The mortgage real estate investment trust (REIT) sector has had a wild ride over the past three months. Virtually every stock in the sector reported a reduction in book value and has been forced to cut its dividend.
The companies in the sector have reacted to this dislocation in different ways. Some sold off the riskiest assets, while others sold off the safest.
How did Chimera (CIM +1.07%) approach the issue?
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Repo lines and margin calls
The COVID-19 crisis tightened the credit markets, causing banks to become more conservative and, as a result, forced some REITs to respond in. a way that negatively affected their holdings. A little operational background can help explain what happened.
In normal times, most of the mortgage REITs used repurchase agreements (or repos) to leverage their balance sheets. A repurchase agreement works like this: The mortgage REIT takes a portfolio of mortgage-backed securities and sells it to a bank at a discount. The REIT then agrees to buy back the securities at a later date at a higher price. The difference in prices amounts to the implied interest rate. The loan is secured, which means the bank is protected if the REIT fails to pay because it has the securities.
During late March and early April, the price of mortgage-backed securities fell and the banks worried that collateral was worth less than the loan amount. The banks required the REITs to put up more cash as collateral (a margin call). Many didn't have the money, so they were forced to sell assets in the market instead.
Chimera unloads the agency portfolio
Chimera sold its portfolio of agency mortgage-backed securities, which are guaranteed by the U.S. government. These securities performed the best in the market dislocation, so it made sense to sell them as they would fetch a better price. In fact, on the earnings call, CEO Matthew Lambiase said that the agency portfolio always served a dual purpose: to earn returns, but also to function as a secondary source of liquidity. Chimera risk exposure now is much more based on credit and the overall economy than it is on interest rate volatility.
A dividend cut and a new credit facility
The company recently announced its second-quarter dividend. As expected, it was cut from $0.50 to $0.30 per share, which is a 40% decrease. The REITs have all slashed their dividends. Some (like MFA Financial) have suspended them.
At the same time, Chimera announced a $400 million debt facility by Ares Capital (ARCC +0.45%). As Lambiase put it: "This commitment led by Ares further enhances our strong liquidity position and diversifies our financing sources away from traditional bank repo markets and gives us the ability to seek new investment opportunities."
For its part, Ares Capital gave a vote of confidence to Chimera. Ares partner Kevin Alexander said: "We believe Chimera is well-positioned in its industry and we are pleased to support the company in its next phase of growth."
This is a three-year secured commitment, which means that Chimera will be less exposed to repo line rollover, where the banks choose not to renew loans. It isn't necessarily cheap money -- Chimera is paying 7%, plus some equity warrants -- but it will help the company diversify its funding sources.
The stock is cheap, but there are other options
Chimera is currently trading at a 17% discount to book value, and its dividend yield now sits at 11.6%. This is similar to where the other mortgage REITs are trading. Given the credit risk, I would prefer that it trade at a bigger discount and yield compared to the agency REITs like AGNC Investment or Annaly Capital. Those stocks have less volatility and credit risk.
That said, Chimera's book value is probably increasing as asset prices recover, so its discount is probably higher. If we are out of the woods economically, the whole sector is pretty attractive, except for the few that are still in forbearance negotiations with their creditors.
