Chimera Investment's (CIM) CEO Matthew Lambiase on Q3 2017 Results - Earnings Call Transcript

Chimera Investment Corporation (NYSE:CIM) Q3 2017 Earnings Conference Call November 2, 2017 9:00 AM ET

Executives

Emily Mohr - IR

Matthew Lambiase - President and CEO

Bob Colligan - CFO

Mohit Marria - Chief Investment Officer

Analysts

Sam Choe - Credit Suisse

Trevor Cranston - JMP Securities

Lee Cooperman - Omega Advisors

Operator

Welcome to the Chimera Investment Corporation Third Quarter 2017 Conference Call and Webcast. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. [Operator Instructions]

It is now my pleasure to turn the floor over to Emily Mohr of Investor Relations. Please go ahead.

Emily Mohr

Thank you, Lori, and thank you everyone for participating in Chimera's third quarter 2017 earnings conference call. Before we begin, I'd like to review the Safe Harbor statements. During this call, we will be making forward-looking statements, which are predictions, projections or other statements about future events. These statements are based on current expectations and assumptions that are subject to risks and uncertainties, which are outlined in the risk factor 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. During the call today, we may also discuss non-GAAP financial measures. Please refer to our SEC filings and earnings supplement for reconciliation to the most comparable GAAP measures. 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.

I will now turn the conference over to our President and Chief Executive Officer, Matthew Lambiase. Please go ahead.

Matthew Lambiase

Good morning and welcome to the Chimera Investment Corporation's third quarter 2017 earnings call. Joining me on the call this morning I have Mohit Marria, Chimera's Chief Investment Officer, Bob Colligan, our Chief Financial Officer, Choudhary Yarlagadda, our Chief Operating Officer and Vic Falvo, Chimera's Head of Capital Markets.

I want to start today's earnings call by welcoming Teresa Bazemore, Chimera's Board of Directors. Teresa was formally a President of Radian Guaranty and brings with her a wealth of experience in residential mortgage finance. Before radian, she held executive positions in Nexstar Financial, Bank of America Mortgage and PNC Mortgage Corp. Ms. Bazemore is currently a member of the Board of Directors of the Federal Home Loan Bank of Pittsburgh and has previously served on the Economic Advisory Council of the Philadelphia Federal Reserve Bank and the Board of Directors of the Mortgage Bankers Association. Both Chimera's management and its independent directors are excited to have someone of Teresa's expertise and experience to our Board and we look forward to her input in the years ahead.

This quarter, Chimera continued to expand upon our seasoned mortgage loan strategy. We purchased and securitized $783 million alone. And after quarter-end we issued a $512 million rated securitization, our first since 2012. This transaction was rated by both Fitch and DBRS with AAA ratings assigned to the most senior tranche. This is a positive development as it avails additional opportunity for Chimera to reach a broader investor base for securitized debt strategy. Mohit will explain the economics of these transactions later in the earnings call.

We continue to see good liquidity in the financing market for our non-agency mortgage securities. And this quarter we arranged a $356 million non-mark-to-market two-year secured term financing for unrated legacy bonds in our portfolio. This is the first non-mark-to-market financing that the company has executed outside of securitization and it underscores increasing liquidity in the financial markets available to Chimera.

The underlying fundamentals of the residential housing market remained positive. Home prices have been increasing nationally. And there's persistent low inventory in the starter home segment of the housing market. This is important for Chimera because the average outstanding balance on our loan portfolio is just $90,000. And increasing home values in this segment means we have more collateral and potentially better performance for our mortgages.

Over time, this should translate into lower loss assumptions and help bolster prices on our credit asset. We continue to believe the season low loan balance mortgage loans offer the best value in the fixed income market. In addition to positive housing fundamentals, this segment offers the benefits from a supply and demand imbalance.

The overall size of the non-agency market is less than half the size it was before the credit crisis. And investors demand for attractive risk adjusted spread product in this low interest rate environment remains very high. With positive economic housing performance and fewer bonds available for investors, we see liquidity remaining strong and the positive signs for valuation continuing until new supply offsets the strong investor demand which we think at this point may be years away.

These trends have been very good for our portfolio. This quarter Chimera's book value increased by 2.3% and year-to-date book value increased by 6.6%. Total economic return taking into account common stock dividend and change in book value was 5.3% for the third quarter and it's been 16.1% for the first nine months of 2017. Chimera now has a $21 billion balance sheet with 79% of our capital allocated to residential mortgage credit assets.

