Chimera Investment Corp Q3 FY2022 Earnings Call

Good day, everyone, and welcome to the Chimera Investment's Third Quarter 2022 Earnings Conference Call. All lines have been placed on a listen-only mode, and we will open the floor for questions and comments after the presentation. At this time, I am pleased to turn the floor over to your host, Victor Falvo, Head of Capital Markets. The floor is yours, sir.

Thank you, operator, and thank you, everyone, for participating in Chimera's third quarter 2022 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 Factors 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 will 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 CEO and Chief Investment Officer, Mohit Marria.

Good morning and welcome to the third quarter 2022 earnings call for Chimera Investment Corporation. Joining me on the call today are Choudhary Yarlagadda, our President and Chief Operating Officer; Subra Viswanathan, our Chief Financial Officer; and Vic Falvo, our Head of Capital Markets. After my remarks, Subra will review the financial results, and then we will open the call up for questions. Before we begin, I would like to congratulate all the Chimera employees and members of our Board of Directors, past and present, as we celebrate our 15th anniversary as a New York Stock Exchange listed company. I'm very proud of the team we have built and very much appreciate all their contributions to the company. While elevated market volatility in the third quarter has led to higher rates and wider spreads, putting further pressure on our book value, we believe this has created several opportunities for Chimera on both sides of the balance sheet. In particular, to the end of October, we've been able to increase our cash position, increase the amount of non-mark-to-market financing, and either added or committed to add new investments to our portfolio. It has been a busy period for us, which I will discuss in more detail in a moment. But first let me describe the overall market and how that translates to our portfolio and expectations. The capital markets have been volatile this year, buffeted by global complexities, higher inflation, a rapidly rising interest rate environment, and a weakening U.S. economy. Inflation, which Federal Reserve officials believed to be transitory in nature last year, has turned out to be persistent, with the Consumer Price Index reaching 8.3% on a year-over-year basis in September. As a result, the Federal Reserve raised interest rates 75 basis points at each of their July and September meetings, bringing the total tightening of short-term interest rates to 300 basis points over the first nine months of this year. The magnitude and velocity of the Fed's tightening has put downward price pressure on all fixed-income products, including treasuries, corporate bonds, and mortgage-backed securities. Higher rates across the capital markets have flowed through to consumers, with the rate of 30-year conforming mortgages rising to 7.04% at quarter end versus 3.18% one year ago. Higher mortgage rates have substantially slowed down new home purchases and eliminated refinance activity. As reported in September, sales of existing homes declined for eight consecutive months to the lowest level in the past decade. As a result, we believe this year's mortgage rate shock to the consumer will have an impact on slowing down the economy and ultimately lead to lower rates, as many consumers will have less disposable income to spend. Chimera's portfolio of residential mortgage credit is unique and differentiated among our peers. It is well-seasoned and has experienced many interest rates and economic cycles. We have approximately $1.2 billion of non-agencies RMBs, mainly comprised of opportunistic purchases made after the previous housing crisis. This portfolio has provided double-digit returns for a long period of time for our portfolio, and we expect that to continue into the foreseeable future. Since 2014, we have amassed an $11.8 billion portfolio of residential mortgage loans with substantially different characteristics than available through typical mortgage banking channels used by banks and traditional mortgage-backed security investors. Our loan portfolio consists of 115,000 loans with an average loan balance of $102,000. The loans are an average of 15 years seasoned, and the average loan-to-value at origination was 83%. Importantly, 88% of our loans were originated in 2007 or earlier, which means homeowners have been making mortgage payments on their homes for 15 years or more. And the portfolio is geographically diverse, with only three states having geographic concentrations above 5%. Overall, this portfolio is different. A small loan size equates to low monthly mortgage payments, the age of the loans has afforded many homeowners a reasonable long period of time to catch up with home price appreciation and/or mortgage amortization. There is a long and demonstrated history of monthly mortgage payments made by the homeowners. All of these factors are very important features when evaluating a mortgage borrower's paying ability. Our seasoned re-performing portfolio is a cornerstone of our business, and we believe our portfolio of seasoned re-performing loans will continue to outperform the market. We believe market conditions also present new accretive investment opportunities. Since the beginning of the year, we have been scaling into new investments. We believe our patience and investment discipline throughout this year will benefit our shareholders over the long term. Now I will take you through our recent activity. During the third quarter of 2022, we committed to purchase $687 million in residential mortgage loans, with $211 million of this total settling in October. We expect to close $476 million in loans into a long-term non-mark-to-market structure, which we anticipate will generate double-digit returns. Due to the delay in settlement, we expect to see the full benefit of these loans in 2023. Additionally, we purchased and settled $66 million in business purpose loans during the third quarter of 2022. As we have mentioned in the past, we like the loan characteristics associated with business purpose loans. They have a short duration and provide good spread income for the portfolio. In total, we committed to purchase $753 million in loans in the third quarter. As of the end of the quarter, 96% of our capital was allocated to residential credit assets. Securitizations remain the primary source of financing for our loans. In September, we sponsored CIM 2022-R3, a rated securitization of seasoned re-performing residential mortgage loans, with a principal balance of $370 million. Securities issued by CIM 2022-R3, with an aggregate balance of approximately $284 million, were sold in a private placement to institutional investors. These senior securities represented approximately 77% of the capital structure. We've retained subordinate notes and certain interest-only securities with an aggregate balance of approximately $86 million. We also retained an option to call the securitized mortgage loans at any time beginning in September of 2027. Our average cost of debt for this securitization is 5.80%. As of the end of the quarter, securitized debt represented 72% of our total financing, with an average cost of 2.7%, and 98% of our securitized debt is fixed rate. Largely because of securitization this quarter, we reduced our overall recourse financing by $328 million. On the remaining 28% of our financing, we retained a portion of our secured credit financing with either none or limited mark-to-market facilities. This quarter, we extended a maturing $489 million non-mark-to-market facility by an additional 29 months to February of 2025. We continue to believe these facilities are valuable components of our liability structure. The third quarter experienced a significant increase in interest rate volatility. Given the market outlook for higher rates for an extended period, we entered into a $500 million two-year and a $385 million five-year interest rate swap. These swaps complement the $1 billion swaps we entered in Q2, allowing us to partially hedge our borrowing costs over a longer period. In total, during the third quarter, we entered into $885 million in pay-fixed interest rate swaps. In the post-quarter end, we ended October with approximately $350 million of cash on our balance sheet, entered into an additional $1.1 billion of pay-fixed interest rate swaps, and entered into a new two-year non-mark-to-market secured financing facility for $250 million to finance retained securities from our securitization, and sponsored $145 million CIM 2022-NR1 with existing loans from our warehouse. These transactions further strengthened Chimera's liability and liquidity position since quarter end. Throughout 2022, we have managed our balance sheet to lock in long-term funding while seeking opportunities to add higher yielding mortgage assets to our portfolio. We have maintained low recourse leverage and adhered to our discipline of carrying none or limited mark-to-market financing for many of our subordinate credit assets. Despite challenging markets since the beginning of the year, we have closed or committed to acquire $1.6 billion in loans, completed five securitizations totaling $1.6 billion, repurchased $50 million of our common stock, and entered nearly $3 billion hedge transactions to protect against further increases in interest rates. We expect to add new credit financing partners, bringing none and limited mark-to-market facilities to nearly 50% of our secured financing. We believe our credit portfolio is strong and will continue to outperform other mortgage assets in the marketplace. Chimera strongly believes in securitization, which provides us with stable, non-recourse long-term financing. We've taken many steps to strengthen our balance sheet so that we can weather the current economic storm. We believe we are well positioned to take advantage of the new market opportunities and that our patience and investment discipline will benefit our shareholders over the long term. I will now turn the call over to Subra to review the financial results for the quarter.

