Chimera Investment Corporation — Q3 2014 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2014. Chimera is an externally managed mortgage REIT investing in Agency and Non-Agency residential mortgage-backed securities (RMBS) and residential mortgage loans. Unless stated otherwise, financial amounts below are in U.S. dollars.
Key financial results
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Net interest income, GAAP | $151.5 million | $105.3 million | $363.3 million | $303.2 million |
| Net income | $377.6 million | $67.4 million | $582.7 million | $290.4 million |
| GAAP diluted earnings per share | $0.37 | $0.07 | $0.57 | $0.28 |
| Core earnings, non-GAAP | $115.8 million ($0.11/share) | $92.9 million ($0.09/share) | $282.0 million ($0.27/share) | $263.3 million ($0.26/share) |
| Economic net interest income, non-GAAP | $134.3 million | $99.8 million | $328.5 million | $286.8 million |
| Economic net interest rate spread | 3.93% | 5.29% | 6.85% | 7.72% |
| Economic net interest margin | 4.30% | 6.84% | 7.91% | 9.80% |
Q3 earnings rose sharply, but the increase primarily reflected fair-value gains rather than recurring earnings: a $162.9 million net unrealized gain on financial instruments at fair value, compared with a $27.9 million loss a year earlier. The new seasoned subprime loan portfolio contributed a $139.0 million unrealized gain, and related fair-value debt contributed a $29.5 million gain. Management cautioned that unrealized gains may not be realized and do not determine dividend-paying capacity. Q3 also included a one-time approximately $24 million payment from FIDAC, the manager.
Economic net interest income increased, while spread and margin contracted year over year as average asset yields declined more than funding costs. Management attributed the higher interest income primarily to portfolio expansion in Agency RMBS and securitized loans.
Financial position, funding and cash flow
- At September 30, 2014: total assets were $17.49 billion, versus $6.94 billion at December 31, 2013; stockholders’ equity was $3.59 billion, versus $3.33 billion. GAAP book value was $3.50 per share. Management’s non-GAAP estimated economic book value was $3.15 per share, $0.35 below GAAP book value; management noted this estimate is judgmental and not a substitute for GAAP book value.
- Portfolio shift: Agency RMBS pass-through fair value increased to $7.96 billion from $1.95 billion. The company acquired interests in trusts holding approximately $4.8 billion of seasoned subprime residential loans during Q3. At period-end, the portfolio at amortized cost was approximately 50% Agency RMBS, 16% Non-Agency RMBS and 34% securitized loans, compared with 36%, 50% and 14%, respectively, at year-end 2013.
- Debt and leverage: repurchase agreements were $7.84 billion, up from $1.66 billion; reported total leverage was 3.8:1 versus 1.0:1. Recourse leverage was 2.6:1 at September 30, 2014. Repurchase agreements had a 0.57% weighted-average borrowing rate and 67-day weighted-average remaining maturity. Consolidated VIE liabilities were $5.07 billion and are non-recourse, generally payable only from the related asset pools.
- Liquidity and cash flows, nine months: cash increased to $241.6 million from $77.6 million. Operating activities provided $155.4 million; investing activities used $5.47 billion, largely reflecting purchases of Agency RMBS; financing activities provided $5.48 billion, chiefly from net repo borrowing. The filing states management believes cash and available financing are adequate for anticipated short-term needs, but collateral-value declines could trigger margin calls and force asset sales.
- Dividends: $0.09 per common share was declared for Q3, and the board declared $0.09 per share for Q4 2014. Dividends declared were $0.27 per share for the first nine months.
Material changes and unusual items
- Balance-sheet scale and leverage increased substantially, particularly through Agency RMBS purchases financed with repurchase agreements and the Q3 consolidation of seasoned subprime loan trusts.
- Q3 net income included $64.1 million of net realized investment-sale gains, alongside the significant unrealized fair-value gains. The nine-month results also included a $47.8 million gain on deconsolidation and a $2.2 million loss on extinguishment of debt.
- Net derivative losses were $10.2 million for Q3 and $60.4 million for the nine months, compared with losses of $3.4 million and gains of $4.3 million in the respective 2013 periods. Derivative positions are used to manage interest-rate exposure, but are not designated as GAAP hedges.
- The management agreement was amended in August: the annual management fee increased from 0.75% to 1.20% of gross stockholders’ equity, and FIDAC made the approximately $24 million one-time payment. The agreement has a two-year term and provides for a termination fee in certain circumstances.
- Cash paid for dividends during the nine months was $482.8 million, including $205 million of special dividends declared in Q4 2013 and paid in Q1 2014.
Outlook, risks and controls
- Management said additions to Agency RMBS and loan holdings are expected to support net interest income in coming quarters, and that it expects to continue expanding holdings when opportunities are favorable. No specific earnings or return guidance was provided.
- Major exposures include interest-rate and funding mismatch, prepayments and extension risk, Non-Agency credit losses, real-estate values, collateral haircuts and margin calls, counterparty performance, and fair-value uncertainty. A disclosed model estimated annual economic net interest income would change by -20.90% under a 100-basis-point rate decline, -13.86% under a 50-basis-point decline, +8.18% under a 50-basis-point increase and +5.91% under a 100-basis-point increase; management cautioned actual outcomes may differ materially.
- Many Non-Agency RMBS, seasoned subprime loans and related debt rely on Level 3 fair-value estimates using significant judgment and unobservable inputs. Changes in prepayment, default and loss-severity assumptions may materially affect reported results.
- Management stated that previously identified material weaknesses in internal control over financial reporting were not fully remediated and disclosure controls were not effective at September 30, 2014. Enhancements to review procedures and systems were underway.
- Because of prior late SEC filings, Chimera was ineligible to use Form S-3 to raise equity until it had filed timely for a full year, limiting rapid access to public equity capital. The filing reported no material changes to the risk factors in its 2013 Form 10-K.
- The Audit Committee reached an understanding with FIDAC resolving issues raised in derivative demand letters; it was also pursuing additional remedies against other parties related to prior accounting and restatement matters. Management disclosed no contingencies requiring accrual at quarter-end.
Important facts for investors to verify
- How much of reported profitability and book-value movement depends on unrealized fair-value marks, and how recurring core earnings compare with GAAP earnings.
- Whether the acquired subprime loan pool’s performance, delinquency levels and Level 3 valuation assumptions support the reported asset and financing values.
- How the higher repo borrowing and 3.8:1 total leverage affect refinancing, collateral and margin-call risk, particularly if asset values or funding markets weaken.
- Progress in remediating material control weaknesses and the timing of restored eligibility to use Form S-3.
- The effects of the higher management fee, the terms and potential cost of ending the management agreement, and the status of remaining legal or derivative-demand matters.