Anyone who flies a lot, especially the transatlantic fall/winter route, knows how disturbing mid-flight bouncing around can be. Invariably the pilot comes on and says we just hit some “clear air turbulence.” Occasionally we even get a warning passed on by another plane ahead of us, but more often it’s a surprise. Consider this the pilot coming on and suggesting you buckle up because a plane flying ahead of us is reporting they encountered clear air turbulence.
A note came from Wunderlich Securities’ mREIT analyst Merrill Ross today. She discontinued her price target for Chimera (CIM) and pointed out the difficulties that this non-Agency mREIT is probably having with its portfolio valuation. In particular, they have delayed their quarterly SEC filing, and the best guess is that a permanent impairment charge may be coming on a chunk of their portfolio. That would trigger both a loss in book value and hit to current earnings as the impairment is recognized.
The issue of attributing earnings to expectations of a future cash flow is especially tough on portfolios where the source of leverage (to give acceptable returns to equity investors) is structurally created by selling off (securitizing) the front end of the cash flows.
The positive of such a strategy is that the securitization provides financing for the portfolio that is not subject to the vagaries of nightly valuations and margin calls from repo lenders.
To me, the most interesting part of Ms. Ross’s note this morning wasn’t the warning on CIM. Everybody understood there was a large unknown risk when the company announced they would delay their quarterly report a few days ago.
Her note said, in part:
We think this issue is distinct to CIM and that others (specifically, MFA) have accreted discount more ratably and fairly. However, the group will be under pressure, and especially the shares of NLY are likely to be caught in the downdraft because CIM is externally managed by a subsidiary of NLY.
In case anyone is just coming in to the movie now, NLY is the $100 billion gorilla in the mREIT space, by far the largest, with over $14 billion in market cap. In the recently-announced subsector ETF called MORT, NLY is nearly 20% of the portfolio.
Even though the asset valuation issues that may hit CIM will not be an issue for pure Agency mortgage REITs like NLY, AGNC, ANH and CYS, the fact is that the portfolio management team at NLY runs the portfolio at CIM and has been setting the values from which they get their (non-cash) earnings. Now, if those change dramatically, the fallout on Annaly is likely to drag down the entire group, at least temporarily.
Also, mREITs from Pimco and Putnam that are in the queue to launch IPOs will get pushed back further if the whole group trades to a discount to asset value.
On the positive side, savvy investors may get the chance to own Agency MBS at a discount to the real market for those MBS. By coincidence, it’s just over two years ago that I posted about this kind of opportunity.