The last couple of months have been a crucible for mortgage real estate investment trusts (mREITs). The COVID-19 crisis has caused extreme volatility in the bond markets, and mortgage-backed securities generally abhor volatility. Every mREIT has a different investment strategy, and pretty much every one has reacted in its own way. 

Chimera Investment Corp. (NYSE:CIM) is an mREIT that invests in agency and non-agency mortgages. In other words, some of its portfolio is guaranteed by the U.S. government and some is not. Chimera went into the first quarter with about 24% of its portfolio in residential mortgages guaranteed by the government. It exited the quarter with almost nothing left. It used the proceeds of the sale to pay down short-term borrowings (repurchase agreements). What does this mean for Chimera's investment risk going forward? 

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The last two months have been awful for mREITs

Chimera had a rough first quarter, losing $2.08 per share, compared with a loss of $0.54 per share in the same quarter last year. The balance sheet shrunk dramatically, with assets falling from $27.1 billion to $19.2 billion. Book value fell from $4 billion to $3.2 billion.

During the quarter, huge swaths of the mortgage markets seized up as mortgage-backed securities devalued relative to Treasuries (in trader parlance, as spreads widened). Investment banks that had provided leverage for REITs requested additional collateral against their loans, resulting in margin calls. Every mREIT dealt with this by selling assets and paying down debt. As a result of margin calls, Chimera liquidated its entire portfolio of agency mortgage-backed securities. On the Q1 earnings conference call, chief investment officer Mohit Marria explained the strategy:

In response to the significant drop in interest rates, increased price volatility and repo margin calls, this quarter, we sold our entire portfolio of $5.7 billion residential agency pass-throughs. These pass-throughs were the most liquid and lowest yielding assets in our portfolio and have always been part of our strategy to meet our liquidity needs. We also terminated all our agency hedge positions comprised of U.S. Treasury note futures and $4.1 billion notional balance on interest rate swaps.

Here is what Marria is saying: Chimera sold its residential agency pass-throughs, which means it sold its mortgage backed securities guaranteed by the government because they had the lowest interest rate and the company needed the cash. Chimera also liquidated the hedges for them (the interest-rate swaps) because there was no longer a position to hedge. 

Chimera dumped most of its interest rate risk and kept its credit risk

At the end of March, Chimera's portfolio consisted mainly of $13 billion in loans, which are mainly held as collateral against securitizations. These loans are used to fund the cash flows for the securities Chimera sold to the market. In addition, Chimera still holds $2 billion of non-agency residential mortgage-backed securities (RMBS) and $3 billion of agency commercial mortgage-backed securities. Corporate debt fell from 3.2 times equity to 2.2 times equity. 

What does all this mean for Chimera's risk?  The upshot is that Chimera will be much more sensitive to the overall economy than it was going into the crisis. The biggest difference is that interest rate risk fell and credit risk rose. Agency RMBS are 100% interest rate risk and 0% credit risk. Net interest spreads (the difference between what Chimera earns on its assets and the cost of funding the portfolio) will rise because the agency portfolio had the lowest returns.

The next shoe to drop is a dividend cut

Chimera trades at a 36% discount to its book value of $12.45 per share. It paid its $0.50 dividend in the first quarter, and it is highly likely that the dividend will get cut. Most mREITs have cut their dividends already, and the market is treating the rest as if they will. Chimera trades at a 25% dividend yield, which is a bright red flag that the market sees a cut coming.

Currently almost all non-agency mortgage backed securities and whole loans are trading based on liquidity, not necessarily intrinsic value. In other words, as things calm down in the markets, these assets should appreciate as forced sellers exit the landscape. That said, if the economy stays mired in a downturn for several quarters, Chimera will have to write down some of these assets, especially as borrowers seek forbearance. Chimera is hard to recommend at these levels, especially when agency REITs like AGNC Capital are trading at substantial discounts to book value, and have already cut their dividend.