Should You Trust Chimera's Executives?

There are few stocks in the market that offer the level of opportunity and risk that mortgage REIT Chimera Investment (CIM -0.24%) does. On one hand, it pays an absolutely monster dividend yield of 14% and trades for a nearly 20% discount to book value. But on the other hand, the company has failed to file its 2011 annual report, as well as a slew of quarterly updates.

While this isn't necessarily fatal, it's pretty ominous and adds a significant amount of uncertainty to any valuation of the company. It also means the leadership at Chimera is that much more important: Are they making the right decisions, and as an investor, can you trust them? To help answer those questions, and many others, the Fool has published an in-depth report on Chimera, detailing the strengths and weaknesses of the company as well as the key things you should watch if you're an investor in the stock (or thinking about becoming one). This article is an excerpt from the report, which you can download here.

At its core, an mREIT could be seen as a lightly regulated hedge fund that specializes in real estate. As such, and unlike a Coca-Cola (KO 0.31%) or an ExxonMobile (XOM 0.23%), which can seamlessly transition from one group of executives to the next, much of an mREIT's success and critical access to capital markets depends on the reputation of the executive(s) in charge.

In Chimera's case, it's managed by FIDAC, a wholly owned subsidiary of Annaly Capital Management (NLY 0.59%). For many years, FIDAC and Annaly were run by Michael A.J. Farrell, their founder and chief executive officer whom many considered to be a trailblazer in the mREIT space. But in October of 2012, Farrell died, leaving Wellington Jamie Denahan-Norris, the company's former chief operating officer, in charge.

Putting aside the accounting errors at Chimera, there are four critical red flags that investors should be aware of when it comes to how Chimera and Annaly are run. In the first case, executive bonuses at Annaly are tied to book value and not a more relevant performance metric. This incentivizes them to do one thing above all others: issue new shares.

In the second case, here at The Motley Fool, we like to see executives with significant skin in the game. In Ms. Denahan-Norris's case, she owns $14.6 million of shares in Annaly. While this is nothing to shake a stick at, to be sure, it nevertheless pales in comparison to the $35 million compensation package she received in 2011.

In the third case, at least three of Chimera's top executives, including its CEO and CFO, are close relatives of either executives or board members of Annaly, raising the concern that familial ties may have trumped merit in the hiring process. I shouldn't go without noting the possibility that Chimera's CFO was potentially chosen for the position because she's the sister of Annaly's current CEO, which certainly adds another angle to Chimera's ongoing accounting problems.

And finally, immediately prior to founding Annaly, Farrell was censured and had his securities license suspended by the NASD, the predecessor to FINRA, for failing to "maintain [...] minimum required net capital," filing "incomplete and inaccurate annual audit reports," and failing to "maintain accurate books and records." I point this out, and particularly the latter two charges, only in light of the problems now plaguing Chimera.