In the current fixed income market both attractive yield opportunities and high quality assets are scarce. Our strategy of securitizing seasoned mortgage loans and creating high quality assets for investors has been welcomed and well received by both financing counterparties and high grade bond investors. They have a large unique portfolio residential mortgage credit assets, which have become increasingly more valuable over the last year and we remain constructive on residential mortgage credit going forward. We continue to believe that Chimera is well positioned to generate steady income for our investors and to capture market opportunities in the increasingly volatile fixed income markets ahead.

And with that I'll now turn the call over to Mohit to review the quarterly portfolio performance.

Mohit Marria

Thank you Matt and good morning everyone. Q3 was so much of the first two quarters of the year, with both equity and fixed income markets continuing their strong performance. Trading rates changed modestly over the quarter, with short-term interest rates being - have been higher versus longer term rates causing the yield curve to flatten. Strong investor demand for fixed income assets continued to lead credit spreads tighter, helping to drive the increase in our portfolio's net asset value.

Chimera's agency pass through portfolio was marginally lower this quarter by 60 million as we remain cautious on agencies with a flatter yield curve and ahead of the potential unwinding of the Federal Reserve's $1.8 trillion agency portfolio. In agency investment, we currently favor the return profile and more certain cash flow characteristics of agency CMBS and added 400 million to our portfolio this quarter.

This segment of our portfolio has grown to 1.8 billion representing approximately 42% of our agency investments. We continue to like and deploy our capital in seasoned mortgage credit opportunities. This quarter, Chimera bought and securitized 783 million seasoned performing loan balanced residential mortgages.

The weighted average coupon of the portfolio was 6.46% and the weighted average loan age was 143 months. This pool of loans had an average loan balance of 89,000. Chimera retained 156 million subordinate bonds as an investment and expect to generate low-to-mid double digit levered returns.

This securitization closed at the end of August and was unrated. After quarter end, in October, we completed our first rated RPL transaction with loans we settled down in Q3 totaling 512 million. This deal CMI 2017-7 was rated by Fitch and DBRS and had AAA ratings on the senior most rated tranches by both rating agencies.

Rated bonds provide Chimera access to a broader range of investors for our securitizations affording us more opportunities in the future to structure deals best suited to the individual loan packages. CIM 2017-7 had a 5.08% weighted average coupon, weighted average loan age of 137 months and 144,000 average loan balance.

The return profile for this investment looks very similar to Chimera's other recent securitizations. Also after quarter-end, we refinanced 1.3 billion of outstanding bonds including the final Springleaf deals, Springleaf 13-2A and Springleaf 13-3A as well as their first Springleaf re-lever CSMC 2014-CIM1 and CIM 2016-5. We will provide more complete information and economics for these series of transactions on our next earnings call.

As of the end of Q3, Chimera has acquired over 146,000 loans for a total unpaid principal balance of 13 billion. The aggregate portfolio has a weighted average loan balance of 89,000, 6.97% weighted average coupon and 143 months weighted average loan age. Improving housing fundamentals will continue to benefit our residential credit portfolio. A strong credit performance and our currently low recourse leverage, we have ample ability to increase our portfolio when attractive investment opportunities are available.

I will now turn the call over to Rob to review the financial results.

Bob Colligan

Thanks Mohit. I will now review the financial highlights for the third quarter. GAAP book value at the end of the third quarter was $16.92 per share and our economic return on GAAP book value was 5.3% based on the quarterly change in book value and the third quarter dividend per common share. GAAP net income for the third quarter was 130 million, up from 106 million last quarter. On a core basis, net income for the third quarter was 116 million or $0.62 per share, up from 112 million or $0.60 per share last quarter.

Securitization deal expenses were 3 million in the third quarter compared to 1 million in the second quarter. Net interest income for the third quarter was 156 million, up from 151 million last quarter. The increase in net interest income relates primarily to the increase in Chimera's loan portfolio, partially offset by higher financing costs as LIBOR has increased. The yield on average interest earning assets was 6.3% compared to 6.2% last quarter.

