Chimera Investment Corporation (CIM) Q2 2019 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the Chimera Investment Corporation Second Quarter 2019 Earnings Conference Call and Webcast. [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 statement. 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 quarterly 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 supplements 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.

Good morning and welcome to the second quarter 2019 earnings call for Chimera Investment Corporation. Joining me on the call this morning are Mohit Marria, our Chief Investment Officer, Rob Colligan, our Chief Financial Officer, Choudhary Yarlagadda, our Chief Operating Officer and Victor Falvo, Chimera's Head of Capital Markets. I'll make some brief comments, then Mohit will review the activity of our portfolio and Rob will discuss our financial results. Afterwards, we will open up this call for questions. In a very challenging second quarter, Chimera posted an economic return of 3.6%, which is a solid result considering the extremely low interest rate environment and the flatness of the yield curve. During the period, the yield on the 10-year treasury fell 40 basis points to a 2% yield, a level not seen since November of 2016. Global interest rates also hit multi-decade lows in the second quarter, where the 10-year German bonds add negative 33 basis points and 10 year Japanese bonds fall into negative 16 basis points. There are now reportedly over $13 trillion global bonds trading at negative yields. Low bond yields are happening at a time with LIBOR remains stubbornly high. One month LIBOR a key rate for short-term borrowing, closed the quarter at 2.4% underscoring the difficulty that most financial companies have, maintaining a healthy net interest margin when borrowing costs are higher than asset yields. 30-year agency mortgage backed securities did not perform well as the treasury market rallied in the quarter. The lower interest rate environment, increased mortgage prepayment expectations causing shorter duration and lower yields on outstanding bonds. While our longer interest rates fell, repo funding costs for mortgage backed securities remained high. Historically, the borrowing cost for agency mortgage backed securities approximate the one month LIBOR rate. In the second quarter agency repo costs were an average about 20 basis points higher than LIBOR. Declining yields and higher borrowing costs put pressure on our margins in the second quarter. However, we're hopeful that we'll get some relief in the second half of the year from the Federal Reserve where there are one or two interest rate cuts. On a brighter note, our Ginnie Mae project loan portfolio outperformed in the quarter. Their superior call projection and the lack of new originations made Agency CMBS an attractive asset class and their prices outpaced U.S. treasuries. Chimera now has over $3 billion of Agency CMBS and their positive price action helped our book value in the quarter. Underlying housing fundamentals remain strong across America. U.S. unemployment rates are among the lowest we've seen in 50 years and home prices continue to rise on a national level. This economic environment is favorable for residential mortgage credit and in the quarter we saw a significant tightening in credit spreads, added an increase in the prices on new issue non-agency senior securities. Tighter spreads on senior bonds is helpful because it creates an opportunity for Chimera to buy pools of mortgage loans and securitize them, allowing us to retain the higher yielding subordinate bonds and we're having a good amount of success in finding new credit investments. In the second quarter, we funded $188 million to support an investment in a Freddie Mac SLST loan transaction and we closed our second investor loan mortgage securitization of 2019. And post quarter end, our investment team has identified and committed to purchase over $1 billion of whole loans, which aim to settle and securitize before the end of the year. While this is a difficult environment to navigate, we remain confident in the ability of our portfolio to create meaningful risk adjusted returns for our shareholders. We are seeing residential mortgage credit offers some of the best value in the fixed income market and our team continues to be successful in finding investments to add to that portfolio. Last night our Board of Directors announced a $0.50 per share common dividends for the third quarter and we reiterated our intention to pay $2 in common dividends for the full year 2019. We believe Chimera is well positioned to continue to produce meaningful dividend income to our shareholders into the quarters ahead. And with that I'll turn it over to Mohit to discuss the portfolio in the quarter.

