income market, we believe that our portfolio sets us apart, and that investors will see real differentiation as Chimera continues to consistently produce its strong dividend into the future.
Now, I'll turn the call over to Mohit to discuss the details and the changes in the portfolio for the quarter.
Thanks Matt, and good morning everyone. I will briefly review macroeconomic factors, and then go over the investment activity for the quarter. The second quarter was characterized by spread tightening across the board as the market check-off the volatility experienced in Q1 2016.
The largest check-off was the post Brexit sell-off and risk, though that was extremely short-lived, with the markets having retraced well through pre Brexit levels. Interest rates, on the other hand, continue to slide lower with 10-year yields falling below 1.5%, and as a result have put rate hikes by the Federal Reserve on hold for the near term. While the fed may still raise rates for the share, we believe slower global economic growth would likely limit their ability.
In the second quarter, we initiated a substantial portfolio allocation shift. As Matt mentioned, this quarter we sponsored three identical securitizations on our shelf, totally approximately $5 billion. The underlying loan pool for these securitizations has some similarities to our Springleaf portfolio, and is over 10 years seasoned. This loan pool has a weighted average coupon of 7.35%, and an average loan balance of 107,000. 90% of the pool has full documentation. 95% of the borrowers are current for the past 12 months, and the loans were purchased at a discount to par value.
The senior bonds in these securitizations represent 70% of the capital structure, and were sold with initial coupon of 2.95%. Our equity investment over the three deals totaled $769 million. We expect unlevered loss-adjusted returns on this investment to be high single digits, while levered returns are expected to be mid-to-high teens.
The $1.5 billion CIM 2016-1 transaction settled on August 29, and the aggregate $3.5 billion CIM 2016-2 and 3 settled on May 31. So Q3 should begin to reflect full run rate performance of these investments, but the growth of the residential credit portfolio we reduce our interest rate sensitive Agency MBS portfolio in the second quarter by over $2 billion, a combination of 3.5% and 4% coupons. Along with the reduction in the Agency MBS portfolio, we terminated $2.3 billion in future contracts and interest rate swaps. The remaining $3 billion of the Agency MBS portfolio is highly liquid, and a potential source of capital should other mortgage credit opportunities arise.
Our Agency CMBS portfolio continues to grow, and we added over $160 million in new commitments this quarter, and it's now $1.3 billion in total. The investment activity this quarter produced the following end results for the portfolio. For the combination of Springleaf and the new loan pool, we now own a high-yielding small balance residential loan portfolio totaling $8.8 billion.
Through securitizations, we added 769 million call protected high-yielding mortgage assets. 83% of our equity capital is now allocated to mortgage credit, an increase from 73% in Q1. Our recourse leverage ratio from repo funding has decreased from 2.6 to 1 in Q1 to 2.0 to 1 at the end of Q2. Post quarter-end, we announced on July 26, that we were the winning bidder for Freddie Mac's pilot structured sale of seasoned mortgage loans that Freddie Mac currently guarantees.
We will acquire and simultaneously secure ties up to $199 million of loans with Freddie Mac purchasing the senior tranches of the securitizations at par. This transaction is expected to close by October of 2016. We continue to use securitization as the primary vehicle for financing our long-term mortgage credit in assets. With a challenging landscape our fixed income market we believe our portfolio remains well-positioned to produce attractive risk-adjusted returns for shareholders.
I will now turn it over to Rob to go through the financial results for the quarter.
Thanks, Mohit. I will review the financial highlights for the second quarter. The portfolio changes during the quarter have added approximately 5 billion of consolidated loans while reducing 2 billion of agencies. These changes have increased total leverage from 4.0 to 4.7 to 1 while reducing recourse leverage from 2.6 to 2.0 to 1.GAAP book value at quarter end was $15.78 per share and economic book value was $14.65.Our total return on GAAP book value for the quarter was 4.8% based on the increase in book value and the dividend paid.
GAAP net income for the second quarter was 74 million down from 83 million last quarter. On a core basis, net income for the second quarter was 96 million or $0.51 per share down from 110 million or $0.58 per share last quarter. We did incur 13 million or $0.07 per share of deal related expenses in connection with the 5 billion of loan securitizations we sponsored during the quarter. Excluding the deal expenses earnings would have been consistent with last quarter at $0.58 per share.
Debt interest income for the second quarter was 138 million even with last quarter. The yield on average interest earning assets was 6.2% up from 5.9% last quarter, our average cost of funds was 2.8% up 2.5% last quarter and our net interest spread was 3.4% even with last quarter. Although it's a challenging quarter to manage interest rate risk, our net interest return on equity was 17.6% for the quarter up from 17.3% last quarter.