Thank you, Mohit. I will review Chimera's financial highlights for the third quarter of 2022. GAAP book value at the end of the third quarter was $7.44 per share. Our economic return on GAAP book value was negative 13%, based on the quarterly change in book value and a third quarter dividend per common share. GAAP net loss for the third quarter was $205 million or $0.88 per share. Our earnings available for distribution basis, net income for the third quarter was $63 million or $0.27 per share. Our economic net interest income for the third quarter was $104 million. For the third quarter, the yield on average interest-earning assets was 5.5%. Our average cost of funds was 3%, and our net interest spread was 2.5%. Total leverage for the third quarter was 3.9:1, while recourse leverage ended the quarter at 1.1:1. For the quarter, our annualized economic net interest return on average equity was 14.8%, and our annualized GAAP return on average equity was negative 26.5%. Lastly, our third quarter expenses, excluding servicing fees and transaction expenses, were $15 million, consistent with the previous quarter. That concludes our remarks, we will now open the call for questions.

And our first question comes from Kenneth Lee from RBC Capital Market. Go ahead, Kenneth.

Hey, good morning, and thanks for taking my question. There's a lot going on in terms of the financing side between the extending the non-mark-to-market and the rate swaps you've been entering into. Just wondering if you could talk a little bit about how you think funding costs could trend over the near term given all these changes? And importantly, how responsive would funding costs be to rising rates? Thanks.

Good morning, Ken. This is Mohit, that's a good question. As we entered 2022, the expectations of the Fed from where it started to where it was going to end were anticipating about three to four rate hikes. As we mentioned in the opening remarks, that has gone much further, and yesterday they raised an additional 75 basis points for the Fed funds rate to be at 4%. As a result of how quickly these expectations have changed, we started laddering into swaps and hedges to protect our financing costs over the last two quarters and even post-quarter-end. So, the vast majority of our recourse borrowings are of a floating rate nature. Therefore, any adjustments in the index on the Fed funds rate translate into an increase in financing costs. However, these hedges will lock in rates over the next two to three years, but from a spread perspective, in terms of the assets we are looking to finance, there is still ample cash at those spreads to finance those assets. So, it’s more the benchmark rate as opposed to the spread that is our bigger concern.

