The last two days have been difficult for Chimera Investment Corp. (CIM).  After announcing earnings post market close on February 8, the stock spent the next 2 days trading lower, closing Wednesday down 10% from it’s close before the announcement.  Investors are worried that the company will experience significant losses in the coming year due to turbulence in the residential mortgage market.

Chimera’s business is classified as a REIT (Real Estate Investment Trust) which means that the company does not have to pay taxes at the corporate level.  As part of this designation, Chimera must pay at least 90% of its earnings to shareholders on a quarterly basis.  Chimera is in the business of purchasing residential mortgages and other Residential Mortgage Backed Securities (RMBS) with the goal of collecting interest payments and eventually selling these securities at a profit.  The company is able to borrow significant amounts of capital and use the proceeds to buy a larger pool of assets – thus leveraging their investment and theoretically providing greater returns for  investors.

The leveraging strategy didn’t work out so well over the past several years as the value of mortgage securities dropped significantly.  The bursting of the housing bubble along with the financial credit crisis had a profound negative effect on Chimera.  The company’s liabilities did not change with the crisis, but the value of its assets plummeted sending the stock from a high near $20 in early 2008 to a low near $1.50 at the height of the panic.  Since that time, Chimera appears to have learned its lesson and is now operating with significantly less leverage.

The mortgage investment market is a unique environment which is not typically available to individual investors.  Similar to many credit card loan originators, personal loans are originated by various financial institutions and then often securitized and sold to market participants.  But unlike a credit card processing service, many of these securitized loans are guaranteed in some way by the government in what is typically considered “Agency Mortgage-Backed Securities.”  For these loans, investors don’t have to worry about whether they will receive their principal back.  Instead, the risks are weighted toward prepayment (mortgage holders refinancing), and interest rate risk (if the cost of funds exceeds the return for the mortgage investments).

Chimera currently holds 25% of their portfolio in agency MBS positions with the remainder in non-agency mortgages which carry more risk.  But where there is risk, returns are usually higher.  For instance, Chimera’s average cost for non-agency mortgages is 58 cents on the dollar which leaves the company with significant potential for gains on these purchases.  And the company has begun to operate very conservatively with a current leverage ratio at 1.1 to 1.  In addition, the company has set aside $1.7 million in the last quarter to guard against loan losses in the coming months.

In our markets, demand for securities has improved from the depths of the financial crisis as investors take into account realistic performance expectations, new capital comes into the market and the securitization market continues to recover. While new non-government-backed mortgage originations remain well below prior levels, as we look ahead to the new year, we continue to see opportunities in the securities market and we look forward to the new opportunities that will arise when the primary mortgage securitization model becomes operational. ~Matthew J. Lambiase, CEO

Based on the last three dividend payments (CIM skipped a dividend during the March 2009 quarter) and the current stock price, Chimera sports a 12% dividend yield.  This measure will likely only go up as the company is expected to pay  a dividend during the first quarter which will offset the skip from Q1 2009.  The strong dividend should help to support the stock price and give investors some valuable income.

At the same time, I expect the mortgage portfolio to remain relatively stable and potentially increase.  As non-agency mortgages pre-pay or refinance to get better rates, Chimera will be able to mark some mortgages higher and realize a profit on investment.  The low cost of funds may also allow the company to pick up additional investments at an attractive price while paying a low rate on debt.  I wouldn’t like to see the company become heavily leveraged, but a ratio of 1.5 to 1 or even 2.0 to 1 might be reasonable and add to investor profits.

The bottom line is that Chimera is a risky investment with significant exposure to mortgage backed securities.  But with these investments marked down to reasonable levels, and with the potential for opportunistic purchases, investors could be rewarded with strong profits.  The recent lower trade in the stock may offer significant opportunity to pick up shares at a discount and I expect a healthy dividend yield to benefit investors while they wait for capital appreciation.

FD: Author has a long position in Sound Counsel Investment Advisers portfolios

Enjoy this article? Sign up for the ZachStocks Newsletter,
Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies