3 Dividend Stocks to Sell on the Verge of Bankruptcy 3 Dividend Stocks to Sell on the Verge of Bankruptcy

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Ada Pitts
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1 3 Dividend Stocks to Sell on the Verge of Bankruptcy A Special Research Report from The Dividend Hunter

2 Introduction By Tim Plaehn Filing for bankruptcy is a last resort for a company that cannot generate enough revenue and gross profits to pay its obligations. For publicly traded companies, the big BK comes when a company piles on too much debt and then at some point in the future does not generate enough cash flow to service the interest payments. A big debt maturity that cannot be refinanced or would get replaced at a much higher interest rate can also trigger a need for a company to throw itself on the mercy of the bankruptcy courts. With stocks that are currently paying a steady dividend, there is less fear and, in most cases, a much lower probability of the company going from one that can share profits as dividends to getting so far in the hole that declaring bankruptcy becomes necessary. If profit margins get squeezed, the company can reduce or eliminate the dividend payment, preserving cash flow to pay business obligations. In most cases, investors owning a dividend stock will see warning signs that the cash flow to cover the dividend is dropping, or in the worst case a dividend cut is a big warning sign to get out of a stock. Share price losses from a dividend cut can be significant, but not the total 100% wipe out of a bankruptcy declaration. However, there is one business type and structure that can result in a fall from high-yield, financially stable company to being taken over by creditors in a matter of just months. During the 2007 to 2008 financial crisis 10 companies out of about 30 in this sector became insolvent and are no longer in business. I had the front row seat to be both a shareholder and was writing about one of these companies as it imploded. However, I will note that I had sold 90% of my holding before the bad news became apparent. That said, after the share price dropped from $25 to $10 in a couple of days, I kept looking for reasons why the company and stock would recover. My hope was unfounded and creditors took over the company within a year. The type of company I have referred to are the mortgage REITs that use multiples of leverage to turn 3% mortgage backed securities (MBS) yields into 10% dividend yields. A mortgage REIT derives a large percentage of its interest income through the strategy of buying MBS and financing the purchase with short term borrowed money. The difference in yield is pure profit, as long as interest rates do not change. It is not unusual for a mortgage REIT to buy mortgage securities in amounts of 7 to 10 times the capital at risk, borrowing the 6 to 9 times equity to finance the investments. Borrowing for the portfolio securities is usually in the form of repurchase agreements or repo financing. This financing is cheap because the bank providing the money to buy the securities will hold the MBS as collateral. This arrangement is the danger point for the highly leverage mortgage REITs. If the lender feels its chances of repayment are at

3 risk, it can hold on to the REIT's mortgage securities. This can prevent the REIT from selling MBS to pay other obligations or creditors. The final danger point is if a mortgage REIT has become complacent about the dangers and risks of rising interest rates. Due to Fed action short term rates have been effectively at zero for almost 6 years, making repo borrowing exceedingly cheap. When rates start to rise, margins will be squeezed. On the other side, higher rates will cause MBS prices to fall, which may force a REIT into selling assets, but those assets may be "held" by one or more repo lenders, putting the REIT into a bind. It is very likely that when the Fed starts to jack up short term rates, some mortgage REITs will be caught in a falling spread, falling prices bind that could end up with the repo lenders owning the REIT's MBS and shareholders holding an empty bag. Here are three mortgage REITs that my research shows are at considerable risk in this scenario.

