Earnings Call Transcript - CIM Q3 2023

Operator, Operator

Greetings and welcome to the Chimera Investment Corporation Third Quarter 2023 Earnings Call. At this time, I would like to pass the call to Victor Falvo, Head of Capital Markets. Thank you. You may begin.

Victor Falvo, Head of Capital Markets

Thank you, operator, and thank you, everyone, for participating in Chimera's Third Quarter 2023 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 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 call over to our Chief Executive Officer, Phil Kardis.

Phillip Kardis, CEO

Good morning, and welcome to the Third Quarter 2023 Earnings Call for Chimera Investment Corporation. Joining me on the call are Choudhary Yarlagadda, our President, Chief Operating Officer and Co-CIO; Subra Viswanathan, our Chief Financial Officer; Dan Thakkar, our Co-CIO; and Vic Falvo, our Head of Capital Markets. After my remarks, Subra will review the financial results, and then we'll open the call for questions. I'd like to start by welcoming two new members to the Chimera team. Susan Mills has been elected to our Board of Directors effective November 13. She recently joined Academy Securities, a veteran-owned investment bank. Before that, she spent 36 years at Citibank, where she held various senior management positions and businesses related to North American residential mortgages. She brings a wealth of expertise and experience in the residential mortgage market, and we're very excited to have her as part of the team. Also, Miyun Sung is joining us next week as our Chief Legal Officer. She has over 23 years of legal experience both as external counsel and in-house. She has spent the last seven-plus years as Senior Vice President, Chief Legal Officer and Secretary of Urstadt Biddle Properties Inc., a New York Stock Exchange listed equity REIT. We're excited to have her join the team. During the third quarter, the fixed income market experienced both increased volatility and higher rates. In July, as expected, the Federal Reserve increased its Fed funds target rate by 25 basis points. And while the Fed paused their rate hikes at the September meeting, they did reduce the projected rate cuts in 2024 by half or 50 basis points. The resulting backup on the long end of the yield curve caused the 10-year treasury rate to increase 73 basis points over the course of the quarter to 4.57%. The 10-year yield continued its climb after quarter end and briefly reached 5% in mid-October. These higher interest rates have moderately reduced the value of our portfolio. We saw our GAAP book value per share drop quarter-over-quarter from $7.29 to $6.90, a decrease of 5.4%. Considering the market conditions, we remain cautious and mostly on the sidelines, which left our investment portfolio relatively unchanged during the quarter. We did, however, continue to focus on liquidity and liability management. This quarter, we added three new repo counterparties. And post quarter, we refinanced a high fixed-rate non-mark-to-market facility into a new two-year limited mark-to-market facility. We expect this facility will save us approximately $16 million in interest expense over the next 12 months. What is our outlook? Looking ahead to the fourth quarter and into 2024, we are planning for rates to remain high. While inflation has moderated since last year, it remains much higher than the Fed's 2% target. And although it appears the Fed is nearing the end of its hiking cycle, recent data appears to support another rate hike. The U.S. labor market remains strong. Third quarter GDP increased to nearly 5%, and consumer spending increased more than expected in September. In addition to the Fed funds rate remaining elevated in 2024, we note the relatively quick escalation of long-term rates, driven by several factors, including the strength of the economy and the Fed pushing out rate cuts. Also, the growth of the federal deficit and associated interest cost, coupled with concerns about participation by China and Japan in treasury auctions and the Fed effectively engaging in quantitative tightening, have created supply and demand imbalances, which have helped push long-term rates higher, and we believe for a longer period. In fact, the sustained move in the 10-year treasury yields above 5% cannot be ruled out. Home sales are on pace for the slowest year since the great financial crisis. Elevated home prices, constrained housing inventory and high mortgage rates have created a trifecta of headwinds perpetuating the housing affordability crisis. Apart from the data-driven volatility, there is also a rising risk of government shutdown and an escalation of the war in the Middle East that can further exacerbate volatility in the capital markets. So what's our strategy? We continue to manage our business with the belief that interest rates, both short and long term, will be higher for longer. Our focus remains on strengthening our balance sheet and managing our liabilities. To help reduce various risks associated with recourse financing, we frequently seek longer-dated maturities, obtain non or limited mark-to-market terms, and utilize financial derivatives such as swaptions and futures contracts to soften the impact of rising rates. Through these initiatives during the first nine months of 2023, we have reduced our recourse financing by more than $800 million. We have non or limited mark-to-market financing on 57% of our outstanding recourse financing. We have hedged $1 billion or roughly half of our floating-rate financings with a weighted average swap rate of 3.26%. And we have $1.5 billion in swaptions, which give the company the option to pay a fixed rate of 3.56% for one year beginning in the second quarter of 2024. Even in this higher rate environment, our assets continue to perform well. Our interest income quarter-over-quarter and year-over-year is relatively unchanged. Credit performance on our portfolio has been better than our original investment expectations. We believe our portfolio is unique. Most of our securitizations are backed by approximately $11 billion of re-performing loans with low LTVs and an average seasoning of 17 years, which we expect will continue to perform well over a range of economic conditions. Our securitizations continue to delever. And depending on future interest rates, we will be able to terminate and take out cash when appropriate. In addition to focusing on liability management and liquidity, we intend to optimize our investment portfolio, and we will seek opportunities to acquire assets that will improve our returns and liquidity. Finally, to improve our liquidity and better position ourselves for investment opportunities, we have reduced our dividend to a level consistent with what we expect to earn through the end of next year. We believe that it is prudent in this macroeconomic environment and in the best interest of our shareholders over the long term to reset the dividend. Today's market conditions are challenging, but we remain optimistic about our future. Our portfolio continues its strong performance, both in income generation and credit. Our securitizations continue to deliver with 14 deals callable in 2023, another four become callable in 2024 and another six in 2025. We believe that as our financing costs decrease, we expect our economic performance will significantly improve. We believe we're taking prudent steps which will benefit Chimera's shareholders over the long term. I'll now turn the call over to Subra to review our financial results.