Our average cost of funds was 3.6% compared to 3.5% last quarter and our net interest spread was 2.7% unchanged from last quarter. Total leverage for the third quarter was 4.6 to 1, while recourse leverage ended the quarter at 1.8 to 1. Our net interest return on equity was 16.9% for the quarter, up from 16.6% last quarter and a return on average equity was 15.4% for the quarter, up from 13% last quarter. Expenses for the third quarter, excluding servicing fees and deal expenses were 12 million in line with the second quarter.

That concludes our remarks and we'll now open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Bose George of KBW.

Unidentified Analyst

Thanks good morning, it's Eric on Bose and congrats on another solid quarter. Can you tell us the yield leverage levels and expected ROEs on incremental purchases that you made during the quarter including the securitization that you completed I guess after quarter end.

Mohit Marria

Sure, hey Eric, this is Mohit. The expected yields on loans that we've acquired in third quarter and heading into the fourth quarter probably range anywhere between mid-4s to high-4s depending on the credit profile of the loan pool. And through securitization, we're able to get an advance rate anywhere between 75% to 80% which you can probably finance that around swaps plus 100. So, all-in cost of debt is probably just inside 3%. So your levered returns on a cash basis are probably mid-high single digits, probably around 7 - potentially 8% and with some recourse leverage generating mid-teens type of leverage returns.

Unidentified Analyst

And is there a funding benefit that you guys expect to capture from having the one deal that you did rate. And then I assume that the plan is to rate more deals as they come through. And if there's a funding benefit that you expect to capture there. Thanks.

Mohit Marria

And having the ratings definitely opens up as Matt said on his opening remarks, the investor base in addition to the tighter execution. AAA's unrated securitizations have tightened in to anywhere between 70 to 75 swaps where non-rated stuff as I just mentioned is around 100 swaps and have been tighter. So there's definitely a pickup there, but your advance rates on AAAs range anywhere from 55% to up to 80% depending on again the collateral profile. I think having done one rated securitization now, going forward, as we review our loan packages that we have on balance sheet as well as new stuff we're looking to acquire, we have a better understanding of what the rating agencies are looking for to optimize the advanced rates on our structures going forward and optimize the financing costs.

Matthew Lambiase

And I think that point, we are seeing just a tremendous amount of liquidity in the bond markets for unrated deals as well as rated deals. And we see the spreads compressing both on the rated transactions and on the unrated transactions and there's a certain amount of ease in terms of selling unrated securitizations versus the rated securitizations. And the rated securitizations have extra costs involved. So it becomes - the spreads on rated bonds are much tighter, but they also have other costs that go with it. And I think, as time progresses, there will be times when we want to do rated deals or unrated deals depending on where spreads are, but certainly we have - we certainly opened up to a whole new range of investors in our securitizations.

Unidentified Analyst

One more from me if you don't mind. What's the initial credit reserve that you guys took on the NPL securitization you completed?

Matthew Lambiase

We didn't complete any NPL securitization.

Unidentified Analyst

Sorry, the one that you guys did post quarter end?

Matthew Lambiase

Oh, that's another rated RPL securitization, similar to the ones we've done. I mean as far as reserves, I don't think we take reserves.

Bob Colligan

Well, we used our value accounting for that. So we don't have a reserve concept for those deals.

Operator

Your next question comes from the line of Douglas Harter of Credit Suisse.

Sam Choe

This is actually Sam Choe filling in. You guys had a good quarter in terms of adding loans this quarter. So I just wanted your thoughts on what you're seeing in terms of the pipeline going forward?

Mohit Marria

Hey, Sam. This is Mohit again. As far as flows, loan activity has definitely picked up, heading into quarter four. We're still seeing loans that are being shared by the GSEs. There is loan packages out for sale from mid-tier banks as well as some private equity funds. So as far as supply goes, there's ample supply heading into Q4 and I think that's a result of sort of the tighter execution people are getting on their loan packages, but that's being offset by a pretty good execution on the securitization side for entities like us. So I think there's no shortage of loans to look at.

Matthew Lambiase

Yeah. It seems to us that the loan market is probably the most vibrant part of the fixed income markets, in structured finance and CUSIP trading, you're seeing less and less actual bonds trade. But we are seeing loans and loan packages come out and we've had no problem to date finding things that we want to invest in.

Sam Choe

And my other question was how do you see leverage trending out throughout the year and into 2018?

