Courageous Call on CIM

Yesterday Merrill Ross at Wunderlich put out a sell opinion, even though she was potentially angering the largest player in her stock sector.  You simply don’t see that among equity analysts.

Hold, maybe.

But an outright sell?  Never.

Long time MoM readers know that I had doubts about the non-Agency business model Chimera was pursuing.  Specifically, by selling off the front end cash flows of the MBS bonds they bought in the marketplace, they were setting themselves up to earn a (non-cash) profit only to the extent that the back end cash flows were worth more each quarter, at least until the front end bonds were paid off.

The big risk was that losses on foreclosures would be higher than estimated, which would slow down the payoff on the front end bonds, and leave less to pay the shareholders once the front end bonds paid off.  In the worst case, it was even possible that the front end bonds never paid off, leaving the shareholders owning nothing.

I was never that pessimistic, and I certainly expected that most of the front end bonds would be paid, though the speed with which they were paid was highly dependent on the pace of foreclosures and sales.  Neither has been very fast.

A true skeptic would say that the servicing banks had no incentive to hurry, since they got to record enormous late fees, and those fees came off the top once the house is foreclosed and sold.  A clever manager at a servicing operation might just let a delinquent borrower slide for a while as long as eventual house sale would more than cover the servicer’s advance payments and fees.  But that would never happen, right?

When Chimera recently announced the delay of their quarterly report, the stock price plunged as investors held their collective breath.  How bad was the bad news?

Then they announced that it wasn’t that bad, and that they weren’t going to restate prior earnings.  They did indicate that some of their holdings may be permanently impaired, but the net effect was small.  We still wait for the accountants to finish their work before we know the results.

Ms. Ross was already pretty courageous when she pointed out that questions about portfolio valuation might redound negatively on CIM’s parent/sponsor, Annaly.  After all, CIM is “externally managed” by FIDAC, a wholly-owned subsidieary of Annaly.  For any asset manager, questions about the valuation of a portfolio under management can have a far bigger negative effect than the change in values alone.  A loss of trust is the issue.

Ross was the only equity mREIT analyst, as far as I know, who pointed out that Annaly might have some risk simply because it’s Annaly people who put the numbers on the Chimera portfolio.

Now, she has “doubled down” by stating that the fundamental business model at Chimera doesn’t work.

Key points in yesterday’s report:

What are the loss assumptions on credit-sensitive assets? CIM has said that it accretes discount on a loss-adjusted basis, but has never disclosed the magnitude of loss reserves. Neither has the company disclosed the amount of discount that is not accretable because it has been pledged in financing transactions. We believe market participants have the right to examine this information in order to make informed investment decisions.

No OTTI, no change in discount accretion. Contrary to what the market seems to believe, we believe CIM did not dodge a bullet when the accounting change did not trigger any change to the valuation of its bonds, because it gained no flexibility to change its loss assumptions that govern discount accretion. Because CIM appears to have no choice but to continue to overpay the dividend, we wonder if the next step will be to de-REIT. At least, if the company overpays taxes, it can generate tax benefits.

Valuation. Given the declining trend we project in book value, we believe the dividend will not provide price support over the next 12 months. Basically, the dividend is not covered by net interest spread, but can’t be cut because taxable earnings have to be paid out at 90% to maintain REIT status. We target a price of $2.50 per share, which is a 7% discount to forward 12/31/12 estimated book value. We believe this business plan, long term, doesn’t work, and we are downgrading the shares from Hold to Sell.

I find the observation that avoiding a change in fundamental assumptions about recovery rates, prepayment rates and time for foreclosures to complete is especially cogent.  It’s as if avoiding admitting a mistake traps you into continuing that mistake.

Bad for policy makers, as we see watching our national political farce, but even worse for portfolio managers, because they need the flexibility to re-value their assets when things don’t work out as expected.

I can already hear the response that assumptions can be changed over time, and that they are.  True, but the point of permanent impairment adjustments is to let the shareholders get all the bad news out at once.  In fact, most of the time, a one-time adjustment gives an organization a chance to throw everything possible into that adjustment, making future profits much easier to realize.  The classic $275 million loss Merrill Lynch took on their famous IO/PO deal (Merrill Trust 13) that they did with Ernier Fleischer of Franklin Savings comes to mind.  I remember thinking at the time that there was no way that one position (PO priced too high) could have that size loss in it.  Clearly, everything in the portfolio was whacked down to fire sale prices, Howie Rubin took the blame (and a generous kiss goodbye), and life moved on at MLPF&S.

Only time will tell whether Ross is right on this call.

I suspect her firm won’t be getting any stock underwriting mandates from Annaly, Crexus or Chimera for the next couple of years.  As to Chimera, as I pointed out in my first analysis here, they do get the “halo” effect from being part of the 800-lb. gorilla of the sector.  After being way too early with their initial stock offering, the Street was quite willing to raise tons of new equity for them.  That could happen again, in which case paying out dividends on the accretion (non-cash) of the existing retained portfolio will be less painful.  If, on the other hand, investors don’t step up, they’re going to have to hope for a housing recovery sooner rather than later.

hh

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6 Responses to Courageous Call on CIM

  1. Taymere says:

    I’ve been making money by listening to Merrill for years, she is one of the few analyst that I trust. She spoke with me in 2009 about how she refuses to succumb to sell side analyst investment banking pressures and how she’d rather lose a job than tell lies to get underwriting fees.

  2. irongate says:

    Really…. Kudos to her for having an independent mind and maintaining her integrity in this ol’ boys club. And thatnks to you howard for your continual insight on these somewhat convoluted investments

  3. Patrick says:

    Did you see the Cantor Fitzgerald report that openly mocked Annaly? It was really unbelievable. http://blogs.wsj.com/marketbeat/2011/11/18/annaly-cantor-analyst-gets-creative-with-his-criticism/?mod=yahoo_hs

  4. laterre says:

    Yes, bravo to Merrill Ross for saying what others are probably thinking: you can’t trust their marks. And thanks for your insights, Howard. Love your posts.

    I’ve been digging into their 10-Q trying to get my head around the real number for NAV. I’d always assumed it was what they’ve lately been calling “Economic Value,” but even this is only the GAAP # with the assets and liabilities of the securitizations taken out.

    By their own account, their typical pool is a 2007-2008 jumbo alt-a, CA or FL, 74% LTV (probably not counting a 2nd), mid 700 FICO (back then). After the re-remics, they’re left holding $2 billion of what they’re calling “Subordinated” (first loss, prepays completely locked out) plus $2 billion of senior, non-retained (but still consolidated on their books). After all the accreted discounts mumbo-jumbo, if I’m looking at this correctly, they’re marking the Subs at 42 and the Senior at 112 (“fair value” divided by “principal value”)!? Show me a bid right now for anything similar in this universe…

    They’ll say that the cash mbs market doesn’t matter, as they’re not selling, and that’s fair enough. But what do you think the cash flows look like on those subs? Could those realistically go to zero? I’d assume they’ve long since burned through the original subordination and everything’s now coming out of their piece. So long as they keep paying there’s value there, but if I were a CIM investor I’d be pretty miffed to wake up one day and find $2 bill suddenly evaporated from NAV because the cash spigot on those IO subs finally got shut off late one Friday night.

    Call me paranoid, but a 17% dividend doesn’t begin to allay those concerns…

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