Chimera Investment Corporation (CIM) Q1 2016 Earnings Report, Transcript and Summary

Good morning. And welcome to the Chimera First Quarter 2016 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Mr. Matthew Lambiase, President and CEO of Chimera. Please go ahead.

Thank you. Good morning and welcome to Chimera Investment Corporation’s first quarter 2016 earnings call. I’ll make a few brief comments this morning, and then Mohit Marria our CIO, will discuss the changes in the portfolio and afterward Rob Colligan, our CFO will review the financial results for the period. Then we’ll open up the call for questions. Before we start, I’d like to comment on the special dividend that the company paid in March. As disclosed in our annual report Chimera’s audit committee pursued remedies against parties relating to our accounting for non-agency RMBS and the restatement of our financial statement. The audit committee Chimera’s Board of Directors and management all determined that it was in the best interest of our shareholders to resolve these matters for $95 million. It’s characterized as taxable income for 2016 and resulted in a special dividend that we paid out in March. To obtain this positive result for our shareholders, we had to undertake certain confidentiality obligations which prohibit us from further discussing the matter. As such, we’ll take no questions on this in order to protect our shareholders. Both management and our Board of Directors are very happy to put this matter behind us and to move forward. And we believe Chimera has a very bright future ahead. As many on the call know, the rules for the mortgage market have been evolving over the last few years and Chimera has worked diligently to stay at the vanguard of the change. Perhaps most important new regulatory change in the mortgage market, are the risk retention requirements with securitized transactions. These new rules require that all mortgage backed securities must have an economic sponsor in the deal. The sponsor must have skin in the game. Sponsors are required to own a meaningful amount of securities in the deal and have the ability to hold these securities for an extended period of time. The goal of the new rules are to ensure that every new securitization has a sponsor who wants to see the deal perform well and is economically on the hook if it doesn’t perform well. The logic of risk retention is pretty clear. And I believe the rule will go a long way to stop reoccurrences of the excesses that we saw in the mortgage market before the economic crisis. For Chimera and other mortgage participants with permanent capital, this rule is welcome. Risk retention is nothing new to us. As our business model has always been to evaluate mortgage credit risk and to structure securitizations in the credit that we like. Since the start of the company in 2007, Chimera has always eaten its own cooking and has never sold an equity position from securitization that we sponsored. I believe that the new risk retention rules for mortgage securitization will benefit companies like Chimera who have permanent capital, the ability to understand mortgage credit and the expertise to structure securitization. In fact, I find it difficult to see a new mortgage securitization market getting off the ground without companies like mortgage REIT taking an active equity retention role. In this light, yesterday, we announced that Chimera sponsored and closed on a new $1.5 million non-agency mortgage securitization at the end of April. This is our first securitization under the new risk retention rule. The collateral in this deal is highly seasoned performing residential loans that were blocked from a major financial institution. Chimera will retain a $225 million economic interest in the transaction, proving once again that we can continue to add high-yielding credit investments to our portfolio in meaningful size. The loans that are securitized in the deal are similar to those with our Springleaf portfolio which were sub-prime at origination. We’ve experienced good credit performance and moderate prepayment speeds on the Springleaf pool due largely to loan seasoning. These new loans are also seasoned. They have over 10 years of pay history roughly 95% have been current for the past year and have an average loan balance of just over $100,000, an important fact that these loans have been outstanding for 10 years, because pay history in our experience is a powerful predictor of future loan performance. The current payroll macroeconomic conditions have a meaningful impact on these homeowners’ ability to pay. On average, the monthly mortgage payment in this pool is about $700. And considering that rents have been increasing nationally, continuing to pay is likely the most affordable housing option available. These borrowers also feel the benefit of lower energy prices every time they gas up their car or fill their oil heating tanks. There is a massive transfer of wealth occurring from oil producing countries to the middle-class of America. And we think the credit quality of our portfolio will be stronger because our borrowers will have more disposal income and therefore greater ability to pay. It’s our belief that the longer energy prices remain low, the better the credit our portfolio gets. As I’ve stated on other earning calls, Chimera has a portfolio of unique mortgage credit assets that I believe will be very difficult for anyone to recreate in today’s market. We’ve been able and we’ve been active in creating through securitizations the bonds that we own in our portfolio. Being able to create the spoke credit investments differentiates us from other participants who simply buy assets in the marketplace. In the period from 2009 to 2011, we were in the forefront of the non-agency re-securitization market. We structured and retained the large portfolio of high-yielding REMIC subordinate bonds many of which remain on our balance sheet today. In 2014, we purchased $4.8 billion of seasoned securitized residential loans and worked to restructure the financing by executing four new securitizations, we retained the high-yield bonds from those deals. Today, we start a new chapter in our history by being a pioneer in risk-retention investments. We believe that Chimera has the expertise and the capital to be a significant player in the evolving mortgage market. The investment that we sponsor will go a long way to create both franchise value for the company as well as allowing us to continue to pay the high and durable dividend to our shareholders into the future. Now, with that I’d like to turn the call over to Mohit to discuss the changes in the portfolio and the economics on our new securitization.

