Earnings Call Transcript - CIM Q3 2020

Operator, Operator

Thank you for joining us. Welcome to the Chimera Investment Corporation Third Quarter 2020 Earnings Conference Call and Webcast. I will now hand it over to Emily Mohr from Investor Relations. Please proceed.

Emily Mohr, Investor Relations

Thank you, Laurie. And thank you, everyone, for participating in Chimera's third 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 Factors section and our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. I 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.

Matt Lambiase, CEO

Good morning and welcome to the third quarter 2020 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 COO; and Vic Falvo, the Head of our Capital Market. I'll make some brief comments, then Mohit will discuss the changes in the portfolio, and Rob will review our financial results. Afterward, we'll open up the call for questions. Chimera continues to work remotely, and I'm happy to report that the team is safe and our remote work environments have been successful. Over the past 6 months, we've taken many steps to strengthen our balance sheet, protect our desirable credit assets and stabilize the earnings stream of our portfolio. These steps included selling agency mortgage-backed securities, selectively selling agency CMBS, negotiating new non-mark-to-market financing arrangements and lowering the company's overall recourse leverage. The actions taken over the period enabled us to participate in the market recovery of asset prices from the depressed levels that we experienced in March. For the quarter, Chimera's book value appreciated 12% to $11.91 per share. We generated $0.33 of core earnings, and we paid $0.30 in common dividend, resulting in nearly 15% economic return for the period. The rebound in residential mortgage prices this quarter can be attributed to a very strong housing market, which has been boosted by a generational lull in U.S. interest rates. The COVID-19 pandemic has had a dramatic effect on housing in the United States. The market for single-family homes is thriving as many families are fleeing cities for more spacious quarters in suburban and rural areas of the country. Families across America are seeking additional living space for home offices, home classrooms and safe outdoor environments. Accordingly, according to the Stanford Institute for Economic Policy Research, 42% of the U.S. labor force is currently working full time from home. Demand for single-family homes is booming. The rate of existing home sales rose in September to 6.5 million homes, the highest level since 2006. The available inventory of existing home sales has decreased nearly 20% from the previous year to 1.5 million homes. At the current pace of home sales, all-in inventory currently on the market could be sold in less than 3 months. Much of this housing demand is driven by record-low borrowing rates orchestrated by the Federal Reserve. Since March, the Federal Reserve has increased its balance sheet by 75% to over $7 trillion, helping to provide low interest rates and ample liquidity to the mortgage market. The average rate for 30-year mortgages was recently reported at 2.8%, the lowest rate on record dating back to 1971. Additionally, fiscal stimulus from the federal government for COVID-19 relief has added over $3 trillion into the economy and has helped many mortgage borrowers through this difficult economic period. Both political parties in Washington are currently discussing additional fiscal stimulus packages that, if enacted, we believe will continue to support troubled borrowers and be constructive for both the housing and the mortgage market. A robust housing market, paired with low mortgage rates and government support, provides a very strong pace for owning residential mortgage credit. As of quarter end, nearly 90% of Chimera's investment portfolio was allocated to mortgage credit. The mortgage securitization market has also returned to near pre-pandemic levels, and in some cases better, as a result of lower interest rates and comparable advance rates. This quarter, Chimera completed 3 securitizations while committing to purchase $640 million of mortgage loans. Due to the improving housing fundamentals and better credit conditions, investor demand for highly rated senior mortgage securities is very strong. Chimera is a frequent issuer of these securities, which enables us to secure long-term, non-mark-to-market financing for our credit portfolio assets. Our investment team continues to find opportunities and is successful in adding to our portfolio for future securitizations. The housing market is one of the few bright spots in the U.S. economy, and higher housing prices can contribute to better mortgage credit fundamentals. In a world of low investment returns, having a high-yielding portfolio with a favorable credit profile is an enviable position to be in. We believe that Chimera's portfolio is well-positioned to take advantage of these positive trends and to continue to produce strong dividend income for our shareholders in the quarters ahead. And I'll now turn the call over to Mohit to discuss the portfolio.

