At the end of last week, Chimera Investment Company (CIM +1.93%) finally broke its silence. For over a year, the high-yielding mortgage REIT had kept investors largely in the dark about its financial condition and performance, releasing only cursory updates about its GAAP and economic book values in lieu of its quarterly and annual financial filings. The reticence had gotten so bad that on three occasions, it had to request permission from the NYSE to allow its stock to continue trading on the exchange.
The issue, as we learned last August, was that Chimera had incorrectly accounted for the deterioration in its non-agency residential mortgage-backed securities portfolio, which makes up roughly 75% of the company's holdings. By doing so since its inception in 2007, it had overstated its net income by a factor of nearly three. But critically, the impact on its balance sheet and thus book value was neutral.
For a time, this led analysts, including me, to question the integrity of Chimera's executive team. Fueling my concerns was the fact that both its chief executive officer and chief financial officer are related, respectively, to a director and executive at Annaly Capital Management (NLY +2.36%), Chimera's manager. The implication being that nepotism as opposed to merit was behind both their positions and seven-figure salaries.
But after combing through Chimera's 2011 10-K, which was filed belatedly last Friday, I've concluded that the issue appears rather to be one of competence and not integrity. And specifically, competence about the manner in which credit-impaired non-agency MBSes should be treated for accounting purposes. Bear with me for a bit, and you'll see what I mean.
Painting with a very broad brush, there are two sets of rules that a financial company like Chimera uses to account for MBSes. The first set governs agency MBSes -- that is, MBSes that are either issued or otherwise backed by Fannie Mae and Freddie Mac. On the balance sheet, if these are characterized as available for sale, as they are on most REIT balance sheets, then they are held at fair value. Any deterioration in value, which is bound to be minimal assuming the security wasn't egregiously overpaid for, is typically recorded as other comprehensive income (loss), or "OCI." And on the income statement, the amount of interest recorded over the life of the security is equal to the contractual cash flows of the security and the accretion/amortization of any purchase discount or premium.
The operative word in the rule governing interest income on agency MBSes is "contractual." Because the interest payments on agency MBSes are implied to be insured by the full faith and credit of the United States, outside of prepayment risk, it's effectively safe to presume that all such payments will be made. The amount of interest accrued each month, in turn, is a function of the contractual -- and not the actual or expected -- cash flows of the security and thus the underlying mortgages. In addition, because the principal is similarly guaranteed, the magnitude of any other-than-temporary impairment to the security's value, or "OTTI," is narrowly constrained.
This is notably not the case with non-agency MBSes, which are governed by different rules for accounting purposes. On the balance sheet, like agency MBSes, if these are characterized as available for sale, then they are held at fair value. If the value of a security does deteriorate, however, and the deterioration is recognized on the income statement as an OTTI, then the corresponding amount is debited from equity via the retained earnings/accumulated deficit line item. On the income statement, meanwhile, the amount of interest recorded over the life of the security is equal to the amount and timing of cash flows expected to be collected. Additionally, if there is a negative change in expected cash flows, then an OTTI equal to the adverse change must also be recorded.
If you've followed me this far, then you likely see that the principal difference in accounting between agency and non-agency MBSes lies in the income statement and not the balance sheet. With respect to interest income, the difference is between contractual and expected cash flows. By their very nature, contractual cash flows related to agency MBSes are largely static; the credit risk has been eliminated, leaving only prepayment risks to worry about. Conversely, expected cash flows related to non-agency MBSes are much more volatile, as they change on an ongoing basis as a result of both credit risk and its proverbial little brother, prepayment risk. And the same is true when it comes to OTTI.
Thus, to get back to Chimera, its mistake was in treating its non-agency holdings as if they were impliedly backed by the full faith and credit of the United States, as agency MBSes are. The implications are threefold. First, it overstated its interest income since inception in 2007 by approximately $411 million from approximately $1.88 billion to $1.46 billion. Second, and over the same time period, it understated its OTTI by approximately $293 million from approximately $190 million to $484 million. And finally, it recorded $695 million in offsetting fair value adjustments in OCI as opposed to retained earnings/accumulated deficit. Thus, while the net impact on its balance sheet was effectively neutral, its restated net income declined by approximately $695 million, or 65.5%, from approximately $1.06 billion to $367 million.
To be fair, as is probably obvious at this point, accounting rules can seem complicated and esoteric. But this is not a legitimate excuse to be used by purported experts that are compensated -- generously, I might add -- to study and apply the rules at issue. There is no excuse for the type of egregious accounting error committed by Chimera's executive team here. And there should be consequences for the errors. At the same time, however, as best as I can tell, they were just that: errors and not lapses of integrity. That being said, the question of whether Chimera is a legitimate investment vehicle at this point remains open to debate, as it does for any other stock, for that matter.