Expenses for the second quarter excluding servicing fees and deal expenses were 11 million as certain of our expenses post internalization continued to ramp up. Specifically, we're still implementing new systems to help grow and scale our business. Importantly, we expect our expenses this year to be lower as an internally managed company than they were last year when we were an externally managed company.
That concludes our remarks. We'll turn the call back over to Mike for questions.
[Operator Instructions] The first question we have comes from Bose George of KBW. Please go ahead.
Thanks, good morning. It's Eric on for Bose. Excuse me.
Hi, good morning, guys. Hoping you can tease apart for us to non-accretable discount that you're holding for the three new securitizations, and if you can review the methodology that you use to change that number around over time, that would be great?
When you say changed the number around, clarify a little bit.
Just the path of that non-accretable discount over time?
Sure. So the non-accretable discount would be the difference between your purchase price and PAR on discounts that we don't expect to earn, right? So when we buy some of these pools, we don't expect to earn every single dollar. So, our loss-adjusted yields are still very positive. But we do have components of the bond or loan that we don't expect to recover to PAR. Over time, you know, we do have and you've seen the real reports of accretable and non-accretable discounts occasionally, and it's been somewhat of a pattern that if the credit performance better than our underwriting, some of the non-accretable discounts can actually move to the accretable discount and become a component of yield in the future. That answering your question, or do you have anything else you want to clarify?
Yes, as of today what is that non-accretable discount number for the three securitizations?
I don't have that number in front of me, I'll come back to you on that.
Okay. What is your cumulative default assumption on the three deals, can you share that number?
Hi, Eric. Yes, this is Mohit. We are liquidating, or our assumption is to liquidate around 21% to 22% of the pool.
Great. Thanks, Mohit. And last question from me; is there an effort to get any future Re-REMIC deals rated?
Yes, I mean we reevaluate that on each deal whatever we do 50 economics makes sense to include a rating, but given the strong demand for the asset type, we haven't really needed it rating agency. I think people are comfortable with the credit profile of the loans.
Yes, I think that's the kind of I think that underscores this whole market is that there's just thirst for high quality assets out there, and we were able to price three transactions in the quarter. And so, billions of dollars worth of senior bonds without any ratings on them and I think that just goes to the fact that in this market it's just very hard for large, it's too short [technical difficulty] for buyers to find high quality assets. But we have a rating or not, you know, it doesn't really matter. I don't think the economics would be that significantly different. And for us, it's about timing; if we had to go through a rating agency process on those three deals that we did this quarter, it would have taken probably months and months to get their arms around that. And the investors are -- the senior buyers are all very sophisticated people that can do their own credit work.
So I just think that for us that the market is evolving to the point where we probably don't need to have the rating agencies actively involved, and if you want, the securitization 2.0 that we're so involved in with the sponsorship of these deals is really becoming more of an adult swim in the marketplace, where you're not seeing -- you're seeing a lot of the deals getting done with just the couple large investors getting involved buying the seniors or support and picking up the subordinate.
That's very helpful. Thanks, guys.
Next we have Brock Vandervliet of Nomura Securities.
Thanks for taking the question. How much flexibility do you have with respect to the whole pool test or any other REIT constrained in terms of running down the agency book to fund these new non-agency structures?
Yes, this is Rob. I'd say we do have a little bit of room, we've disclosed in the past and I don't think it's changed as we have -- we would need about $2 billion of agencies. Obviously these new deals help as compared to old Re-REMIC deals which did not meet the whole pool test. But given the new loan securitization that we've done has actually helped the testament less reliant on the agencies. So I'd say we could take agency book down to about another down to about 2 billion in aggregate before or close to any breaching any of the tests.
Yes, but I would also say Brock just to that point is that, as just managing the company it's nice to have liquidity and it's nice to have more than you probably need to make the bare-minimum of comfort. So you know we will probably keep more than the bare-minimum on our balance sheet just because we do like to have liquidity. The agency, the genetic project loans that we've been acquiring and we have commitments to buy are very liquid. But then again, I think you know our choice is not to really sell them to take down the portfolio. So I think you're always going to see this kind of where we are as a pretty good comfort level for us and agency mortgages at the moment. But and I think we're going to be adding to the agency MBS over time.
Okay, great. And can you give us any further color on this Freddie Mac transaction in terms of the type of an age of collateral behind that I don't have that press release in front of me but it looked like whatever efforts Freddie had made in the past they were quite small, any sense of how large this could be?