Mohit Marria, CIO

Thank you, Matt. The 10-year treasury ended the quarter with a yield of 68 basis points, down from 1.92% at the start of 2020. The overall magnitude of this rate movement has generated price appreciation in 10-year treasury notes of approximately 10 points since the beginning of the year. Our agency CMBS investments over the last 5 years have primarily been Ginnie Mae project loans. These securities carry government guarantees, and due to explicit prepayment lockout and penalties, the Ginnie Mae permanent loan certificates are longer-duration assets. The price performance of these assets has greatly benefited as treasury rates have fallen. During the third quarter, we acted on the strong price performance and selectively sold $659 million in securities from our agency CMBS portfolio. With the sale, we harvested approximately $65 million in gain and plan to reallocate capital into mortgage credit. The objective of the reallocation is long-term optimization of the portfolio income for the benefit of our shareholders. We continue to monitor our agency CMBS holdings relative to their market values and their explicit call protection to maintain a right-sized and optimal portfolio of our agency CMBS. Our remaining agency CMBS holdings at quarter end were $1.8 billion, comprising 10% of Chimera's total investment portfolio. The new issue market for securitized products remained strong in the third quarter, and spreads on certain parts of the capital structure have approached pre-COVID-19 levels. Tighter spreads and low absolute interest rates create compelling opportunities for frequent and well-recognized issuers like Chimera to meet investor demand for securities. For the third quarter, Chimera closed 3 securitized transactions totaling a little over $1 billion. The senior notes from all 3 deals carried investment-grade ratings. In July, we issued CIM 2020-R5 with $338 million in loans from our existing loan warehouse. The underlying loans in the deal had a weighted average coupon of 4.98% and a weighted average loan age of 149 months. The average loan size in the R5 transaction was $152,000 and had an average LTV of 70%. The average FICO score for the borrowers was 678. We sold $257 million in senior securities from this deal and retained $81 million in subordinated notes and interest-only securities. Our cost of investment-grade debt for CIM 2020-R5 was 2.05% with a 76% advance rate. Separately, in 2 transactions, we securitized pools of prime jumbo mortgage loans and a pool of agency-eligible investor mortgage loans. CIM 2020-J1 was our first prime jumbo securitization for 2020. The deal had $362 million in loans with a weighted average coupon of 3.76% and a weighted average loan age of 6 months. The average loan size was $732,000 and had an average FICO of 766 and an average LTV of 67%. CIM 2020-INV1 was our first agency-eligible investor loan securitization for 2020. This deal size was $335 million with a weighted average coupon of 4.31%. It had an average loan size of $332,000. The loans had an average FICO of 765 with an average LTV of 64%. The J1 and the INV1 securitizations are not consolidated on our balance sheet. We invested $22 million in these transactions for our non-agency RMBS portfolio. During the third quarter, we committed to purchasing over $400 million of seasoned reperforming loans. Post-quarter end, we securitized these loans into CIM 2020-R6. Strong investor demand for senior notes enabled us to move quickly from purchase to securitization. The deal priced on October 30 and is expected to close in early November. We will report the details of this transaction on our fourth quarter 2020 earnings call. We continue to invest in residential business purpose loans. These loans, commonly referred to as fix and flip, provide attractive, high-yielding, short-duration assets for our portfolio. The market for these loans continues to expand and is well supported by a positive housing market and repeat business purpose borrowers. For the year, we successfully purchased approximately $135 million in business purpose loans and ended the quarter with approximately $210 million on the balance sheet. The average coupon on this portfolio was 8.57% with a weighted average LTV of 80%. Our investment portfolio is well positioned as we approach year-end. The market trends in single-family housing are positive, and the securitization market is strong. At quarter end, we had $412 million in loans on our mortgage warehouse for potential future securitizations and have ample liquidity to opportunistically acquire new pools of loans. On the liabilities side of our balance sheet, we have taken steps this year to lower the impact of mark-to-market risk on our secured financing. Recourse leverage is materially lower on the year and currently stands at 1.3x capital. We have ample liquidity to make new investments. As part of our call optimization strategy, we actively monitor our outstanding securitizations to optimize our long-term debt structures. As of September 30, Chimera has $5.8 billion of outstanding securitized debt in 16 separate deals that are either currently callable or will be callable through the end of 2021. I will now turn the call over to Rob to review the financial results.