Thank you, Matt. The recent downward trend in the interest rate and the flattening of the treasury yield curve that began late last year continued in the second quarter. Over the past three quarters 10-year U.S. treasury yields have fallen by over 100 basis points after reaching a peak of 3.24% in November. LIBOR rates which impacted our cost of borrowing and hedging over the same time period have increased 14 basis points for one month LIBOR and decreased 8 basis points for three month LIBOR. Not only the difference between one month LIBOR and 10-year swaps, is at a negative 44 basis points. With one month LIBOR at 2.4% and 10-year interest rate swaps below 2%. The Federal Reserve Open Market Committee concludes their two day meetings this afternoon. We anticipate much of the discussion will focus both global and domestic economic activity, U.S. trade wars and inflation expectations. At recent congressional testimony, Chairman Powell set the stage for a potential cut at interest rates, which will be the first time in a decade. We believe most of the interest rate interstate discussion at the Fed meeting will send around the amount of any rate cuts and further monetary policy accommodations through quantitative easing. Consistent with a consensus in the market, we believe that will cut rates by 25 basis points. Any easing of policy should provide some relief on both LIBOR and repo rates. Homeowners can refinance their homes at any time. Like treasuries, the rate on mortgage loans has fallen resulting in market expectations of an increase in prepayment speeds. This has lowered the yield and shortened the duration of our residential Agency mortgage portfolio. To help manage the agency portfolio duration this quarter, we further reduced our net interest rate swap exposure by 1.8 billion notional value of hedges, Chimera‘s agency portfolio is differentiated amongst our peers. $3 billion or approximately 26% of our agency portfolio is allocated to agency CMBS. This portfolio of Ginnie Mae project loans carries explicit call protection, benefiting the holders of these securities. This prepaid protection helps better define the true duration of these securities, enabling us to closely match up our slopped hedges and lock an attractive net interest margin. The recent volatility in interest rates and embedded call protection in Ginnie Mae project loans have attracted additional demand from investors, resulting in tighter spreads and higher prices for the quarter. And as Matt mentioned, the better convexity and positive credit performance of our Agency CMBS helped benefit our book value this quarter. In credit, our non-agency mortgage backed securities and residential loans combined to represent 73% of our equity capital and 55% of our overall assets. Our credit portfolio continues to perform well, and across the board has exceeded our projections made at initial investment. This quarter, we funded a $188 million investment in Freddie Mac, as well as the 2019-1. This investment is backed by $1.2 billion in seasoned re-performing loans. The loans have a weighted average coupon of 4.2%, have a weighted average loan balance of 161,000 and a 75% weighted average loan-to-value ratio and the underlying cycle on the deal is 581. Separately, we securitized but did not consolidate 364 million of CIM, 2019-INB2. This is our second investor loan securitization in 2019. The loans have a close WAC of 5.1% and an average loan balance of 253,000. The investor deal has a 68% loan-to-value ratio and an average FICO of 770. Chimera retained a $34 million of investment in subordinate bonds and IO securities in this deal. The market for loan securitizations continue to improve over the course of the quarter, and the drop in interest rates specifically on the short and intermediate points of the yield curve have helped generate additional demand from institutional investors for high quality fixed income spread products. The tightened spread and we were absolute yields on senior securities bodes well for our new issue securitization business. Efficient and successful whole loan securitizations have been paramount to our past success, enabling Chimera to continue creating high yielding subordinate securities for a long-term investment portfolio. Post quarter end, we've committed a purchase an additional 1 billion in mortgage loans. These purchases are now in the underwriting and due diligence phase of acquisition. Consistent with our historical reporting, we will give more clarity on the investment characteristics of these transactions upon settlement and the order of closing. I will now turn the call over to Rob to discuss the financial results for the quarter.

Thanks, Mohit. I'll review the financial highlights for the second quarter of 2019. GAAP book value at the end of the second quarter was $16.24 per share and our economic return on GAAP book value was 3.6%, based on the quarterly change in book value and the second quarter dividend per common share. GAAP net income for the second quarter was $40 million. On a core basis, net income for the second quarter was $98 million or $0.53 per share. Economic net interest income for the second quarter was $143 million. For the second quarter, the yield on average interest-earning was 5.4%, our average cost of funds was 3.4% and our net interest spread was 2%. Total leverage for the second quarter was 5.7 to 1, while recourse leverage ended the quarter at 3.7 to 1. For the quarter, our economic net interest return on equity was 14.5%, and our GAAP return on average equity was 6%. Expenses for the second quarter, excluding servicing fees and deal expenses were $19 million, down from the first quarter, primarily related to lower compensation expenses, partially offset by higher G&A. That concludes our remarks, and we'll now open the call for questions.