Subramaniam Viswanathan, CFO

Thank you, Phil. I will review Chimera's financial highlights for the third quarter 2023. GAAP book value at the end of the third quarter was $6.90 per share, and our economic return on GAAP book value was negative 2.9% based on the quarterly change in book value and the third quarter dividend per common share. And for the nine months year-to-date, our economic return was zero percent based on the change in book value since year-end and the first three quarters dividends per common share. GAAP net loss for the third quarter was $16.3 million or $0.07 per share. On an earnings available for distribution basis, net income in the third quarter of approximately $29 million or $0.13 per diluted common share. Our economic net interest income for the third quarter was $66 million. For the third quarter, the yield on average interest-earning assets was 5.8%, our average cost of funds was 4.5%, and our interest spread was 1.3%. Total leverage for the third quarter was 4.1:1, while recourse leverage ended the quarter at 1:1. For financing and liquidity, the company had $606 million total cash and unencumbered assets at quarter end. We had $1.5 billion of either non or limited mark-to-market features on our outstanding repo arrangements. We had $1.9 billion floating rate exposure on our outstanding repo liabilities. We had $1 billion pay-fixed interest rate swap at a rate of 3.26% as a hedge position for our liabilities. And we had $1.5 billion swaptions to pay fixed for one year beginning in the second quarter of 2024 at an average rate of 3.56% as a hedge position for liabilities. For the quarter, our economic net interest income return on equity was 10.4%, and our GAAP return on average equity was 0.3%. And lastly, our third quarter 2023 expenses, excluding servicing fees and transaction expenses, were $12.6 million, modestly lower than the second quarter. That concludes our remarks. We will now open the call for questions.

Operator, Operator

Our first questions come from Stephen Laws with Raymond James.

Stephen Laws, Analyst

Phil, I wanted to follow up on some of your prepared remarks regarding your cautious stance and being mostly on the sidelines. Can you discuss your satisfaction with the current liquidity position, which appears quite defensive? What are your thoughts on your willingness to increase stock repurchases or consider other options in your capital structure? Additionally, where do you anticipate returns on new investments if you choose to deploy capital more aggressively?

Phillip Kardis, CEO

Stephen, thanks for the question. Currently, we are satisfied with our liquidity position. However, given that interest rates are expected to remain high for an extended period, it makes sense to strengthen our liquidity. Our immediate priority is ensuring we have sufficient liquidity. We anticipate that investment opportunities will arise in the near future, and we aim to utilize our liquidity for those investments. When considering stock repurchases, whether common or preferred, we will take various factors into account. In the short term, our focus is primarily on liquidity and potential investment opportunities, and I will now hand it over to Dan to discuss where we see some of these opportunities.

Dan Thakkar, Co-CIO

Sure. So this is Dan Thakkar. So in terms of the opportunities, we think the primary capital allocations will be between non-QM, especially in the DSCRs, BPLs and Jumbo Prime to the extent we are able to source that. We're targeting mid-teens returns to those securitizations. I will point out that as far as the securitization economics is concerned, it's pretty stable, especially in the non-QM space with the newly originated high gross WAC loans with coupons around 8.5%. That said, recent deals on the AAAs are pricing in the high 100s versus mid-hundreds in the third quarter. So any more underperformance there will deteriorate the ARB, so we are very cautious there. Obviously, the widening that we have seen on the non-QM AAA has widened in sympathy with the Agency RMBS. So it is kind of stable and compelling at this point, but it can deteriorate really quickly in the macro environment we are in. I hope that answers your question.

Stephen Laws, Analyst

That's helpful color. I appreciate the comments. And just wanted to verify one thing. I think you mentioned $16 million savings in interest expense from the refinance of a higher cost facility. A $0.06 to $0.07 benefit there annually? Is that right? Or is there an offset to that somewhere?

