At the end of last week, Chimera Investment Company 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 , 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, …read more
Source: FULL ARTICLE at DailyFinance