Business context and reporting period
Chimera Investment Corporation filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2011. The externally managed REIT invests primarily in residential mortgage-backed securities (RMBS), using leverage to earn the spread between investment income and funding costs. Its portfolio remained weighted toward non-Agency RMBS, while Agency RMBS grew substantially.
Financial performance and position
Amounts below are in millions of dollars except per-share data and ratios.
| Metric | Q3 2011 / Sept. 30, 2011 | Comparable period / prior year-end |
|---|---|---|
| Net interest income | $179.9 | $154.5 in Q3 2010 |
| Net income; diluted EPS | $65.9; $0.06 | $116.3; $0.13 in Q3 2010 |
| Nine-month net income; diluted EPS | $372.0; $0.36 | $349.6; $0.45 in 2010 |
| Comprehensive income | $48.6 for Q3; $80.5 for nine months | $148.2 and $498.8, respectively, in 2010 |
| Total assets | $9,714.2 | $8,073.7 at Dec. 31, 2010 |
| Stockholders’ equity; GAAP book value per share | $3,354.1; $3.27 | $3,683.0; $3.59 at Dec. 31, 2010 |
| Estimated economic book value per share | $3.01 | $3.23 at Dec. 31, 2010 |
| Cash and cash equivalents | $9.8 | $7.2 at Dec. 31, 2010 |
For Q3, management reported a 7.21% annualized yield on average earning assets, a 2.33% economic cost of funds, and a 4.88% net interest spread. The comparable 2010 figures were 8.85%, 4.58%, and 4.27%. Economic net interest income was $175.4 million, versus $152.0 million in Q3 2010. Nine-month economic net interest income was $592.3 million, versus $459.1 million.
Q3 2011 other-than-temporary impairment (OTTI) losses were $249.3 million gross, including $41.2 million of net credit impairment recognized in earnings. Nine-month net credit impairment was $105.5 million, versus $51.1 million in 2010. Interest-rate swaps generated $29.8 million of combined realized and unrealized losses in Q3; losses on embedded derivatives in interest-only RMBS were $28.2 million.
For the nine months, operating activities provided $338.1 million; investing activities used $2.0 billion; financing activities provided $1.6 billion. Total debt was approximately $6.2 billion, compared with $4.1 billion at year-end 2010. Period-end leverage rose to 1.8:1 from 1.1:1; recourse leverage was 1.2:1, versus 0.5:1. Repurchase agreements were $4.17 billion, with a 0.30% weighted-average borrowing rate and 70-day weighted-average remaining maturity. The company declared $0.13 per share in Q3 dividends and $0.40 per share for the first nine months.
Material changes versus prior periods
- Agency RMBS fair value increased to $4.95 billion from $2.13 billion at year-end 2010; non-Agency RMBS fair value was $4.41 billion, down from $5.53 billion. Management reported portfolio principal-value mix shifting to 25.5% Agency RMBS and 71.6% non-Agency RMBS, from 12.6% and 83.4%, respectively.
- Lower funding costs and increased average earning assets lifted net interest income and spread, but the asset yield declined to 7.21% from 8.85% in Q3 2010. Q3 net income and EPS fell year over year, primarily due to higher swap losses and losses on embedded derivatives in interest-only RMBS. Nine-month net income increased, but EPS declined as the weighted-average share count increased and impairment and derivative losses weighed on results.
- Other comprehensive income was negative $291.6 million for the first nine months, compared with positive $149.2 million in 2010; accumulated other comprehensive income fell to $30.0 million from $321.5 million at year-end.
- Common dividends were $0.13 per share in Q3, down from $0.18 in Q3 2010; nine-month dividends were $0.40 per share, down from $0.52.
Outlook, risks, contingencies, and unusual items
No specific earnings or dividend guidance is provided. Management expected to continue financing largely through repurchase agreements and stated that current assets, leverage, and borrowing arrangements were expected to support anticipated short-term liquidity needs. It cautioned that falling collateral values can trigger margin calls and could require asset sales, potentially at a loss, or additional debt or equity financing.
Key risks include credit deterioration in non-Agency RMBS, interest-rate and funding-cost changes, mortgage prepayments and extension risk, collateral valuation and liquidity, and reliance on short-term repo funding. At September 30, 82.75% of the consolidated non-Agency RMBS portfolio was rated below B or unrated. Management’s interest-rate sensitivity model projected that a 75-basis-point increase would reduce portfolio value by 4.68% and increase net interest income by 1.65%; a 75-basis-point decrease would increase portfolio value by 4.88% and reduce net interest income by 10.75%. Actual results could differ materially.
The SEC was reviewing interpretations of the Investment Company Act exemption relied upon by the company; an adverse change could require asset or financing changes and materially restrict leverage. The company reported that it met REIT and exemption requirements at quarter-end. Management reported no material legal proceedings or unreported contingencies and no subsequent events.
The filing includes immaterial restatements of prior-period results related to applying ASC 325-40 to certain non-Agency RMBS and to presentation changes. Separately, the company identified a material weakness in internal control over financial reporting: existing controls failed to prevent or detect the accounting error, and disclosure controls were not effective. It engaged an external accounting adviser and enhanced review procedures; remediation effectiveness was not established in this filing.
Most important facts an investor should verify
- Whether the accounting-control remediation has been implemented and independently tested, and whether any further restatements are required.
- Credit performance, valuation assumptions, and impairment trends in the large non-Agency RMBS portfolio, particularly its below-B or unrated holdings.
- Repo counterparties, collateral haircuts, refinancing availability, and potential margin-call exposure as leverage has increased.
- The sustainability of net interest spread and dividends under changing interest rates, prepayment speeds, and funding costs.
- Progress of SEC review of the Section 3(c)(5)(C) exemption and any effect on eligible investments, financing, or leverage.