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

Thanks. Understanding that you'll give us more detail on the loan portfolio next quarter, but I was just hoping you could talk about kind of your capital position to fund that portfolio acquisition and whether you can do that through just adding leverage or whether you would reduce the Agency portfolio in order to finish that acquisition?

Good morning, Doug, this is Mohit.

Good morning.

We have ample liquidity to fund the acquisitions that'll be happening in the third quarter. We are selling agencies and we have ample cash flow, so depending on availability of further assets, we have both tools that are disposable to fund purchases.

Great. Thanks, Mohit. And you've now done a couple of investments property securitizations. Can you talk about kind of your outlook for that continuing to be kind of the source of investment?

Yes. I mean, I think as we’ve mentioned in prior calls, we think Agency eligible loans securitized on the private label side is an ample opportunity. We've done it in the investor space. We've looked at LTV loans as well. We hope to do a deal a quarter in the future, so we think there's going to be ample supply there.

All right. Thanks, Mohit.

Your next question is from Eric Hagen with KBW.

Thanks, good morning. A couple housekeeping items. Number one, leverage ticked down, but it looked like the portfolio was basically the same size quarter-over-quarter. I just wanted to understand kind of the nature behind that leverage coming down. Number two – well, actually if you give a sense of that and I'll jump to number two after that. Thanks.

Eric, this is Rob. I think what happened at quarter end last – at the end of the first quarter, we did have some agency trade settling over quarter end where we had the repo on, but the deal or the trade settled right after quarter end. Even though the balance sheet doesn't look dramatically different, we had some repo pay off early April.

Got it. Thank you. And then, the transfer from – the second question on the housekeeping. The transfer from the credit reserve almost $16 million in the quarter. Can you just identify where that came from in the quarter – or in the portfolio, excuse me?

That’s still part of our nonagency book and it generally points to improvement in cash flows on the portfolio as we run and update them every quarter.

Got it. Was that in the securitized loan portfolio or was it the legacy non- Agency RMBS portfolio?

Primarily, the legacy RMBS.

Got it. Okay. Great. And then a follow-up on the investor property deals. How does the WAC on those loans compared to the presumed rate that the borrower would get if they finance those loans to the GSEs?

The loans originated for GSE execution deliverability. So I don't think the WAC necessarily different, but given the rates have decreased quite significantly and also over the start of the year, the WACs that we require obviously higher and as the rates reset down, future origination should be lower WACs.

Yes. And just to be clear, the loans that are originated could be put into agency pools. So they are eligible for agency guarantees, but the guarantee fee that the agencies charge is worse execution for the originators than putting them into a private label security. So these are very high-quality mortgages and the execution is better in private label than do it through the agencies.

Okay. But just to be clear, just because of that difference in the GSE, the actual rate to the borrower wouldn't actually change. It's the execution in the secondary market that is…

That's exactly right. Yes.

Got it. Okay, great. And if you can just shine some light on where current spreads and returns are within the buckets of your Agency portfolio that'd be great. Thank you.

Sure. So I'll start with the agency pass-through bucket. Given the spread widening that occurred in Q2, we think levered returns there net of hedges are probably going to be high single digits, low double-digits. Given the sort of WAC and repo financing, as we've discussed on the opening remarks, the Agency CMBS, however, has lagged some of that. Actually, quarter-over-quarter spreads were tighter. So levered returns there are going to be between 12% to 13%. Q2 was slow in originations, so we weren't able to acquire much, but we anticipate Q2 to have some more originations, which should be accretive to the portfolio and an opportunity to add some more assets there.

Great. Thanks for that color. One more actually for me if you don't mind. What percentage of your securitized debt is floating versus fixed rate at this point? And what's the index and the margin on that floating rate debt, please? Thanks.

