CIM -- Business Model

In this last “background” post on CIM, I am going to talk about how CIM actually makes money and the risks of investing in this stock.

How will CIM actually make money?

The company will take the $520M of cash it raised last month in the IPO (this is called equity) and buy real estate backed loans (these are CIM’s assets) that will produce an income stream in the form of interest and principle paid to CIM. It’s a bit confusing, but CIM’s assets are loans made to someone else. So at this point the company’s balance sheet essentially looks like this …….

$520M in assets yielding lets say $25M in income to CIM
($520M in equity raised as part of IPO)

Then CIM will use its assets as collateral to borrow money and will pay X% as interest expense to the lenders. The company will than use this borrowed money to buy more assets hoping that its assets will yield X%+Spread. So now CIM goes from having $520M in assets yielding $25M, to ……

$520M in assets yielding lets say $25M in income to CIM
$5,000M in additional assets yielding $250M in income to CIM
($5,000M in new liabilities which cost CIM $200M in interest expense)
($520M in equity raised as part of IPO)

So, by leveraging its equity CIM goes from earning $25M or 5% return on equity for shareholders to earning $75M ($25M on equity raised in IPO + $50M in difference between interest income on $5B in assets and interest expense on $5B in liabilities used to pay for those assets) and ROE jumps to almost 15%. Since this is a REIT, 90% of the income gets paid to shareholders in form of a dividend so the shares will have a much higher yield than other equities.

This is a very simplistic example but this example give a good example of where the cash will actually come from and how a company with $500M in equity can have 10x the buying power.

Seems easy enough, but what could go wrong?

The first problem is that CIM’s business model is exposed to the yield curve because CIM will borrow using shorter term loans like commercial paper but will buy long term assets with that money like 30 year mortgage loans. There is a mismatch in maturities that creates a big risk of the yield curve flattening. If the yield curve flattens than the difference between costs and revenue will shrink and CIM will earn less money. This is exactly what happened in 2005 and CIM’s parent Annaly Capital Management got whacked as a result, more on this later.

The second problem is that the company will use a lot of leverage, that’s part of the business model, and is sensitive to what is happening in the credit markets beyond the shape of the yield curve.

For example, if the banks CIM borrows money from all wake up one day and say that they want their money back at the same time or the assets that they are holding as collateral are now worth less than they were yesterday, CIM could be in some series trouble. At this point, CIM either has to find someone else to lend them money, issue more stock which dilutes current shareholders, or have a fire sale on its assets to pay off its lenders. This is called a “credit crunch” and is exactly what happened in early August and is happening right now.

The third problem is that the value of the CIM’s assets is uncertain and changes every day while the cost of its liabilities is written in stone. CIM’s assets are loans to others either in the form of actual loans it buys from a major bank that originated them or in the form of a credit security backed by mortgage loans. Since these are long tem loans there is always a risk that borrowers will default and CIM does not get all the interest/principle it expects to get so the actual yield they realize on their assets is lower than expected.

The other risk is that one day the market can simply decide that its assets are worth much less than originally thought but the liabilities CIM owns will stay the same. If this happens there is a mismatch between loans and assets and that mismatch will be made up buy shareholder equity and will kill the stock. This is by the way exactly what is happening with just about any financial institution that owns any mortgage related assets.

So this is why CIM’s business model is a “catch 22” proposition. On one hand its extremely simple – just borrow short at X and lend long at X+Spread—and leverage that trade up 10 times and you are printing money.

On the other hand, CIM is exposed to the yield curve as well as the gyrations in the credit markets which can change overnight. If CIM takes on to much leverage or can’t sell its assets to raise money in a credit crunch, the company can go out of business overnight or suffer a serious impairment to shareholder equity and therefore the stock price. Also, the company may simply overpay for assets and not earn as much as it expected on them.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.