Chimera Investment Corporation (CIM) Q2 2018 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by and welcome to the Chimera Investment Corporation Second Quarter 2018 Earnings Conference Call and Webcast. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session. [Operator Instructions] It is now my pleasure to turn the floor over to Emily Mohr of Investor Relations. Please go ahead.

Thank you, Christy and thank you everyone for participating in Chimera’s second quarter earnings conference call. Before we begin, I’d like to review the Safe Harbor statements. During this call, we will be making forward-looking statements, which are predictions, projections, or other statements about future events. These statements are based on current expectations and assumptions that are subject to risks and uncertainties, which are outlined in the Risk Factor section in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the forward-looking statement disclaimer in our earnings release in addition to our quarterly and annual filings. During the call today, we may also discuss non-GAAP financial measures. Please refer to our SEC filings and earnings supplement for reconciliation to the most comparable GAAP measures. Additionally, the content of this conference call may contain time-sensitive information that is accurate only as of the date of this earnings call. We do not undertake and specifically disclaim any obligation to update or revise this information. I will now turn the conference over to our President and Chief Executive Officer, Matthew Lambiase. Please go ahead.

Thank you, Emily. Welcome to the second quarter 2018 Chimera Investment Corporation earnings call. And joining me on the call this morning, I have Mohit Marria, our CIO; Robert Colligan, our CFO; Choudhary Yarlagadda, our COO; and Victor Falvo, Chimera's Head of Capital Markets. I'll make some brief comments and Mohit will review the activity in the portfolio and Rob will review the financial results. Afterward, we will open up the call for questions. Chimera had a 2.3% total economic return for the second quarter and a 6.9% total economic return for the first half of 2018. Our economic results for the first half of the year are strong, given the flat yield curve and tight credit spreads, which are creating a challenging environment with the fixed income market. The Federal Reserve has been raising short term interest rates due to the strength of the US economy. This has increased borrowing costs for all financial companies at a time when longer US Treasury yields have not increased as we would have expected. The resulting flat yield curve with the 10-year treasuries just 30 basis points more than the 2-year treasury yield creates a difficult market for all fixed income investors who use leverage. Whether you’re a bank, savings alone or mortgage REIT, no one is immune from the effects of a flat yield curve. The good news is that the stronger US economy has helped the housing market and valuations of mortgage assets. With more people working, we expect to see less delinquencies and continued improvement in home values, both are important metrics in mortgage credit performance. A key driver in Chimera’s returns is our residential mortgage loan portfolio, which was approximately 60% of our total assets. This portfolio was accumulated at an opportune time in the market and has been performing better in both prepayment and credit performance than our expectations at purchase. Our $12.8 billion residential loan portfolio has an average balance of just $90,000 and average coupon of 6.89% and the loans have been outstanding for over 10 years. The low loan balance and age of these loans are enviable characteristics that help dampen prepayment volatility, which is what you want with a high coupon portfolio like ours. We believe there are several reasons for slower prepayments on our loan portfolio. One important factor is that it's difficult to justify paying large upfront refinancing fees to achieve small savings on a monthly basis. Credit is still constrained for some borrowers, as current mortgage origination continues to favor the highest FICO borrowers. 75% of new mortgage originations have 7.20 or higher FICO scores. And additionally, existing homeowners are staying in their homes longer than in past, on average four years longer than they were pre-crisis. The improving US economy has boosted home values nationally. There is very little new inventory in the starter home market, which we define as homes under 2400 square feet. Most of our low loan balance loans are secured by properties, which fall into this starter home category. With better employment prospects for potential home buyers and little new inventory being built, this sector has the shortest time on the market for sale. Starter home price appreciation should continue to translate into improving credit performance as loan collateral values increase over time. The overall strength in the housing market has brought large new investors into the residential loan and credit markets. They look to get a pickup in yield over other fixed income instruments, while gaining exposure for the positive credit fundamentals of the US housing market. The demand-led increase in price on residential credit assets has been good for Chimera’s book value over the past several quarters. However, the surge in demand has created an investment challenge and that credit spreads are tighter and yields available in the market for new purchases are lower. Consequently, in the current market, the relative value of mortgage credit looks somewhat rich to that of agency mortgage-backed securities or new investments. We've discussed on previous earnings calls, Chimera has been operating with low recourse leverage, which enables us to take advantage of opportunities when they arise. In the second quarter of 2018, agency mortgage-backed securities had poor price performance and widened out on spread. Our low repo exposure afforded us the opportunity to increase our overall recourse leverage ratio from 2 to 2.5 and take advantage of that spread widening. Chimera has a history of managing our agency portfolio by increasing and decreasing its size, depending upon the availability, price and relative value in the marketplace. We are currently operating in a challenging fixed income market. This team has navigated through top markets before. I know the markets have a habit of changing, sometimes very quickly and it's important to remain ready to take advantage of that change. I believe that our portfolio is in a good place and should continue to perform well and our balance sheet retains the flexibility to take advantage of opportunities with the goal to continue to produce strong core earnings for our shareholders. Last night, we reiterated our board's intention to pay a $0.50 quarterly dividend for the remainder of 2018. And with that, I will turn the call over to Mohit to review our portfolio activity in the period.

