Business:

Chimera Investment is a mortgage REIT that invests in agency and non-agency residential mortgage loans and residential mortgage-backed securities.

Summary:

Chimera presents an opportunity to purchase an unlevered portfolio of residential mortgage-backed securities at a steep discount to their probable realizable value. The primary driver of return will be the continued strength in the US residential housing market. At the 3/31/13 economic book value of $3.08/share, I estimate that the $7.7b principal/notional portfolio is being carried at a ‘fair value’ estimate of $2.7b or 35% and with an accreted yield reserve of $2.3b or 30% for an estimated recovery value of 65%. Furthermore, loss assumptions on the portfolio were established at purchase in 2009-2010 and are highly conservative and the credit performance of the underlying collateral has exceeded expectations to date. Consequently, I believe that actual recoveries may approach 70% - 85%.

Currently, the portfolio is trading at 0.96x economic book value. The portfolio consists primarily of private, non-rated mortgage-backed securities that are the subordinate and mezzanine tranches produced by 6 re-REMIC securitizations that CIM constructed in 2009-2010. If the portfolio realizes the recovery value estimated in the initial loss assumptions reflected in the accreted discount, an additional $2.22/share or 75% upside will be released over the next several years. If the ultimate recovery is to 70% - 85%, exceeding the initial loss assumptions, an additional $0.13 - $0.53 or 4% - 18% upside will be realized over the next several years.

Currently, I believe that the portfolio is being marked very conservatively and would command a price in the 40% - 45% range if sold to a private buyer today. I base this assumption on reviews of the underlying credit performance of the collateral for the 6 securitizations, as well as ABX index performance of other AAA and AA rated mortgage securities issued in 2006 and 2007. The underlying loans are primarily Alt-A jumbo whole loans issued to borrowers with FICO scores above 700. The portfolio is not subprime, not option-ARM collateral. Basically, simple jumbo loans issued to high credit borrowers that happened to be issued at a market top for the underlying home.

Consequently, I think there is a large margin of safety with the stock trading at book value which I believe understates current economic value. A permanent destruction of capital would require a change in underlying residential credit trends adverse to the portfolio. I believe the likelihood of this happening in the near term is nil, creating a highly asymmetric reward-to-risk profile for CIM.

In addition, since the cash flow on the securitizations waterfalls down from the senior to the subordinate tranches and the securitizations have now been performing for 3 – 4 years, cash flow should increasingly be directed towards the sub tranches that CIM owns.

The primary reason that CIM is mispriced is that it suspended publishing current financial statements after Q3 2011. Essentially, CIM was treating high credit quality and low credit quality loans identically and GAAP requires distinct treatment for each. Specifically, estimated and realized losses on high credit quality loans flows through the income statement, while such losses flow through both the income statement and the statement of comprehensive income for low credit quality loans. CIM filed its 10K for 2011 in March 2013, and is expected to file its 2012 10-Q’s and 10-K in 2013 following a change in auditor.

Notably, the accounting restatement impacts GAAP income, but does not impact book value, cash flow or taxable income. The company has been issuing quarterly press releases stating book value. In addition, CIM has committed to paying a $0.09 quarterly dividend through the end of 2013 representing a 12% yield.

CIM has sold off in recent weeks along with other mortgage REITS relating to interest rate fears. While CIM does have an estimated $3b agency portfolio that is primarily held to ensure compliance as a REIT and exemption from the ’40 Act, this portfolio is not the primary driver of CIM’s economics. The agency portfolio is levered 7x on $437MM in underlying equity, but these figures are estimated as the last portfolio data is for 12/31/12 and CIM may have well reduced the size of the agency portfolio since then as it was their only funding source available in the last 18 months since the lack of current financials has precluded them from raising equity.

Financial statements should become current in the next few months. 

 

Annaly who manages CIM will likely try and aquire the portfolio on the cheap (once financials are current) as they did with CreXus. Omega and Third Point are involved and I would expect a fight on price. Notably, given the accounting screw up, Annaly reduced their fee from 1.5% to 0.75% (no performance interest before or current) but also changed their contract to allow for them to be more readily fired as manager. I believe this gives great leverage in any merger negotiation.

 

Finally, the cash flow can't be ignored forever even if they continue to temper down the marks on the portfolio. Cash flow should accelerate sharply in the next few years as cash waterfalls down to the sub tranches held by CIM