I think the breakout between fixed and floating is still around 50/50. I think 49/51. The index on all the debt issued is one month LIBOR and the DM, the margin ranges anywhere from 100 to 250. I don’t have a blended rate, but we could get you that number.

No, that’s helpful. Thank you so much, guys.

Thank you.

Thanks, Eric.

Your next question is from Stephen Laws with Raymond James.

Hi, good morning. just want to touch first on the macro side. The Consumer Financial Protection Bureau and – stated I guess, a couple of weeks ago, they're going to let the QM patch expire in 2021 January. So about 18 months, I guess, could shift $150 billion of loans from the government side to the private market roughly. Can you talk about that opportunity? How much of that you think holds and types of product that you would look to invest or provide – obtain some type of credit fees behind the pool of loans, but can you talk about that transition as the opportunity in the private market looks like it's going to continue to grow here going forward?

Yes. I mean anything that removes the GSEs from acquiring more assets would be good for private capital. We will see you if it comes to fruition, but as we've mentioned earlier, I mean, we're already looking at stuff that is GSE eligible that we're financing on the private label side, given the GSE. I think in some of the near-miss stuff that the GSEs are currently taken on the QM side, I mean, the non-QM market has seen a lot more issuance has become a significant part of the market. And I think there's opportunities there for us to deploy private capital and be accretive to earnings.

All right. Well, hopefully, we'll continue to get more color on that as it – in the near-view mirror – near-view focus but shifting – actually first, follow-up on Doug's question about funding new investments and shifting from Agency. What would you'll need to see out there to raise capital? I know you – I think did a prefer deal, if I remember maybe late last year. But how do you – what is the internal discussion between raising new capital to fund investments versus reallocating away from the Agency portfolio?

Well, hi there, it's Matt. I just like to say that I think we have plenty of capital at the moment to execute the transactions we have in front of us for the next six months. I think it's our desire to probably slowly get out of our Agency mortgage-backed securities, the residential pass-throughs and deploy that capital into residential mortgage credit. I think the fundamentals for residential mortgage credit are really terrific. The unemployment rate in the country is very low, which is very good for housing credit. More people working means more people paying their loans. And we're seeing housing prices, although the prices are coming up slowly, they are coming up. And that's actually good for residential mortgage credit too. And I think there's been a tremendous amount of cash flow into the money managers. If you listen to BlackRock's earnings calls and there are some of the other big money managers, they're getting some significant influence into their fixed income funds. And I would imagine it's got to come from these foreign investors that are facing negative returns in their home markets and they're looking to the United States for positive returns. And that money comes into these money managers, and it's really growing into mortgage credit. And I think that dynamic is going to be pretty strong for the rest of the year. And I think it just underscores our conviction that residential mortgage credit is the best place to be and the securitization market is going to – in my opinion, is going to be strong for the rest of the year. So the short answer is I think we have plenty of capital. I think we would come out of our Agency mortgage-backed securities to 13-year residential stuff and deploy it into deals that we securitize, the subordinate pieces and deals that we securitize.

Great, appreciate the color. Matt, a couple of your comments kind of lead into my next question. Just – I think the disclosure and the comments you guys provided on financing costs and sensitivity to rates is well disclosed. I appreciate the color there. But just kind of thinking about how lower rates – may be at the high level if you could talk for a second is, on the legacy book, I mean I think some people may see their mortgage payments resetting lower depending on their – what type of product they're in and where their rate is, but how is that impacting the performance or delinquency rates of nonagencies and legacy RPLs? How does that impact the value of the loans? And maybe talk a little bit about how the higher level these lower rates are going to impact the more credit-sensitive type assets in your portfolio?

Well. it's an interesting thing. I think lower rates on our balance sheet, we have very large amount of loans that we consolidate on our balance sheet. And you know that we have calls embedded in all the financings on those deals. And if rates trend lower, we go into a negative environment, which I don't think we are. I think the economy is strong. I can't see it happening. But if rates trend lower that means we're going to be able to call those deals and refinance our debt at lower and lower interest rates. So I think we'll be able to keep up and still produce a very high rate of return in a low interest rate environment because we have all these loans on our balance sheet that we consolidate, and we've embedded calls into all the financings. And I think that's a big benefit to our balance sheet that may be people don't 100% understand.

