Don't let it get away!
Keep track of the stocks that matter to you.
Help yourself with the Fool's FREE and easy new watchlist service today.
Chimera Investment Corp. (NYSE: CIM ) counts itself as one of a handful of so-called mortgage real estate investment trusts. Otherwise known as mREITs, these are leveraged investment funds, not unlike hedge funds, that specialize in assets related to real estate. Chimera's business model consists of borrowing money at low short-term interest rates, typically in the repo market, and then using the proceeds to purchase higher-yielding mortgages or mortgage-backed securities. In short, they make money by arbitraging interest rates, and they juice their returns with leverage.
What makes mREITs such attractive investment vehicles is the fact that they distribute the vast majority of their earnings to shareholders. At a time when bond yields are at or near all-time lows, many mREITs are offering very attractive yields. For example, while the benchmark 10-year Treasury is kicking out far less than 2%, the industry's largest players, Annaly Capital Management (NYSE: NLY ) and American Capital Agency (NASDAQ: AGNC ) , are paying out over 13% and 16%, respectively. One key reason for these hefty yields is their special tax treatment. Like a partnership or limited liability corporation, mREITs are entitled to pass through tax treatment so long as they distribute at least 90% of their earnings to shareholders.
Although it may seem ironic given the fact that mREITs invest in assets related to real estate, these vehicles have been absolutely killing it since the financial crisis began. At the height of the housing bubble, Annaly was earning just over $1 per share in net interest income. Today, it's clearing more than $3 per share. And the same can be said about many others in the field.
The explanation for this has less to do with the value of real estate itself, and more to do with the difference between short- and long-term interest rates. In an effort to spur lending over the last three years, the Federal Reserve has dropped short-term rates to near zero. Because long-term rates stayed the same for much of that period, the interest rate spread that mREITs rely on to make money has widened. As you can see in the chart below, for example, between 2008 and 2010, the difference between the 2- and 10-year Treasuries nearly doubled, going from an average of 1.46% in the first quarter of 2008 up to 2.77% in the fourth quarter of 2010 -- though it should be noted that this spread has since contracted.
You'd be excused, then, for wondering why I issued such a dire warning about Chimera at the beginning of this article. The reason is that, unlike Annaly and American Capital, which invest principally in mortgage-backed securities issued by Fannie Mae or Freddie Mac, Chimera invests so-called private label mortgage-backed securities. Even though these are virtually identical in structure -- both are trusts containing mortgages -- their risk profiles couldn't be more dissimilar. Mortgage-backed securities issued by the government-sponsored enterprises are presumed to be backed by the full faith and credit of the United States, ostensibly insuring investors against losses of principal and interest. Private-label securities carry no such protection, exposing the holders to both interest rate risk and credit risk.
It's here where Chimera has run into problems. In the third quarter of 2011, the company notified the SEC that it wouldn't be filing its quarterly financial statement. The reason, according to its official notification of late filing, had to do with how it was accounting for mortgage-backed securities that had deteriorated in value. Although much of this remains speculative at this point, as Chimera hasn't filed a single quarterly or annual update with the SEC for over a year now, it appears that the company was inappropriately accounting for the losses associated with the deterioration of its portfolio.
And to make matters worse, it's been doing so for virtually the entirety of its life as a publicly traded corporation. Over the roughly four-year time period, interest income is expected to decrease from approximately $1.88 billion to $1.46 billion; other-than-temporary impairment losses is expected to more than double from approximately $190 million to $484 million, and net income is expected to decrease by roughly two-thirds, from approximately $1.06 billion to $367 million. The one saving grace is that the changes are purported to be balance-sheet neutral.
There's a lot to pay attention to if you're considering an investment in Chimera. The massive double-digit dividend on Chimera Investment looks very tempting, but there are some very large and bright red flags to be seen when investors start to dig in. Should you follow the dividend's siren song into Chimera's stock, or yield the warnings? To help you figure out whether the stock is a buy right now, The Motley Fool has just released a new premium research report on Chimera. Click here now to claim your copy of this must-have investor's resource.