Thanks Matt and good morning everyone. I will briefly review macroeconomic factors and then go over the investment activity for the quarter. And lastly the securitization we completed at the end of April. Consistent with themes from prior quarters, Q1 started with significant volatility across rates, equities, commodities and credit. By mid-February, equity markets were down around 10% and the 10-treasury rates touched 1.66%. In addition, credit spreads across fixed income markets experienced significant spread widening inter-quarter. However, most of these markets at end of the quarter largely unchanged. While the Fed may still raise rates this year, a combination of slower global economic growth and lower commodity prices will likely limit their ability. A more favorable interest rate outlook and wider spreads on new investments improves the portfolio’s long-term potential. Our credit metrics remain unchanged and the residential credit portfolio continues to perform well. Housing fundamentals remain strong as home prices, delinquency rates and household formation are all showing improvements. The strengthening fundamentals continue to bode well for our seasoned non-agency mortgage portfolio. Given these strong fundamentals and wider spreads, we continue to evaluate new non-agency mortgage investments for incremental returns for the portfolio. In the first quarter, Chimera continued to grow with agency CMBS portfolio investing an additional $120 million. This sector saw some pretty dramatic spread widening in late Q4 which carried into Q1 and we were able to add to our portfolio of wider spreads. The steps taken in Q4 to rebalance the agency pass-through portfolio were validated as we experience four prepayments during Q1, even with a significant value and treasury rates. Financing rates on the agency pass-through portfolio however increased in the first quarter as a result of an interstate hike in December. Our residential credit portfolio was largely unchanged for the quarter as we were able to invest pay-downs back in legacy residential credit. Lastly, as Matt mentioned, we sponsored and closed on a new $1.5 billion non-agency mortgage securitization at the end of April. Chimera’s horizontal equity investment in the deal is about $225 million which from a structural standpoint is consistent with how we have executed prior securitizations. This investment is our first under the new risk retention rule. Under the new rule, Chimera has to retain its equity investment for at least five years. Senior bonds represent 70% of the capital structure which were sold with an initial coupon of 2.95%. Unlike many other first loss residential credit investments, there was less structural leverage in this deal, providing a more stable return profile. We expect unlevered loss adjusted returns on this investment to be high-single-digits while levered returns to be in the mid-to-high teens. This seasoned performing loan pool has similar credit characteristics as a Springleaf portfolio. The new pool is over 10 years seasoned as the weighted average coupon of 7.35%, 90% of the pool has full documentation and 95% of the borrowers are current for the past 12 months. With continued uncertainty around the global landscape, Chimera continues to find attractive credit investments in meaningful size to generate attractive risk adjusted returns for its investors. As discussed in prior calls, Chimera may allocate capital from the agency portfolio to residential credit as opportunities become available. With that, I will turn the call over to Rob, who will discuss the financial results for the quarter.