Robert Colligan, CFO

Thanks, Mohit, and good morning. I'll review Chimera's financial highlights for the third quarter. GAAP book value at the end of the third quarter was $11.91. GAAP net income for the third quarter was $349 million or $1.32 per share. On a core basis, net income for the third quarter was $80 million or $0.33 per share. Economic net interest income for the third quarter was $125 million. For the third quarter, the yield on average interest-earning assets was 6%. Our average cost of funds was 3.5%, and our net interest spread was 2.5%. Total leverage for the third quarter was 3.7:1, while recourse leverage ended the quarter at 1.3:1. Expenses for the third quarter, excluding servicing fees and transaction expenses, were $17 million, in line with last quarter. We continue to closely monitor liquidity and have approximately $1 billion in cash and unencumbered assets as we look for new investments and financing options to support our portfolio and to optimize investment returns. That concludes our remarks, and we'll now open the call for questions.

Operator, Operator

Our first question comes from Doug Harter of Crédit Suisse.

Douglas Harter, Analyst

Just to start off with an easy one, if you can just tell us what the outcome of the election will be. Back to Chimera, can you just talk about the returns, how they look on jumbo versus investment property versus reperforming, and kind of the amount of capital you can deploy, per dollar of loan that you buy into each of those?

Mohit Marria, CIO

Sure. This is Mohit. I'll start by discussing the greatest opportunity, which continues to be in the seasoned reperforming sector. We have completed five securitizations this year and believe there is still a significant supply from the GSEs, particularly due to the forbearances and deferments affecting the GSE portfolio. We anticipate more supply that will create substantial opportunities. The securitization market remains robust, allowing for term financing that can cover up to 80% of your capital stack, yielding mid-high 1s for rated securitizations and mid-2s for nonrated ones. The backend equity returns can be in the high single digits on a cash basis, and with minimal leverage, these can increase to 12% to 15%. On the jumbo side, originations are picking up again after a slowdown in the second quarter due to the post-COVID climate impacting them. Although returns are less attractive compared to seasoned reperforming loans, we want to engage in new issue origination as we find it appealing. The expected returns will be in the mid-single digits, but more leverage options are available. In terms of agency-eligible investor loans and those not necessarily delivered to the GSEs, we believe there is a larger opportunity forthcoming to acquire loans in the next few months, with returns expected to be similar to the seasoned reperforming sector. We are quite optimistic and have already closed one of each type of securitization in Q3.

Douglas Harter, Analyst

And then can you just talk about how is kind of the depth of the financing for the subordinate bonds today and kind of your comfort in your liquidity position in case we hit another kind of pocket of volatility around those financing levels?

Mohit Marria, CIO

Sure. I mean even pre-COVID, the depth of that market wasn't great and our counterparty selection was limited. We wanted to make sure the people that were financing those assets for us were involved both on the underwriting side and on the cash trading side, making sure there are no market disruptions in prices as we experienced in Q1. So I think that's first and foremost. Secondly, the tenor of those financings was never on a month-to-month basis. The shortest financing we had on our credit assets was around 3 months. In some cases, we had financings, as you recall, as long as 3 years. With what transpired in Q1, we're sort of mitigating any or as much as possible the mark-to-market risk on those assets. We've locked up a lot of non-mark-to-market or mark-to-market holiday financing for those credit-sensitive assets. Of the last few securitizations we've done, we're actually holding the equity pieces for cash and not putting them on recourse borrowings at the moment, just with some of the uncertainty around COVID and the elections.

Operator, Operator

Your next question comes from the line of Bose George of KBW.

Bose George, Analyst

Actually, just in terms of the level of cash and liquidity, what's a reasonable level for that as you get comfortable with deploying more capital?

Mohit Marria, CIO

This is Mohit again. Given the uncertainties regarding election outcomes and COVID, we feel confident about our liquidity situation in terms of cash and unencumbered assets. We are optimistic that the increased volatility as we approach year-end may present investment opportunities for asset acquisitions. With a good balance of liquidity, we are positioned to add assets. As I mentioned in my prepared remarks, we recently acquired some loans that we quickly securitized. Therefore, I believe our overall cash needs will be lessened due to the strength of the securitization market for us.

Bose George, Analyst

Okay. That makes sense. And then last quarter, you noted that if asset prices recover, you could see book value maybe getting back into the $13 to $14 range. Is that still kind of a reasonable expectation? Just updated thoughts here.

Mohit Marria, CIO

Yes. I mean as reflected in the book value performance for Q3, we're still mindful that we think there's plenty of upside in the portfolio. We were fortunate enough to retain all the credit assets that we've taken the last decade to build out. We think there's a liquidity issue, not a credit issue, as reflected in the overall performance of our credit assets. More generically in the market, the concerns around forbearance and deferments have come down quite significantly from the highs in May to where we stand today.