Thank you, Matt. During the second quarter, the US economy continued to show significant strength and as expected, the Federal Reserve raised the federal funds rate by 25 basis points in June. This is the seventh interest rate hike by the Fed this cycle. The US Treasury yield curve continues its flattening with two year yields increasing 26 basis points and 10-year yield only rising by 12 basis points, bringing the two year ten-year spreads to 33 basis points. We continue to believe that the Fed is on the path to higher rates with an additional three to four rate hikes over the next 12 to 15 months. However, with escalating trade tensions and slowing global growth, the path for rate hikes may be slower. 10-year treasury yields reached a 6-year high of 3.11% in May before closing the quarter at 2.86%. Higher Treasury yields and wider spreads created an opportunity to add agency mortgages to our portfolio. This quarter, we added 2.5 billion in agency investments, consisting of 2.35 billion of residential pass throughs and 150 million in agency CMBS. Most of the increase in residential agency passthroughs were 4% coupons and our agency CMBS strategy remains consistent to previous quarters. We continue to optimize as the characterized loan liability structure and this quarter, we refinanced CIM 2015-2AG into CIM 2018-R3. The deal size was 181 million and lowered our financing cost on the senior notes from 4% to 3.7%, providing us a savings of 25 basis points towards senior notes financing on these loans. This quarter, we also issued 387 million of CIM 2018-r4 with loans on our balance sheet. The deal had an effective weighted average coupon of 5.5%, a weighted average loan size of $132,000 and the loans were on average 126 months season with an 83% BPO [ph] LTV. The senior notes were priced at a yield of 4.02%. Post quarter end, we have issued 380 million of CIM 2018-R5, which is the re-lever of our CIM 2015-3AG, leaving one remaining deal for a possible refinancing in 2018. As Matt mentioned, the first half of 2018 is off to a good start. Our portfolio book value has increased from 16.85 at year end to 17.01 at June 30. Portfolio price performance and stable portfolio dividend have provided us 6.9% economic return for our shareholders. We continue to manage both portfolio with relatively low leverage, enabling the investment team to opportunistically execute both credit and agency strategies. Our low leverage continues to afford us the ability to be opportunistic when favorable market conditions exist. The agency investment provides attractive spread income and has the added value of liquidity, giving us the capability to continue our residential mortgage credit investment strategy when appropriate market opportunities are available. We continue to be disciplined in our approach to portfolio investments and are managing our hedge positions to provide stable net income and preserving book value. I'll turn the call over to Rob to go over the financial results.