Thanks Mohit. I will now review financial highlights for the first quarter. GAAP book value at quarter end was $15.52 per share and economic book value was $14.46. While both economic and GAAP book values are down 1% this quarter on a total return basis Chimera returned 5.4% on an economic basis and 5.1% on a GAAP basis when accounting for the dividend. GAAP net income for the quarter was $83 million, down from $115 million last quarter. On a core basis, net income for the first quarter was $109 million or $0.58 per share, up from $100 million or $0.53 per share last quarter. First quarter net interest income was $138 million, up from $137 million last quarter. The yield on average interest earning assets was 5.9%, up from 5.8% last quarter. Our average cost of funds was 2.5% down from 2.6% last quarter. And net interest spread was 3.4% up from 3.2% last quarter. Although it was a challenging quarter to manage interest rate risk, our net interest return on equity was 17.3% for the quarter up from 16.5% last quarter. Expenses for the first quarter were $10 million, lower than previously forecasted and certain of our expenses post internalization are still ramping up. Specifically, we’re implementing a new portfolio management system that will help to grow and scale our business. In addition, the first quarter does not represent a full run-rate for stock based compensation and certain grants were given in the middle and the end of the first quarter. On our last call, we said expenses would be $13 million to $14 performance quarter, but it may take us several quarters to build to that run-rate. More importantly we still expect our expenses this year to be lower as an internally managed company than they were last year when we were externally managed. Matt, and Mohit, both discussed the new securitization deal at close of this quarter. Related deal expenses were approximately $4 million and will be included in the second quarter results. That concludes our remarks. And we’ll now open the call for questions.

[Operator Instructions]. The first question comes from Bose George of KBW. Please go ahead.

Good morning. On the securitization that you guys did yesterday, can you just give a little more detail on the funding side, just how much leverage, the cost of funding etcetera?

Sure Bose, this is Mohit.

Hi Mohit.

As I mentioned the senior portion of the capital structure was 70% which has been placed. And the initial coupon on that is 2.95%. So, and the underlying coupon on the collateral is 7.35%, we have roughly almost three times leverage on the equity piece.

Non-recourse leverage in the securitization and that you’re going to lever that up.

Yes, just on the, the leverage on the piece that you retained?

The recourse leverage on the piece is about 35% haircut. So you could have about 2.5 to 3 times of leverage on that.

Okay, great. And then, just in terms of the market there, were there a lot of bidders for this asset, just definitely it’s surely a very attractive asset for you guys. I was just curious how is the process going?

Yes, I’m sure there are lots of people interested in the asset type, I’m not sure of the number of bidders. But it was definitely done in comp. So, we were able to acquire it and we’re happy about the acquisition.

Great. And then just one more from me, this JPMorgan securitization that was done last month, of conforming loans, are there potential assets in there that you like or do you think those kinds of securitizations could create opportunities for you guys in the future?

Yes, I mean, when we looked at the FDIC Safe Harbor deal, I mean, we looked at obviously the credit investments there. Comparing the first loss piece to that deal which was the zero-two slice the equity investment in this pool is a lot greater, it’s going to produce a more stable return profile for us. But that is something we will look to do if that grows further.

Okay, great. Thanks a lot.

The next question comes from Brock Vandervliet of Nomura Securities. Please go ahead.

To Bose’s question, so do you, how do you read that FDIC, JPM-FDIC deal, was that kind of a Petri-dish experience or is that something like really you think could be a Harbinger’s future structures?

It could be Harbinger for future structures but it is competing against the agencies. So we’ll see how the agencies feel about it, CASTAC [ph] or other credit transactions that they’re doing to reduce credit risk that they have. If Chase decides not to sell to the agencies and issue securitizations on their own, that’s less GPs. And again I think the agencies may have an issue with that going forward. But I think it is supposed to be something that’s going to be an ongoing program from what we’ve heard.

Yes, I think, Brock, for our purposes, risk retention is important for perhaps the non-agency collateral that’s out in the marketplace, of loans they are always going to be larger in size or older or seasoned like this portfolio, like the Springleaf portfolio. In order to get the market off the ground, you need to have somebody take the equity pieces in those transactions. And I think that’s where our capital is going to be best allocated at the moment from all the opportunities we’re seeing. If there is going to be a securitization market, they’re going to need people like Chimera to sponsor the deals going forward. And I think there is going to be a pretty big pipeline of deals for us to do going forward.

Okay, great, that’s exciting. As another follow-up in terms of the structure, are you able based on your prior answer, are you able to place additional leverage on that equity piece that you, no?