Matthew Lambiase

Well, I would say that we're very comfortable with our leverage right now. Recourse leverage ticked up a little bit to 1.8 in this quarter and that really gives us a great ability to increase our leverage when we see good investment opportunities come down the pike and I think we have a lot of room on our balance sheet to grow earnings and it's really just about adding assets - credit assets, loan packages that fit kind of what we want to invest in and we're really not looking to add agencies or take on extreme amount of interest rate risk in this market. We like the credit portfolio that we've developed and really we're in a great spot right now. We have a lot of opportunity, a lot of ways to increase our balance sheet without raising equity and without taking a lot of interest rate risk. And I would say that, I think you've seen modest uptick in leverage going through next year, but nothing crazy.

Operator

Your next question comes from the line of Trevor Cranston with JMP Securities.

Trevor Cranston

So looking at the results, obviously, we can see what the trend has been this year in terms of core EPS versus the dividend that's been paid. Can you guys maybe talk about and give us an estimate on how you think the trend has been in terms of the dividend versus your estimate of taxable income thus far in the year. Thanks.

Bob Colligan

This is Rob. So, we look at the dividend and our run rate at the beginning of the year, as you know, we've set the dividend, preannouncing giving guidance. So usually at the beginning of each year, we take a look at our run rate and get a sense of where we're trending. We don't turn the portfolio over a lot, so we do have decent insight. This year, we've had a number of rate increases that some maybe predicted, others may not, but we do a lot of analytics around the portfolio and run rate. So once we get comfortable with that, then we set the dividend. But I can tell you this year, the dividend is covered with taxable earnings or we expect it to be very close to where the dividend is. Core versus taxable, there are some timing items and other adjustments that don't exactly correlate core to taxable, but probably importantly, we feel that the dividend is covered with taxable earnings.

Trevor Cranston

And then another question on the non-mark-to-market funding facility that you guys were able to put in place. Just wanted to clarify is that - are you guys able to pledge retained positions from your new securitizations that you're doing on that facility or is that strictly for the sort of legacy CUSIP bonds that you own and then also I was just curious if there's any sort of differences in that facility in terms of fees that have to be paid or a difference in the rate versus more traditional repo?

Mohit Marria

This is Mohit. As far as what we've been able to do, that was based off of legacy CUSIPs, but we're also exploring opportunities to potentially finance the back-ends of securitizations that we hold as well and we're vetting that option out currently. Given that it's a non-mark-to-market facility on longer term financing, the rates are probably higher than where recourse lending would take place in the markets, but not significantly higher where the non-mark-to-market and the longer tenure is definitely something that's attractive to us and gives us more certainty on the financing side.

Operator

[Operator Instructions] Your next question comes from the line of Lee Cooperman of Omega Advisors.

Lee Cooperman

I have a series of questions that are by and large interrelated, but before I ask them I just got to give you a shout out. I think, you guys have done an excellent job in working for the shareholders. You intelligently bought back stock when it was very cheap and you did a very good job of managing the enterprise. So I congratulate you. So my questions are interrelated. In the last five quarters, I think our average core earnings are about $0.61 a share. In the current quarter, we had $0.62. Do you look at the current $0.62 as sustainable, number one?

Number two and I think you kind of referenced this a little bit, is the balance sheet fully deployed or is it more leveraging opportunities that you can enhance sustainable recurring earnings? Three, do you feel comfortable that the 15% ROE that you're generating roughly now is sustainable? And I guess fourth, a logical question about the attitude towards the dividend. With the stock trading at a premium to GAAP book value, I would assume repurchase is not something you're actively considering. At what point would you consider the dividend? And lastly, if I said to you a year from today, the Fed funds rate would be 2%, how would that affect the business? How matched are we? Thank you again for - thank you for the answers and thank you for your performance.

Matthew Lambiase

Thank you, Lee. I would say just ticking down here that our earnings, I feel pretty good. I mean, you have to tell me what goes on with the Federal Reserve and where interest rates go and there's a lot of components that go into our earnings stream, but I would say the way the portfolio is constructed and the way it's currently performing, I feel very comfortable around that $0.60 core earnings for the foreseeable future. So I think we feel pretty good about that. We feel good about the way the assets are performing and the nice thing about the portfolio that we have is it has not had a very fast prepayments on it. So we're seeing a pretty large portfolio of credit assets that are prepaying at moderate speeds that have high coupons for a number of reasons, but that's very good for a stable earnings of a company and I think we feel very good about the portfolio going forward.