Thanks, Mohit. I’ll review the financial highlights for the second quarter of 2018. GAAP book value at the end of the second quarter was $17.01 per share and our economic return on GAAP book value was 2.3%, based on the quarterly increase in book value and the second quarter dividend per common share. GAAP net income for the second quarter 109 million compared to 230 million last quarter. On a core basis, net income for the second quarter was 110 million or $0.59 per share, up from 109 million or $0.58 per share last quarter. Economic net interest income, which includes the impact of interest rate swaps, was 147 million, up from 145 million last quarter. Interest income is up versus prior quarter and our swap portfolio has helped the hedge against rising interest rates. For the second quarter, the yield on average interest earning assets was 6.1%. Our average cost of funds was 3.6% and our net interest spread was 2.5%. Total leverage for the second quarter was 5.1 to 1, while recourse leverage ended the quarter at 2.5 to 1. Our economic net interest return on equity was 16% and our GAAP return on average equity was 13% for the quarter. Expenses for the second quarter, excluding servicing fees and deal expenses were 14.5 million. As discussed on the last year earnings calls, expenses are up from last year as a result of equity compensation expenses. The company also incurred legal expenses related to securitization deal activity. This concludes our remarks and we’ll now open the call for questions.

[Operator Instructions] Your first question is coming from Doug Harter of Credit Suisse.

Can you talk about, I guess the balance between kind of deploying money into agency and kind of, while it's liquid, but just the extra risk there versus kind of maintaining the optionality to kind of buy more credit assets when they become available and how you balance that decision?

Sure. I think it's just important to start out by saying that we think that agency mortgage backed securities are relatively attractive or new investments. It's not that we are selling our credit assets to buy agency assets. So as credit and we have paydowns in the portfolio, I think you could expect us to see in this market as long as agencies stay relatively attractive to be adding them to our portfolio. We said, over the last two years, on earnings calls that residential mortgage credit was cheap and we went out and we aggressively bought and accumulated a really unique and great portfolio that's doing very well. We're now saying it's not as attractive and that's largely due to a very large new buyer in the marketplace who is frankly paying prices that are -- we feel are very high. The market can change very quickly on this stuff. Probably every bank seller of loans in the country is scrambling to put the packages together to sell them to the large buyer in the bid and when buyer gets full, it's highly possible that we'll see more normal valuations in mortgage credit and we’ll be there to take advantage of that when that happens. But, right now, I would say that we think mortgages are relatively attractive to presidential credit and we think that agency mortgages are going to be -- continue to be relatively attractive here for the future because the Fed is exiting that position and it should keep the spreads relatively wider.

And Doug, I’ll add to what Matt just said, in 2014, our agency portfolio was ramped up to be north of 8 billion total and when the Springleaf opportunity presented itself late that summer, we were able to pare down the agency portfolio and go into the credit strategies which were attractive at that time and the same flexibility here, but sort of adding agencies here and if something becomes attractive, on the credit side, we will deploy capital there.

Your next question is from Bose George of KBW.

It's Eric on for Bose. The $26 million transferred from the credit reserve last quarter, did that come mostly from the re-remit portfolios or is it the securitized loans?

Those are all from the non-agency portfolio. If you’re looking at the accretable discount in the press release, I’m assuming, Eric.

That’s right.

As we have seen in other quarters, when we have improvements in expected cash flows on the portfolio, we will have once a non-accretable discount reclass into accretable discount and part of our spread income overtime.

Maybe if I can just press you a little bit, Rob, just for the bucket within the non-agency RMBS, did that came from -- was it specifically the re-remits or was it something else?

It’s not something we’ve disclosed. We’ll take a look and maybe we’ll come back to you on that.

Can you guys just remind us, do you have a call feature on all of the securitized loan transactions that you list on slide 5 and which deals or just maybe just the balance of those are callable in 2019? Thanks.

Erica, this is Mohit. I think the vast majority of the deals listed on slide 5 do have call rights I them. As far as 2019 goes, the only deal from this list that is callable that year is the CIM 2016-4.

Great. And maybe you can -- you mentioned that since quarter end, you did call a deal and re-securitized, what was the pickup in ROE or spread that you got from doing that?

I think we'll go over the economics of the refinancing in the next quarter's call, but we just wanted to point it out, given that the transaction closed in July that we had executed another re-lever.

Okay. You said you mentioned that the financing you got on that was down to 375, what was it at before or I guess just before the call?