Yes, yes we are. So, the unlevered yield that Mohit said is going to be between 9% and say 10% we think loss adjusted. And then if you take that and we can get haircut to 30% to 35%, you can lever that up, you can get depending on the tenure how long you want to borrow for, you can get between 15% to say 20% leverage returns on that. So, we think - I think it’s a pretty attractive use of our capital. And the risk retention rules allow for financing of the equity slices, full recourse yes.

Got it. Okay, great. Thank you.

The next question comes from Joel Houck of Wells Fargo. Please go ahead.

Good morning. I just saw you guys had a couple of billion dollars of repo that matured in April. I was wondering if you could talk about the environment kind of real-time and also what strategy you guys, rolled that into going forward-term.

On the non-agency side, we rolled the credit with no problem, and in fact extended the maturities to 12 months. On the agency side, given the uncertainties running the Fed and potential rate hikes, we’ve kept that shorter between 30 to 90 days. Just as we sort of get more clarity on the Fed rule go, a lot of the dealer communities building in the worst case scenario of the Fed going, so it’s increasing rates longer term. So, we’re just balancing that for near-term clarity from the Fed.

Yes, and Joel, I would just add to that saying that the repo market, it’s kind of interesting from our vantage point is that we’re seeing more credit available to us and we’re bringing more people in to look at non-agency repo than agency repo. I think the dealers and the people on the street are more interested in doing the higher haircut, the higher lighter margin, repo transactions and they are doing the agency repos. So, I think it’s been fitting pretty well to our business model that is the agency repo market.

Great. And has there been any, can you discern the availability versus U.S. and non U.S. banks?

We’ve haven’t seen any problems from either. So, we’ve been, and we haven’t seen any changes whatsoever from the funding position from international from domestic banks.

All right, guys. Thank you very much.

The next question comes from Steve Delaney of JMP Securities. Please go ahead.

Thanks. Good morning, everyone, and congratulations on a strong quarter to start the year. I wanted to go back to the, I guess your new $1.5 billion deal. When you put a press release out like that before your earnings call I guess you can expect to get a few questions. So, my angle on it is, you’re going assume you’re going to consolidate this, right? You’re the control bond at the bottom. And I guess this is to Rob. When you consolidate this, those whole loans then on your books, they would be then good assets for meeting the 40-Act exemption am I correct?

Yes.

Yes. Okay, so that leads I guess into thinking about portfolio strategy going forward just in terms of how you’re allocated I guess your asset allocation March you had 45% agency. And Mohit, does this type of structure when you compare the ROEs that you were describing here, do you find that this - the new transaction, would you say that it offers higher levered returns than which you currently see available in the agency market?

Yes, I mean, definitely it’s more accretive than the agency portfolio. But again, I mean, we’ve balanced that over the course of the quarter.

I know exactly where you’re going Steve, and then I think we all would agree with you. It’s hard for anybody who is a participant in the mortgage market not to say that a levered agency portfolio doesn’t have its challenges at the moment when you look forward, right.

Yes.

When you think what would happen to flattening yield curve increasing funding rates, so.

Prepays, yes.

Yes, prepays, all that. So, we’re always evaluating that. And one of the things that you do here is we’re not a total return manager per say, we’re really about making sure. And the goal number one of the investment team when they come into work every day is to think about the dividend and make sure that we earn enough money to payout the dividend to our shareholder, that’s the job number one. So, when we like something we really got to find other assets in order to move things around because we always want to pay the dividend. But you are squarely. We’re all in agreement with you and in the challenges of the agency book at the moment.

Yes, and I guess the greatest benefit of the agency book, I think I’ve heard, many portfolio managers describe, is just liquidity. You can’t beat the liquidity, right?

Yes, right.

And you guys, in this crazy world, having a good slug of liquidity is always both playing offense and defense.

It’s certainly, how good a slug you need?

Yes, that’s right. My final comment is we were really impressed with your book value performance. We thought it could be down anywhere 2%, 2.5%, and it was only down 1%. The lesson there for us I guess, if there is one, just trying to look at generic legacy collateral prices, did you notice something of like a wide disparity in terms of the credit sell-off that we saw in January, February, and, more seasoned loans, better structures? I guess my question is, what do you think it was the characteristic about your credit bonds that allowed your book value to hold up better than maybe some?

I would also say that our book value probably went down a little bit more, just a little bit more than other people in this space, in the fourth quarter. So, maybe there was that and their item, we were having.