I think the 15% ROE is also - we're going to be and I don't like to hang out there too much, but I feel pretty good about our ability to generate a very high ROE going forward into next year. Now again, there's a lot of things that could happen in the marketplace and we're looking very closely whether will get in, as the Fed Chairman and where short term interest rates go, but I think the way we're currently position, we feel very comfortable that we're going to be able to produce this type of return profile, at least, for the foreseeable future, for the next couple of quarters definitely.

I would say that when it comes to dividend, yes, we are producing high core earnings and it is something that we model out and we show to the board. And we discussed with the board in the first quarter. Generally, when we're making announcements for our dividend for the first quarter and the company as you know Lee has been very good about looking out and projecting out what our earnings are going to be for the year and making a dividend announcement, usually the first dividend announcement of the year, we'll give guidance for the rest of the year and certainly the earnings have been stronger and we've been able to grow the portfolio this year. So I think that will all be taken into consideration in the first quarter.

Lee Cooperman

So if I said to you, you asked if I had a view of interest rates, if I said to you, the Fed funds rate a year from today was 2% and the 10-year government was close to 3%, how do you think that would affect our business?

Matthew Lambiase

I'm going to throw Mo in to the bus on that one.

Mohit Marria

Hey, Lee. So as far as Fed funds going up to 2%, I mean we've had three Fed hikes as Rob mentioned this year and the income and the way the portfolio has been positioned has been well absorbed, I mean income as you mentioned has been around $0.61 for the last five quarters and $0.62 currently. We think the portfolio is protected with the hedges we have on, the way the portfolio has been constructed to handle a potential three or four more rate hikes. I mean, they will have some impact on income. I think it may decrease income by 10%, I don't think that's meaningful based on assets we could add if that does happen.

The other metric that we have that could be pushed a little bit tighter is the financing costs. They have come in quite significantly since last year, given the demand of assets from depository to put non-agency credit on and finance it. Spreads there have gone in from 2.50, in some cases down to 1.50 and I think if the Fed was to tighten a little bit more, I think those counterparties would still want to have exposure to those assets and may refine what they're looking for on a spread basis. So I think that could be offset by some of that as well.

Bob Colligan

This is Rob. Let me just add in and thanks for your questions and comments. We've been pretty conservative, obviously, Matt mentioned that leverage is low. It gives us some opportunities to move the portfolio around to make sure earnings are steady and stable for the investors, but I do want to mention too, we've averaged out as we said, the $0.61 a share over the last five quarters, but we may have certain quarters, given deal expenses or other items where we could end up in the low to mid-50s because we have a bunch of deals in one particular quarter and then earnings may be a fair amount higher if we don't have any deals in a particular quarter or so. They will appeal to get locked into expecting an exact number every single quarter. There will obviously be some variability, but over a long period of time and it's a nice way to frame that, we've averaged to nice solid earnings.

Lee Cooperman

As I say, we'll get the answer basically in January I guess because we've been averaging say core earnings or something, et cetera of $0.60 and we're paying a dividend of $0.50, do you want to retain that dime or do you want to retain a little bit less and give more money to shareholders? But I'm happy to have myself in your hands because you guys are doing an excellent job.

Matthew Lambiase

I am on your side Lee.

Lee Cooperman

Look, you guys are doing a terrific job.

Matthew Lambiase

And listen, we think the portfolio is really a tremendous portfolio to provide value to our shareholders for long period of time. It really is a unique large portfolio, you couldn't put this together. It's a very - I think we have a very unique proposition to the marketplace that's going to produce very high income for our shareholders going into the future. We're very bullish on the prospects of our earnings ability going forward and we like the portfolio we've put together and we're just - we think we're in the right place in a very cup market and we're really not out there trying to raise money to go after interest rate risk here. I'm not sure what the upside of that is and I think we just continue with the credit as the market gets better for housing and as there's less and less bonds available in the marketplace, we are in a very good position.

Operator

Thank you. I'll now turn the call to Matthew Lambiase for any additional or closing remarks.

Matthew Lambiase

Well, we look forward to talking to you in the first quarter of 2018 and thank you very much for participating in our 2017 third quarter earnings call for Chimera.

Operator

Thank you for participating in today's conference call. You may now disconnect.