Well, before I let Mohit talk about the deal and the opportunity, I just want to caveat everything saying that we're in the process, building his team of doing due diligence on the loan pool. The final statistics on the pool and the loans haven't been set yet. We have an idea. We have a target out of the pool, but we're still working on it. So just keep that in mind as we go through this. I mean so I don't want to give too many details on it but most and probably just thoughts to the bigger picture.
Sure. As far as the collateral on this transaction goes, we're still finalizing, but what was put in the press release was its about 130 month season it's got a 70 LTV, the prepayment history is spotty at best. It's not like the Springleaf and/or the pool that we acquired in the second quarter, but again the LTV is offsetting that and I mean these are REMIC eligible assets. So, from that standpoint, we got comfort. As far as the opportunity set, I think it's in the billion. I mean I think Freddie Mac obviously has a very large loan portfolio. And, I think it could be up to $20 billion of what they have to sell in the coming years.
Yes, and I would just say that the operative thing, I think the thing that's so interesting for this transaction specifically is that Freddie Mac is going to take care of -- it's going to take the senior bonds off of the transaction, which when you are doing one of these types of pools of loans and having the execution risk is always an issue. So with them taking the senior bonds off and distributing them later, that's the innovation and thing that we think is so interesting for the transaction. And it is a pilot program for us, $200 million is -- doesn't really move our needle, but we do think that it is very interesting for the future because I think whether Freddie Mac -- and I think Freddie Mac has been really innovative in looking at new waves to get out of the credit risk that have on their balance sheet.
I think once -- I think we're working with them to figure out the legal structure and to do it, but once this is done, I think there will be a lot of other people coming into the space. I think the deals could get more liquid. And I think the other guy Fannie Mae might come into the market and do the same thing as well. So, I think the opportunities that could be very large. But this is nascent. This is early stuff and it's a very small deal for our balance sheet. But we think there is going to be a good opportunity there going forward. And as a sponsor of the deal, our biggest risk is execution on the senior sales, and with Freddie Mac guarantying to purchase is an attractive source of firm financing, if you will.
Got it. Okay, thank you.
Actually, Mike, if we can -- we just wanted to follow-up, Rob wanted to follow-up with something here.
Yes, Mike. Just to answer the other part of the question from Eric this morning, the non-accretable discount on the loan pool was about 500 million, so just to add to the number.
Thank you, Sir. [Operator Instructions] It looks like we have a follow-up from Brock Vandervliet of Nomura Securities.
Thank you. Loosing a few queue this morning with some of the conflict…
I think it's a busy morning, yes.
Exactly. You mentioned the CPRs, could you just give a little color, say, Q1 to Q2 on what you saw in terms of the prepayment dynamics?
On the agency or the non-agency portion of the portfolio?
On the non-agency.
Yes. I mean again, even the significant value in rates from December through June 30, the non-agency stuff is pretty flat. I mean I think we are still experiencing high single digit on a weighted average basis. I think the portfolio in the aggregate is probably around eight to nine CPR and that's flat quarter-over-quarter.
Yes, and then of course agencies have picked up, and I think it really underscores these loans in particularly. There is just not a lot of available financing for some of borrowers out there. And I think the small loan balance, if you think about it. We have $92,000 of loan that people will be paying for 10 years. And do you really want to incur several thousand dollars to refinance that and lowering your payment as that the payback period is so long on that that I think that gives us some idea of safety in terms of voluntary prepayments. And if anything, I think we have seen maybe voluntary prepayments trick a lot going into the summers here, which is kind of unusual, but we haven't seen a spike up in these prepayments. I think in a very difficult mortgage market, where you have flat funding costs, low yields, and fast prepayments and everything is at a premium.
When you look at all the different options that you could have on your plate, it's a mortgage allocator -- mortgage money allocator, having money and having these types of loans in big size is a real -- I think is a real benefit to our shareholders because I don't believe that we are going to see a pickup in prepayments. And I think we are going to be harvesting this coupon, and I think we really feel that this is probably one of the best places to invest in the mortgage market today.
Great. Thanks for the color.
At this time, we are showing no further questions. We'll then conclude the question-and-answer session. I would now like to turn the conference back over to the management team for any closing remarks, gentlemen?
Well, I would just like to thank everybody here on my team at Chimera for making our transition to self manage the company so successful. And I would like to thank all of you. I know it was a busy morning for a lot of companies. I would like to thank you all of you for participating on our call and making it to the end. We look forward to speaking to you again in three months.
And we thank you, Sir, and to the rest of the management team also for your time today. The conference call is now concluded. At this time, you may disconnect your lines. Thank you again everyone. Take care, and have a great day.
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