Got you. Very helpful there. Just one follow-up, if I may. I appreciate the discussion on the RPLs and realizing that much of the residential are very seasoned. But one of the things I want to talk about is the potential impact of a slowing housing market and potential home price declines in terms of residential loan valuations or non-agency valuations. Thanks.

Sure. So, the big differentiator for us on our loan portfolio is the vast seasoning that the portfolio has since its origination, with an LTV of 83%. So if you assume that 85% of the portfolio was originated prior to 2007, there's been 15 years of natural amortization, coupled with some strong home price appreciation. So we think the updated or home price index adjusted amortized adjusted LTV on the portfolio is closer to 50%. From a credit performance standpoint, that gives you a lot of equity to work with. If you look at the average loan balance of $102,000, the monthly mortgage payment is under $800 a month. In comparison, a $400,000 mortgage would see a payment increase of $900 due to the adjustment in the mortgage rate from the beginning of the year to now. These borrowers have gone through different interest rate cycles and credit events, so we believe that there won't be a material change, given the lack of housing alternatives that these borrowers have.

Got you. Very helpful. Thanks again.

And our next question comes from Trevor Cranston from JMP Securities. Go ahead, Trevor.

Hey, thanks. Good morning. Can you guys talk a little bit about how the high level of volatility in the rates markets has impacted your investment appetite, just given the risks that there could be a big move in rates and spreads, between the time period when you acquire loans and when securitization takes place?

Hey, Trevor. That's another good question, and one we've addressed in other calls as well. Our approach isn't necessarily to aggregate loans in large sizes that we buy in bulk, producing and warehousing them to transfer servicing and ultimately to securitize. So the period from committing to a trade to funding and securitization is typically within a 60 to 90-day timeframe. We try to limit how much exposure we have to spread and rates adjusting. Now, this year has been unique given how quickly rates have moved in Q3. The two-year rates moved 130 basis points, the five-year by 100 basis points, and the 10-year by approximately 90 basis points, making it a challenging environment on top of the amount of issuance in the new issue market. However, we do take on warehousing risk and manage that as much as possible.

Okay, got it. In the post-quarter update, you mentioned the $476 million of loans. I think you referred to it as being placed into a long-term non-mark-to-market structure. Can you explain exactly what that is? And why you are utilizing that versus securitization?

Sure, as you mentioned and I noted in the previous question, given the challenges in the new issue market currently, we acquire these loans while also locking in a five-year financing arrangement on a non-mark-to-market basis, achieving similar advanced rates that you would get via securitization. We believe this outcome will produce better returns for the company.

Okay. And are structures like that something that you think could be more available in the near term, considering the new issue market doesn't necessarily look as attractive?

Yes, I think given the challenges the new issue market is facing, these structures could become more commonplace. If and when the market returns on the securitization front, we will balance that out on a go-forward basis.

Okay, got it. And last thing, could you provide an update on book value quarter to date?

Sure. I mean, again, we've had this question the last two quarters. Each time we've presented it, it's vastly different depending on market conditions. Since the end of the quarter, rates have moved about 30 basis points across the curve, and spreads are marginally wider. I would suspect book value to be down between 2% to 3% since quarter-end.

Okay. Thank you.

And our next question comes from Bose George from KBW. Go ahead.

Hey, guys, it's actually Mike Smyth on for Bose. My first question is, can you provide an update on your asset acquisition pipeline and the overall level of competition in the space? I'm wondering if any of your loan origination partners have stepped away given the uptick in volatility. And then as a follow-up, can you just remind us how many loan origination partners you have? If any are shutting doors or facing solvency issues due to the rising rates? Thank you.

Sure, Mike. As for sourcing assets, it's not a problem. We've been defensive, maintaining low leverage while adding accretive assets. Since the start of the year, we've acquired $1.6 billion in loans, and we've also completed five securitizations to fund many of those transactions. We bid on loans based on securitization exit prices and seek other long-term financing sources. We don’t have firm agreements with any particular originators regarding flow assets; rather, we can select collateral that meets our criteria.

Yes, that’s helpful. Thank you. And then maybe just one more. Can you talk about where levered ROEs are on new investments? How are you balancing between buying back stock and maintaining a strong liquidity position?

Sure, let me start with the ROE question. As we mentioned, on the loans looking to settle in Q4, the $476 million, we expect double-digit returns on that investment. The majority of the mortgage ecosystem can produce attractive levered returns. However, given higher rates, inflation, and active Fed actions, we’ll maintain a disciplined approach to deploying capital. Maintaining liquidity is our primary focus. We've maintained low recourse leverage throughout the year; we began with 1.0 turns and are now at 1.1, while rates have moved significantly across the curve. At the same time, we want to be judicious in deploying accretive capital since many investments look attractive. Overall, levered returns should be in the mid-teens for us to deploy capital, and we see plenty of opportunities.

Great, thanks a lot for taking the questions.

And there appear to be no further questions. At this time, I would now like to turn it over to management for any closing remarks.

Thank you, operator. And thank you everyone for joining us on our call today. We look forward to speaking to you next year.

Thank you, this does conclude today's conference. We thank you for your participation. You may disconnect your lines at this time and have a wonderful day.