The possibility that Annaly Capital Management (NYSE:NLY) could buy Chimera Investment (NYSE:CIM), a mortgage REIT operating under the Annaly umbrella, became very real earlier this week. On Monday, Annaly submitted an offer to buy Crexus Investment (UNKNOWN:CXS.DL.DL), a REIT that also operates under the Annaly umbrella and specializes in commercial real estate.
Given this, it isn't a huge stretch of the imagination to think that Chimera could also come within Annaly's acquisitive gaze. As my colleague Matt Koppenheffer noted earlier in the week, there's reason to believe we're at the beginning of a consolidation wave in the mortgage REIT space.
Now, the question of whether Annaly should buy Chimera is another issue altogether. And I believe the answer to this is an emphatic "no."
The case against Chimera
Even though Crexus and Chimera both operate under Annaly's umbrella, these are two very different companies. Crexus is almost completely unleveraged with $968 million in assets and $54 million in liabilities -- and roughly half of the latter aren't debt per se but rather dividends payable. As a result, the assumption of Crexus' assets and liabilities by Annaly should be immediately accretive to the latter's bottom line.
Chimera, on the other hand, is more traditionally leveraged. The last time it filed a financial statement -- which, it should be noted, was more than a year ago -- the company reported $9.7 billion in assets and $6.4 billion in liabilities. And given this blackout period, there's a legitimate question as to Chimera's creditworthiness and, thus, cost of funds. There's no guarantee, in other words, that the consolidation of Chimera's balance sheet will be similarly accretive.
In addition, Chimera doesn't have as much to offer in terms of profitability. Beyond the unresolved cost of funds issue, the last time Chimera reported earnings -- which, again, was over a year ago -- its yield on average earning assets, one of the key metrics for mortgage REITs, came in at 7.21%. While this was unquestionably better than Annaly's comparable yield of 3.71% at the time, it comes up far short of Crexus' current 10.29% yield.
The acquisition of Chimera would also expose Annaly's investors to an unknown quantity of credit risk. One of Annaly's key tenets has always been that its portfolio of agency mortgage-backed securities -- that is, securities issued by Fannie Mae and Freddie Mac, and thus presumptively guaranteed by the federal government -- shields its shareholders from credit risk, the proverbial boogeyman of leveraged funds and ardently avoided by other mortgage REITs like American Capital Agency (NASDAQ:AGNC) and ARMOUR Residential (NYSE:ARR).
Alternatively, Chimera holds a significant portion of noninsured, private-label mortgage-backed securities -- or $4.4 billion the last time it published a balance sheet. And again, because we don't know the condition of Chimera's portfolio given its failure to publish financial statements for the past 15 months, it seems unwise for investors to condone such a move without knowing the attendant credit risk.
There's also a huge icky factor when it comes to Chimera. As I've noted multiple times, because of a purported accounting error, the company has failed to file financial statements for over a year now. And to make matters worse, it's restating virtually every financial statement it's filed since going public. The impacts of this, although allegedly balance-sheet-neutral, are sweeping. To give only one example, Chimera's restated net income for roughly 2008 to 2011 will fall by more than 60%. And it shouldn't go without mention that the error happened under the watch of Chimera's CFO, who, perhaps not coincidentally, is the sister of Annaly's CEO and may have her to thank for the position.
The Foolish bottom line
If I haven't made it clear enough, let me come right out and say it: If you're a shareholder in Annaly, and you catch wind that it's thinking about acquiring Chimera, I'd strongly urge you to reconsider whether you want to stay on board.