Great. Well, I appreciate you highlighting that.

As far as the performance of the collateral goes, I think lower rates are going to be beneficial for the borrower. I think it'll continue performing. As mentioned in the opening remarks, the performance of the legacy assets that we do hold, whether in securities bond and loan form has exceeded our purchase assumptions. And I think lower rates overall will continue to be supportive of that.

Great, thanks a lot for the color on that. Matt. Appreciate you taking my questions.

Thank you.

Your next question is from Trevor Cranston with JMP Securities.

Alright. Thanks. You guys gave some good color on the investment opportunity in whole loans and specifically on the newer issued investor loans. I was wondering any of you could maybe compare and contrast what you're seeing in the legacy whole loan market in terms of how much supply you're seeing available right now and how the returns on legacy loans compared to what you'd see in the newly originated investor loan market? Thanks.

I'll start that. This is Mohit. Legacy space, the RPL space still has seen robust sales out of the GSEs. They have a periodic sale once a quarter. We've already seen the sales for Q3 happened in July, we expect another $6 billion will come up before year-end. Overall sales in the RPL space for this year are probably going to be north of $30 billion is our estimate, and we think there's going to be ample supply of that, the comment as we've said on our prior earnings call. So the opportunity said is still there, the return profile on those loans, given Matt's earlier remarks about different funds chasing assets in the residential side has put pressure on yields. We think yields on legacy RPL loans are probably low mid-4%, but if you can finance those through securitization, we still think it’s an attractive opportunity to retain the some pieces of those deals. And we think the return profiles on new issues stuff, depending on what pockets you pick, whether it's the investor loans or some jumbo loans, the opportunity set there is accretive as well and we think our returns there on the routine pieces would be in double digits as well.

Okay, great. Thank you. On the agency portfolio, obviously prepayment speeds picked up healthy amount during the second quarter. Can you maybe comment on where you saw speeds, specifically in July and where you see those trending over the next couple of months as well?

Sure. So speeds in July were slightly slower than what was experienced in June. We think speeds will remain elevated in the near term, given one seasonalities, given the dip in rates, just typically about a six week lag from where our rates are to where you will – what the speeds will be reflective on the bond side. So we think near-term speeds are going to remain elevated in August, September, October and then depending on rates and the Fed action that could carry through for the remainder of the year. But again, post-summer we have more seasonality where housing turnover will be less than those fall and winter months.

Okay, great. I appreciate the comments. Thank you.

Thank you.

Your next question is from Matthew Hallett with Nomura.

Thanks guys. Just a follow-up on the whole loan – legacy whole loan question, have you seen a pickup in and prepayment speeds in some of those legacy pools or is it because of our low loan balances and sort of credit impairment nature of that preventing any sort of refinance activity.

No, the turnover on our loan portfolio has been pretty consistent irrespective of the level of rates. We're still experiencing high-single digits between 8 to 10 CPR on the portfolio in the whole. And that's the beauty of the way we've set up the portfolio with a low loan balance and the seasoning. I think both of those are accretive to the prepayments.

Is there any level on the fixed rate mortgage where that would come into play or is it just these are people that seen low rates before and…

Well, it’s a very interesting thing. I think the low loan balance story really plays out here. You have people who don't want to pay the upfront fees to lower their payment by $50 or $60 a month. Right now, you have a mortgage rate of probably 300 basis points – 200 basis points to 300 basis points lower than our average mortgage in the portfolio. And these homeowners haven't refinanced just because the upfront costs I think outweigh the benefits of the breakeven benefit. It's a very long time to get back to those upfront costs. And so it's been very slow, it's been surprisingly even for us to think that they would be paying as slow as they are, but they have been and that's been very consistent over the years that we've owned these loans.

Okay, good. That's interesting. Then moving along on the $1 billion that you referenced in whole loan, but that doesn't include the Freddie rights stuff that's coming out, you put that separately is that correct?

No, that's all – this is all new purchases that we hope to settle in the next few months and securitize before year-end, this is all brand new.