Operator, Operator

Your next question comes from the line of Kenneth Lee of RBC Capital Markets.

Kenneth Lee, Analyst

Just wondering if you could share your thoughts on whether you still see potential to further extend financing maturities.

Mohit Marria, CIO

Yes, I believe it's important to separate the funding from the agency side and the credit side. Our agency fundings remain short, and the curve is relatively flat between 1 month and 1 year. However, if we aim to optimize the portfolio in that area, we would lose a lot of optionality, so we prefer to maintain a short position for flexibility. As I mentioned, we have sold some of our agency CMBS positions and realized some gains, which we plan to redeploy into credit-sensitive assets. On the credit side, we prefer longer financing. As Matt noted, we've entered into some long-term agreements, with terms extending up to 5 years in certain cases. If that option remains available, we will continue to utilize it, especially to align with the deals that we conduct and leverage.

Kenneth Lee, Analyst

Got you. And then in terms of just a quick follow-up, wondering if you could just share with us how you think funding costs could trend over that near term there.

Mohit Marria, CIO

So like the asset side of the equation where spreads have come in quite meaningfully since the wides in March, financing costs are also coming in. I think on the agency side again, they're pretty sticky. The Fed has illustrated what they're going to do, and those costs are around 20 to 25 basis points between 1 month to 12 months. On the credit side, depending on the credit profile, those spreads have come in and I think will continue to come in as the overall use of financing has decreased from the street. I think there's a balance sheet to be had there. But I would think that as we head into Q4 and Q1, financing costs there should come in as well.

Operator, Operator

Your next question comes from Stephen Laws of Raymond James.

Stephen Laws, Analyst

Just a follow-up on Bose's question. Can you provide some details about where the asset marks and liability marks stand today compared to year-end?

Robert Colligan, CFO

Yes. Sure, Stephen. I think if you take a look at the press release, maybe one way to view it is that this quarter was really good in terms of recovery of book value. But on a year-to-date basis, we haven't completely retraced our marks. If you take a look at our earnings statements through the 9 months, we're still down about $172 million. The asset mix has changed a little bit, but that's a material amount that can still come back and add to book value, getting closer to the book value numbers that Mo was mentioning earlier today.

Stephen Laws, Analyst

Great. I appreciate the color there and quantifying that. When we look at the shift in agency assets, declined sequentially, but corresponding with a pretty sizable increase in asset yield. Can you talk about what you're seeing there and kind of when did that portfolio shift change? How does that impact the weighted average leverage for the quarter versus what quarter end was as we think about the go-forward earnings power of the quarter-end balance sheet?

Mohit Marria, CIO

This is Mohit. So as far as the agency CMBS portfolio, we've spent the better part of the last 6 years acquiring those assets. While I wouldn't say we're in a vastly different rate environment, we did have some lower-yielding assets that were also effectively termed phantom. We locked in some net interest margin relative to the hedges we had put in place. So those asset sales completed in Q3 led to a higher base case yield on what we retained. I think that's the change there. It's not necessarily the addition of new assets; it's just selling the lower-yielding assets to optimize that portfolio. I think we will continue to monitor where those assets trade relative to all protection that's embedded in these securities. As you know, we have no hedges on, so it's also a good way for us to manage the duration of that portfolio given that it is a longer-duration asset outright. If rates remain here and the price action is strong with demand from both the investor base as well as the Fed, then we would continue to take advantages of that. As for the overall leverage and how to think about that, obviously we've decreased leverage throughout the year, at about 1.3x at the end of Q3. I think we're probably going to remain around these levels probably through year-end. As we're a year removed from COVID and the elections in the rearview mirror, we will see if we want to adjust that back upwards and have more earning assets on the books. But relative to our dividend and core earnings, we're out-earning that currently, so we don't see a current need to sort of spend the cash.

Operator, Operator

Your next question comes from Trevor Cranston of JMP Securities.

Trevor Cranston, Analyst

When you were talking about the opportunity set for credit investments, I guess one asset class you didn't mention was non-QM loans. So I was wondering if you could maybe comment on what you're seeing in terms of supply of newly originated non-QM and if that is an asset class that you guys are looking at adding into the portfolio.