Phillip Kardis, CEO

I think yes. I mean that's the number we expect to save, but as you're probably aware, in the early part of next year, two of our preferreds are going to reset from fixed to float, at least we expect that's what's going to happen based on our current information of the applicability of the federal law to those particular things. And so I think as you think about this, we believe that this refinancing has been very positive for us, but it really is going to be primarily offset by what we expect to happen to our preferred stock.

Operator, Operator

Our next question comes from the line of Trevor Cranston with JMP Securities.

Trevor Cranston, Analyst

Can you talk about what you guys are seeing in the bulk loan market, particularly from the banking sector, and if you're seeing a material increase in supply coming out from banks looking to get ahead of regulatory changes?

Phillip Kardis, CEO

Yes, at the moment, we are not observing significant activity in that area. We need to wait for the term facility to conclude, so it hasn't been a primary focus for us considering the current situation.

Trevor Cranston, Analyst

Okay. Got it. And then on the loan facility that you refinanced moving from the non-mark-to-market to a limited mark-to-market, can you elaborate a little bit on kind of what the change in the terms of that facility are in terms of protection for you guys? And also maybe comment on if you think there are further opportunities to refinance any of your other facilities into a sort of lower-cost alternative at this point.

Phillip Kardis, CEO

Yes. So this was a significant facility for us in terms of our desire to refinance it. It was a longer-term facility that allowed us the ability to refinance after a year. And given where we were able to find financing, it makes sense for us to do that now. I think we're just on some of the particular terms, since it was post quarter end, we'll have some more detail in our next statements that will go through that. But it is a limited mark-to-market with a cap on the rate, and this is where we think the savings will come from since it's significantly below where we were financing. As far as other opportunities, right now, the market has been functioning normally. We're able to roll that really in the next, what I would call, high-cost facility. That refinancing opportunity will be coming in early 2025.

Operator, Operator

Our next questions come from the line of Bose George with KBW.

Bose George, Analyst

What is the incremental return on equity for the new investments you are making? Considering the current returns, how long will it take for those to transition into the new return on equity if interest rates stay stable? Additionally, I am curious about the costs associated with funding the maturities you mentioned, particularly in relation to the returns on this portfolio if interest rates do not change significantly.

Subramaniam Viswanathan, CFO

So the current portfolio includes a return on equity of about 10.4%. This figure does not take into account hedge expenses or other administrative and compensation costs. With the current high interest rate environment, if we acquire assets that yield higher returns than what we presently have, that 10.4% could increase. That's our current situation.

Bose George, Analyst

Okay. In order to achieve a more normalized return on equity, does it depend on rates decreasing or restructuring some liabilities over time? I'm considering how we can reach a double-digit return on equity on a net basis.

Phillip Kardis, CEO

Yes. Sure, this is Phil again. So as I mentioned, we had one really high-cost facility that we were able to refinance, and the next one is not until the first month or so of 2025. So I think really the financing abilities in terms of restructuring high costs, we've done a chunk of that already. The rest of it is going to come from some rate moderation.

Operator, Operator

Next questions come from the line of Eric Hagen with BTIG.

Eric Hagen, Analyst

Sorry if I missed this, but did you guys say what your current book value was through October? And then going back to the liquidity, I mean what's the right way to think about just the incremental liquidity that's being generated like on a monthly or quarterly basis just based on paydowns, just natural kind of CPR?

Phillip Kardis, CEO

This is Phil. On the book value since the end of the quarter, I'm going to turn that over to Dan Thakkar.

Dan Thakkar, Co-CIO

Yes. So I think in the investor deck that we released last night, we had stated roughly down to 3%. But given the strong rally that we had in the rates market post the Fed, we are closer to down being 2% versus 3%.

Phillip Kardis, CEO

And then I think you asked relative to paydowns. Is that correct?

Eric Hagen, Analyst

Right. Yes, just a way to think about liquidity that's being generated sort of incrementally just through kind of natural paydowns.

Phillip Kardis, CEO

So I think right now, the portfolio is running around 6 CPR in terms of kind of where the paydowns are coming. I hope that's helpful to you.

Eric Hagen, Analyst

Okay. And then how are we thinking about the option value you have to call and resecuritize the existing portfolio? And really just kind of how sensitive you see that optionality being to interest rates going forward here?

Phillip Kardis, CEO

Yes, it is sensitive to interest rates. As rates decline, it becomes more economical. It also relies on how the transactions have been paid down, the size of the senior loan, and the size of the transaction when you refinance. You need to consider all those factors. Currently, the longer they stay out, the better it is in this environment. As the CPR increases, it will become more beneficial. We now have this optionality, which we believe is very valuable, but we will be cautious in the near term. However, as rates start to stabilize, we will begin to examine this more closely.

Operator, Operator

Thank you. We have reached the end of our question-and-answer session. I would now like to turn the floor back over to Phil Kardis for any closing comments.

Phillip Kardis, CEO

Thanks, everyone, for participating in our third quarter earnings call, and we look forward to speaking to you in February with our call related to fiscal year 2023.

Operator, Operator

This does conclude today's teleconference. We appreciate your participation. You may disconnect your lines at this time. Enjoy the rest of your day.