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Can Investors Trust Annaly and Chimera?

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If you're an investor in either Annaly Capital Management (NYSE: NLY  ) or Chimera Investments (NYSE: CIM  ) , then alarm bells should be ringing.

At the end of last week, Chimera issued a disturbing press release notifying investors that it had "received a four-month extension for continued listing and trading of the company's stock on the New York Stock Exchange." The extension gives the mREIT until the middle of this upcoming January to restate essentially every annual and quarterly financial statement the company has filed with the SEC.

Although the market shrugged this off, as Chimera is trading only marginally lower since the announcement, I'd be doing investors a disservice if I didn't communicate how serious I believe this is. Despite unconscionable analyst upgrades, Chimera may very well be on its deathbed, and given Annaly's role in the accounting improprieties, I think its integrity is no longer beyond reproach, either.

Why is Annaly involved?
You may be wondering at this point why Annaly has found itself tarnished by the misdeeds of Chimera. The reason is, at least for the purposes at hand, these two companies are one and the same.

In 1994, Annaly's chairman and chief executive officer Michael Farrell founded FIDAC, a registered investment advisory company that specializes in managing residential and commercial mortgage loans and securities. Annaly, which was also founded by Farrell, acquired FIDAC in 2004 and positioned it to lead the company. According to Annaly's official depiction of its corporate hierarchy: "The team that manages Annaly plays the same roles at FIDAC." And to connect the final dot, "FIDAC manages various investment vehicles including ... Chimera."

What did Chimera do?
For investors who have followed this story, it may be tempting to accuse me of mischaracterizing an otherwise innocent accounting irregularity. According to Chimera's press release announcing the necessary adjustments: "The restatement is not expected to affect the company's previously reported GAAP or economic book values, actual cash flows, dividends, [or] taxable income for any previous period." In other words, no harm, no foul.

But once you dig further into the press release, it becomes difficult to accept that Chimera's years of misstatements were caused by a simple misunderstanding of accounting standards. Namely, almost all of the errors worked in Chimera's favor. Interest income was overstated by $411 million, or 28%. Losses related to the impairment of assets was originally stated as $190 million, when the figure is actually closer to $484 million. And "net income ... is expected to decrease by approximately $695 million from approximately $1.06 billion to $367 million." In case that last number didn't sink in, net income for the period will be reduced by a staggering 70%.

These aren't immaterial, rounding errors. They cut to the heart of Chimera's economic and financial viability. Most disturbing is the resulting incongruity between restated earnings and dividends paid. Under the original accounting, for the time periods at issue, Chimera recorded $1.06 billion in net income and paid out $1.13 billion in dividends. Under the revised earnings, while its dividends didn't change, Chimera recorded a mere $367 million in earnings.

What gives?
You may be wondering how Chimera financed the nearly $1 billion difference between net income received and dividends paid. If so, then you're not alone, as I'm wondering the same thing.

In the past, Chimera and Annaly have argued that investors shouldn't rely on GAAP net income, but rather on their own in-house, subjective estimate of so-called "economic net income," which purportedly accounts for fluctuations in the value of their MBS portfolios. While this now probably goes without saying, in light of the shocking magnitude of the announced restatements, neither Annaly nor Chimera should remain entitled to such deference.

Looking at the situation objectively, in turn, it seems likely that Chimera used proceeds from new stock issues to finance these distributions. As you can see in the chart below, during the three years that Chimera paid out $1.13 billion in dividends while realizing only $367 million in net income, its outstanding share count ratcheted up from only a few million to over one billion.

Where there's smoke, there's often fire
In 1994, Annaly's founder, chairman, and chief executive officer, the aforementioned Michael Farrell, was censured and had his securities license suspended by the NASD, the predecessor to FINRA, for failing to "maintain its minimum required net capital," filing "incomplete and inaccurate annual audit reports," and failing to "maintain accurate books and records."

In light of the egregious "errors" committed by Chimera, one can't help but wonder if a pattern has emerged. As a result, I'd urge all investors in both Annaly and Chimera to think long and hard about the continued viability of business models predicated on the facts above.

Fool contributor John Maxfield does not have a financial position in either of the companies mentioned above. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Read/Post Comments (10) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 20, 2012, at 3:10 PM, techy46 wrote:

    Interesting article except for one fact. mREITs generate cash to payout dividends by leveraging the spread between short and long term interest rates which is not really accounted for under GAAP. The leverage is created by issuing more stock when the purchase of MBS assets is favorable. It seems like CIM needs to reclassify some interest and impairment items to balance their GAAP books which may not impact quality of assets or diviidend distributions. Nice piece of FUD.

  • Report this Comment On September 20, 2012, at 3:18 PM, StopPrintinMoney wrote:

    what's FUD ?

  • Report this Comment On September 20, 2012, at 3:28 PM, JohnMaxfield37 wrote:

    techy46 -

    No offense, but the net interest income is exactly what's accounted for in GAAP earnings.