Mohit Marria, CIO

Sure. Yes, that's an asset class we spent a lot of time looking at over the last 18 months. Thankfully, we've missed some of the hiccups they experienced in that class in Q1 and Q2. As a result of those hiccups, origination volumes have gone down quite significantly with many originators effectively turning off their positions due to the lack of available financing and warehouse lines. As that reverted, a lot of warehouse lines have been cleaned up. Originations are picking back up as our warehouse line availability for those products. We will evaluate those relative to the other loans that we're focused on, primarily being seasoned reperforming, agency-eligible investor loans, and see how the returns on the equity pieces compare relative to the non-QM space. We've had a lot of in-depth discussions over 18 months with different originators and potential partners to source that collateral. But, as I said, it's in relation to other opportunities available to us.

Trevor Cranston, Analyst

Okay. Great. And then, obviously, you guys had a strong book value number in Q3. Can you comment on what you've seen in terms of credit spreads so far in the fourth quarter and how that's impacted book value quarter-to-date?

Mohit Marria, CIO

Sure. I would say credit spreads are unchanged since September 30 through November 1 here. I think the uncertainty around the election has kept spreads in check. As we get more clarity in the coming days and weeks on that, I think spreads will grind tighter. We feel that the credit space hasn't had the same sponsorship as all the other spread products from the Fed. So I think it still offers, on a relative basis, higher returns. That should continue to grind spreads in tighter in the near term, which is beneficial for our assets and book value.

Operator, Operator

Your next question comes from the line of Lee Cooperman of Omega Family Office.

Leon Cooperman, Analyst

Just really 3 questions. What is the fully diluted share count now, assuming any dilutive securities below $10, let's say? Because you did a lot of financing at a difficult time, but what is the fully diluted share count that we should be looking at? That's question number one.

Robert Colligan, CFO

Sure. The fully diluted is 265 million.

Leon Cooperman, Analyst

I didn't hear you. 265 million or 365 million?

Robert Colligan, CFO

265 million.

Leon Cooperman, Analyst

Got you. Okay. The 1.3 in recourse leverage, I think you addressed it a moment ago, but that's the level you're comfortable at, and you might take it up sometime next year depending upon circumstances? Or do you want to keep it at that level?

Mohit Marria, CIO

No, I think we're comfortable with that heading into year-end. To the extent everything sort of stabilizes, we look to take it up in 2021.

Leon Cooperman, Analyst

How do you view the $1 billion of cash? How much is your minimum cash you need to run the business? And how much additional cash do you have that you can invest where we could assume some kind of spread? What I'm trying to figure out is whether your current earnings are below normalized earnings because you have unemployed cash.

Matt Lambiase, CEO

As a leveraged company, we aim to keep our cash holdings low. Our focus is on underleveraged assets on the balance sheet. Currently, we have sufficient liquidity. As mentioned, there's an election happening today that may extend for a few more days or possibly longer, adding some uncertainty. We're being cautious as we approach year-end. Based on our experiences this year, it's wise for the company to conserve some cash and maintain lower leverage at this time. Once the situation stabilizes, we can increase our leverage. For the next couple of months, it’s prudent for us to adopt a more conservative approach.

Leon Cooperman, Analyst

I agree. It makes sense. You mentioned the election results coming up in the next few days. Do we have a personal bias regarding our business? Do we care about the outcome? It seems to me that the most significant takeaway from the election results so far is the rejection of the left.

Matt Lambiase, CEO

Yes. I think the best thing that happened is that the housing market is performing very well, which is beneficial for our portfolio and its credit. I believe this positive trend will continue regardless of the election outcomes. It seems likely that the Senate will remain closely divided, possibly leaning Republican, and I think having a divided government could be favorable for various markets.

Leon Cooperman, Analyst

My own two cents is I'd be very careful. I mean somebody is going to wake up one day and say, who pays for the party when the party is over? It took 244 years to go from no national debt to $21 trillion, and that's going up 15% to 20% a year. It's not sustainable. Somebody has to wake up, so I'd be careful. But good luck, guys.

Operator, Operator

At this time, there are no further questions. I will now return the call to Matt Lambiase for any additional or closing comments.

Matt Lambiase, CEO

Well, thank you for participating in the third quarter 2020 earnings call for Chimera Investment Corp., and we look forward to speaking to you early next year.

Operator, Operator

Thank you for participating in today's conference call. You may now disconnect your lines, and have a wonderful day.