Again the credit performance of the portfolio has remained pretty consistent throughout this volatility over the last six months. I mean, mid-Feb, credit spreads were extremely wider but sort of retrenched back by the end of the quarter. Again, as our bonds are - levered bonds continue to lever, we’re just pricing at a lower point in the curve. But I mean, I think there is nothing different than what others sort of experienced within the quarter as well. But I would differentiate between CUSIPS and loans. Loan pricing over the quarter was pretty sticky. In fact I would say flat quarter-over-quarter whereas CUSPIPS prices depending on the amount of leverage embedded in them maybe slightly down from Q4 to Q1.

Got it. Well, guys, thank you for the comments. Appreciate it.

The next question comes from Sam Martini of Omega. Please go ahead.

Hi, guys, good morning. Just two questions, first of all, you got around $800 million sitting in agency. Our understanding of this transaction is that there may be more to do just following up on Steve’s question. Is there anything that would prevent us, not saying you would want to, but assuming the economics made sense, is there any amount of that agency book that you need to keep for 40-Act compliance or is that entire equity piece subject to reallocation?

I think we’re going to, you have to have some, we have to have whole pools. So, there is always a balancing act between how much you’re going to keep on your balance sheet and how much you’re going to reallocate with other things. I mean, as I said to Steve, I mean, it is forefront in our mind about the challenges of the agency portfolio and we’re constantly looking at ways to maximize value and maintain the dividend stream for our shareholders. So, I mean, we’re, it is not lost on us, the challenges of agency mortgage.

And am I thinking about it the right way, Matt? Yes.

Yes, Sam, Rob. I just wanted to add to that, with the Springleaf deal and now this new deal, we’re less reliant on the agency trade than we were say two years ago. So, we’re constantly looking to see if we can do other things to optimize the structure. And obviously provide a great yield to the investors.

So, it’s not unfair to say a significant piece of that equity is able to be reallocated there’s no constraints on it that wouldn’t just render it an algebraic exercise as opposed to regulatory or otherwise exercise.

What we’ve said on other calls is, at any time we would probably have at least $2 billion to $3 billion on a gross basis of agencies. And that probably hasn’t changed too much.

Okay. And am I thinking about it right that if I took your returns and I just scribble out the numbers from your supplement, that it’s about a 10-point, that this would be about a 10-point pick-up to the levered agency book? Is that kind of the right zip code in terms of ROE?

Fully levered, yes, I mean, I think it’s definitely a pick-up.

And then I’d be interested, given there is this opportunity for accretion I’d be interested to hear your thoughts on raising the dividend versus buybacks. You didn’t repurchase any shares. You’ve been active in the past. Clearly some of the stocks that have gone after higher and higher dividend increases were not rewarded in the market. So I’m curious, as you’ve clearly got a path towards growing earnings now, which is exciting, what your thoughts are on raising the dividend versus repurchasing shares versus other uses? That’s all from me. Thanks.

Yes, no, I think all those things are, now really it’s about trying to figure out. And when we look at the market, trying to figure out how, the first and foremost thing is to keep the dividend and keep it durable. So, how do you do that? And of course with the agency portfolio and the challenges that you have with the flattening yield curve prepayment speeds, rising interest in the borrowing costs. If we can transition the things that are keep the portfolio, keep the earnings constant, we’re more durable for a long period of time. I think we’re in a good spot. We did not buy back stock in the period. We still have the ability to sell the outstanding $100 million. And I would say that we are finding some really great opportunities to invest right now in our company. And I think, and I’m betting that the franchise value of doing these risk retention trades is going to come to fruition sometime in the future. I don’t think we get benefit for it at the moment. But I think if we continue to show the market that we’re able to find really quality investments and do it in size and be meaningful, I think that at some point the market will give us the bump to our share price that we deserve.

And have it done against only a handful of folks who can compete with you instead of everyone under the sun. It’s exciting stuff. Thanks so much, guys. Thank you.

Thank you.

Thanks Sam.

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Lambiase for any closing remarks.

Well, I would like to thank everyone for participating in Chimera’s first quarter 2016 earnings call. And I’d just like to reiterate that we are very excited about our future. And we look forward to speaking to you next quarter on our earnings call. Thank you.

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.