So, on the Freddie Mac deal you want in the second quarter…

There’s enough brand new loans. There are RPLs and packages of loans but they are new investments to our company.

Okay. But does that include the pipeline that you anticipate winning on the Freddy deals as they come out?

No.

The Freddie Mac deal has been closed. We own it.

Right. But it sounds like that was well bid, you guys want it. I mean, what's your appetite for these deals come out of them Fannie and Freddie that continue bidding on them?

We like that structure that Freddie Mac has come to market with, we think it's accretive, it takes out a lot of the execution risks that we faced on other securitizations that we do ourselves. And I think the financing costs offered by the GSEs are very accretive to the sub-holders.

Got it, okay. And then just, did I hear you correctly on the Investor Day that it wasn't consolidated, just curious and I know it doesn't matter economically speaking, but what can you tell us in terms of deals going forward, whether to really grow step on the balance sheet or whether not you'll just have it, you'll just have the retained piece on your balance sheet and no loans off?

It depends deal-by-deal, when we look at it from a consolidation perspective it comes down to what rates we have. It's pretty consistent that agencies and these investor deals, we don't have the rights and typically don't consolidate, but on the RPL deals, the NPL deals things of that nature we generally do.

Great. And then the last question just on, you've been able to really access the preferred market efficiently, each deal seems like they're getting better than the last one, I mean – what's – you can call some of these legacy deals, there's legacy preferred, but what's the pipeline for that and even some of the – can obviously call some of the legacy securitization. So just curious about what you can do with the existing balance sheet in terms of lowering some of the funding costs?

Matt, on the security side, as Matt mentioned earlier, we do have calls embedded in all of our securitizations, some are three years, some are four years, so as the decrease in rates go, we have the ability to call and optimize the financing there. On the preferred side, we have – our first loan becomes callable in 2021 and depending on the market conditions at the time we would look to optimize that if it's lower rates at that time couple with other investment opportunities.

Got it. Okay, great. Thanks guys.

Thank you.

[Operator Instructions] Your next question is from Jim [indiscernible] Partners.

Hi Guys. Matt, you used the term for the second quarter, what it was exactly, it was challenging and from the outside was certainly an interesting quarter, in other calls I've heard people talk about there being kind of a hiccup in the middle of the quarter where agency backed spreads even without prepayment risk like DUS bonds, GAAP wider as well as – we can follow what's going on with regular pass rates and it sounds to me like when you described your Ginnie Mae commercial portfolio that just steadily grounding over the quarter, is that a fair assessment so far?

Hey Jim, this is Mohit. Yes, that's a fair assessment. The project loan started since the start of the year has down to tighter spreads, were north of 150 at the end of the year and they're probably around 135-ish currently.

Alright. So trying to connect what happened there, it would seem like obviously this is where it gets to be really interesting to me. Some of the widening over the past certainly could've been expectations of a prepaid surge. I'm sure some of it was, but that shouldn't affect the DUS bond. So the DUS bonds and some percentage of the pass through widening without Ginnie Mae, while Ginnie Mae are tightening, would suggest that there might have been something that kind of heard whisperings up in the middle of the quarter, which is a little bit of a concern about the implied government guarantee going away on the agencies would that also be a fair assessment.

I don't know. I wish I had an answer for you on that. I haven't, you're the first person who has brought that up immediately.

And then just talking about DUS bonds and the spreads on those, I think there is an all-in yield bogey that some long creation buyers have, so given the retracement of rates overall and the lower yields, I think there was light widening on DUS bonds, but nothing that material that we noticed on our portfolio.

Okay. So I guess I'm hearing is to the people at the tip of the sphere there really was no concern about implied versus explicit credit guarantees on the GSEs in this quarter.

Sounds well.

Thank you very much.

There are no further questions at this time. I’d now like to turn the call back over to Matthew Lambiase for any closing remarks.

I just like to thank you for participating in our second quarter 2019 earnings call. And we'll talk to you in November. Thank you.

This concludes the Chimera Investment Corp. Q2 2019 earnings call. You may now disconnect.