Yeah. So the refinancing that we referred to in the opening comments was, as it related to re-lever we did in Q2, which was of the CIM 2015-2AG and we went from a 4% yield to a 3.75% yield and we saved 25 basis points on that re-lever. On the securitization that we completed post quarter end, I think again, we had a cost savings in the same context of what we did on the 2AG and both of these are again preexisting Springleaf plant that we had acquired in 2014 that we re-levered in ’15 and given the option, call option we were able to refinance it again.

Thanks. And sorry if I missed that 25 basis points in the opening comments. The $5 billion of interest rate swaps that you guys have, now hedging agency CMBS, what's the pay rate on those swaps?

I think on a net basis, what the pay rate is minus the receive rate, I think it's probably on a blended basis, 60 basis points.

[Operator Instructions] And your next question is from Trevor Cranston of JMP Securities.

So, you guys obviously mentioned that returns in the loan space are less attractive than the agencies right now. Can you comment on, what you're seeing in the more newly originated loan space, such is non-QM or something like loans for single family rentals and if you're seeing any opportunities in that space to maybe start deploying capital?

Trevor, this is Mohit again. On the non-QM space, the whacks that are being originated are probably the mid to high 5% on a gross basis, net to the seller, you're probably looking at a high 4%, low 5% loss adjusted yield. The concern we have there, not really a concern from a credit perspective, but it's a concern on duration the aggregate a large enough amount of collateral to do a deal off of, it's timely and the duration of the assets are relatively short. So, we view it as sort of interim financing until the credit cures and people get into more of a jumbo program, but again, we do evaluate opportunities there, but the size that we see is maybe 25 million to 30 million that is available that will take a long time to aggregate. As we’ve said on prior calls, from a deal perspective, deal size have to be about 300 million to make the economic, relative to the expenses, work. So, it's just time consuming to sort of acquire a larger size in that space. On the single family rental side, I mean, we haven't looked at that too closely, but I think again on a loss adjusted yield basis, it will lead by similar to the non-QM, high-4 to low 5% yields. But again, I think, operationally that’s a little more of an intensive operation to run as opposed to just buying sort of conduit on jumbo loans.

And then with the agency portfolio, can you comment maybe on the types of bonds you guys have been focusing on buying, whether they’re fairly generic pools or if you guys are concentrated more on something like low loan balance when you’re adding to the residential agency portfolio?

Sure. I mean with the backdrop and the view internally of sort of higher rates, our portfolio is concentrated on more sort of generic new production, new origination product which has minimal pay-ups. You’ve noticed the pay-ups have collapsed quite significantly since the rates and Fed has been in play and rates have backed up. So paying up for the prepay protection is not necessarily warranted in the current environment, but again, having said that, if you look at our speeds versus the cohorts, I mean I think we are in line there. I think we’re three months speed on our portfolio, around 8 or 9 CPR versus the cohorts around the 11. So without paying up too much, we're still getting the prepay protection needed and obviously if rates do rally, we will look to see what type of contraction rates that we have and we will manage the hedges and the assets accordingly.

Yeah. And the other thing I would add to that Trevor is that Fannie Mae forced today with a 1 to 1 handle, 1 to 1.5 are a lot easier to figure out the hedging on than when they are at 105, which where they were last fall. And, look at this yield curves and the flatness of the swap curve, the difference between the three years swap and the ten year swap is about 10 basis points. I think the flatness of the swap curve can allow you some interesting optionality in hedging where you can put on longer duration hedges that will, I think, perform better if you do get the sell-off. So, we think it's a very manageable time right now to hedge out the duration in the portfolio.

And I just want to make one point, I clarify one point that I made earlier, on the average pay rate for the company in the financials, we have that the average pay rate as of June 30 was 2.35, Eric for your earlier question.

Thank you. There are no further questions at this time. I’ll return the call to management for any additional or closing remarks.

Well, thank you for participating in the Chimera Investment Corporation’s second quarter 2018 earnings call and we look forward to speaking with you in November.

Thank you. This does conclude today's conference call. You may disconnect your lines at this time and have a wonderful day.