    On this note, if you're interested in seeing how the QE3-induced contraction of the interest rate spread will impact mREITs, and Annaly in particular, read the following article.


  • Report this Comment On September 20, 2012, at 3:33 PM, JohnMaxfield37 wrote:

    techy46 -

    Here's a link to the last 10-Q Chimera filed.

    You'll find its income statement on page 2, at the top of which you'll find its accounting for interest income and expenses.


  • Report this Comment On September 21, 2012, at 4:50 AM, ahrahr wrote:

    Substantially all of the mortgage-backed securities that NLY has acquired have been Agency mortgage-backed securities which, although not rated, carry an implied “AAA” rating.


    CIM is a different beast. This is why NLY and CIM are two different companies - although management is the same.

    Wrt CIM: The RMBS, ABS, CMBS, and collateralized debt obligations, or CDOs, we purchase may include investment grade

    and non-investment grade classes, including the BB-rated, B-rated and non-rated classes.


    With securities meltdown, some CIM investments no longer have a price. If they don't have a price, how do you value them on the balance sheet?

    That's why the prudent investor should avoid CIM.

    In my opinion, it is a mistake to put NLY and CIM in the same basket, even if they share the same managers.

  • Report this Comment On September 21, 2012, at 6:26 PM, jonkai wrote:


    Chimera may very well be on its deathbed,


    and Chimera may be ready to cr*p rainbows... did you really think analyst were unconscionable for a mere upgrading.

    but you are beyond reproach for saying a company was on it's deathbed? that is like saying for all i know you are writing from a deathbed????

    why would that be less credible???


    and given Annaly's role in the accounting improprieties, I think its integrity is no longer beyond reproach


    then you are "challenged" in the special way... because the accountants were responsible, and they got fired.... now there are other "accountants" doing it again... and if they make sugar plumbs come out of chimera ears are you going to blame that on Annaly management too?

    seriously, get a grip.....

    Annaly is not managing Chimera, Annaly owns a management company, and that company manages not only Chimera, but other entities too...

    and i think you should put a short on Chimera, so you get a feel for the company, you'll probably write better stories on something you have a stake in.

  • Report this Comment On September 21, 2012, at 6:44 PM, jonkai wrote:


    Michael Farrell, was censured and had his securities license suspended by the NASD


    he was censured for having been in a capacity of CEO without the proper paperwork.... now, quick since you think this is a big deal, tell us which paper work you need to be the CEO proper.....

    hello? any bells go off there?

    and fined for not having the correct amount of capital in an account, which was because they were advised how much capital to have.... which was the wrong number, they simply settled with a slap on the wrist,

    He did not benefit financially, nor were any clients harmed in anyway from such apparently egregious acts in your mind...

    that is what you have decided to make a big deal of... good luck with that... and I really hope you were short because you sure sounds like someone who is getting burned badly to think that was some sort of big deal over what the real financials are telling us...

    and the investors do have an insider in on what Chimera is doing... it is called Mr. Market... which in these cases is rarely wrong... ask Mr. Market wether Chimera is in big trouble or not.... and you will know some juicy insider info...

  • Report this Comment On September 21, 2012, at 6:48 PM, jonkai wrote:

    oh and I forgot to mention, the accounting firm that was responsible for the wrong number, they later entered into a settlement with M. Farrell and the rest to reimburse them for the fine.

    so... again... what was it you were making a big deal of?

  • Report this Comment On September 22, 2012, at 1:38 AM, JohnMaxfield37 wrote:

    jonkai -

    I think it's important to grasp the significance of the problem here. By NLY and CIM's own admission, CIM made only $367 million while distributing over $1.1 billion in dividends. That's a serious discrepency that needs to be explained the shareholders.

    In addition, according to FINRA, Farrell was censured for doing more than being the titular head of an innocently undercapitalized company without the proper paperwork.

    Here are the other, and more substantitive, allegations from FINRA:

    (1) "filed inaccurate focus . . . reports,"

    (2) "filed an incomplete and inaccurate annual audit report with the NASD," and

    (3) "failed to maintain accurate books and records."

    Also, the consequences were more than just a "slap on the wrist" as you intimated. Farrell and another were fined $150,000 jointly and severely and their licenses were suspended. Those are serious sanctions from a self-regulatory body.

    Look, at the end of the day, I hope I'm wrong. But the facts make it difficult to draw an alternative conclusion.


  • Report this Comment On March 21, 2013, at 6:59 PM, jonkai3 wrote:

    as usual the rich get richer while these writers get poorer....

    If John had turned out any more wrong about NLY and CIM than what he did predict, he would have to turn around backwards to straighten his tie.

    as usual following John's advice will have lost you serious amounts of money, while huge investors made big bets on chimera and won big....

    follow Mr. market, she is much better at figuring out these stocks than these writers... obviously...

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