4 Chimera Investment Corp. Chimera Investment Corp. (NYSE: CIM) has had a troubled history and could surprise share owners with an eventual collapse of its business. In early 2012 the company acknowledged that its financial reporting since a 2007 IPO was not in compliance with GAAP standards. Chimera Investment Corp. (NYSE:CIM) New York, NY Last: $3.16 Dividend & Yield: $0.36 (10.8%) Market Sector: Financial, mortgage investment For the next two years, quarterly and annual reports were significantly delayed, the previous three years of earnings were restated with a 60% haircut and the company faced numerous warnings of exchange de-listing. The only thing that kept the share price from dropping to pennies was the continued payment of a 9 cents quarterly dividend. The dividend propped up the share price at $3.00 plus or minus $0.25 and a 12% yield. During the two years of reporting limbo, CIM did little to change the holdings in its MBS portfolio. The 2014 first quarter earnings 10-Q was released on 7/1/14, only two months late on this one. Out of its claimed portfolio valued at $6.7 billion, $1.93 billion is high quality agency MBS (issued by Fannie Mae, Freddie Mac and Ginnie Mae), repo financed. The remaining $4.8 billion is nonagency MBS, the same transferred to consolidated variable interest entities (VIEs), and $748 million of securitized loans. The bulk of the non-agency holdings are very low credit quality. Debt included $1.5 billion of repo secured by agency MBS, $828 million of non-agency MBS secured debt and $637 million of debt secured by the securitized loans. Chimera's biggest problem is the values that could be realized if it was forced to sell low quality non-agency securities to pay off debt and avoid confiscation of agency MBS or other collateralized holdings. Small investors in Chimera have been given hope because of large hedge fund purchases of CIM. However, it is not inconceivable for a hedge fund to team up with a lender to take Chimera into bankruptcy so they can divide up the assets, leaving small investors holding the "empty" bag.

5 Orchid Island Capital Orchid Island Capital (NYSE: ORC) is just a year-old company that listed on the exchange with a July 2013 IPO. The current 16% dividend yield shows the risk premium the market is putting on this small cap, highly leveraged financial REIT. Orchid Island Capital (NYSE: ORC) Vero Beach, FL Last: $13.26 Dividend & Yield: $2.12 (16.0%) Market Sector: specialty financial services As of June 2014, the company reported $868 million of residential MBS assets, out of which $477 million was backed by 30-year mortgages. Another $264 million was interest-only securities. Both the 30 year MBS and I/O holdings would be much more volatile holdings if interest rates made a significant move. Holding up the interest paying portfolio and providing the leverage was $781 million of repo financing with an average maturity of 42 days. With a $120 million market cap, it would not take a lot of interest rate stress for a few of Orchard Island's lenders to retain possession of MBS the company may need to sell and push this aggressive financial REIT into a bankruptcy filing.

6 Redwood Trust, Inc. Redwood Trust, Inc. (NYSE: RWT) has taken a different approach to the mortgage REIT business. Instead of just buying mortgage backed securities with leverage and earning a spread, Redwood Trust buys whole residential and commercial mortgages. Redwood Trust, Inc. (NYSE: RWT) Mill Valley, CA Last: $19.54 Dividend & Yield: $1.12 (5.70%) Market Sector: Financial, REIT - Diversified This business model provides the needed service of an alternative funding source to Fannie and Freddie. However, this approach does leave the company with a portfolio of whole loans or its own MBS securitizations that may be much less marketable if the mortgage or housing markets run into trouble. On its $3 billion portfolio of loans, own MBS and third-party MBS, Redwood Trust currently carries about $700 million of repo debt. Although Redwood Trust has a much less leveraged balance sheet and strives to make money in the mortgage space by actually participating in the production of new mortgages, the standalone strategy also puts the company at higher risk of losing it all in another disruption to the financial system. Redwood Trust is also exposed to the risk of a double dip in real estate values. While the possibility may be low there remains a real danger of an insolvency causing event for the financial REITs that depend on repo financing to produce spread interest. Rising short term rates can squeeze the spread so that spread interest goes to zero or even negative, causing outgoing cash flow. Rising long term rates drives down MBS pricing, usually faster than for Treasury securities. Lower securities prices would result in assets selling at a loss to pay off repo debt where lenders will not be willing to share in the loss. In this case, losses are also multiplied by the leverage levels. For example, over the first half of 2013 mortgage rates increased to about 4.5% from 3.5%. Share prices dropped by 30% to 40% as the news hit the second quarter earnings reports of the major mortgage REITs. This was without a rise in short term rates that would have hurt results even more. The half decade of zero short rates has left the leverage addicted mortgage REITs very exposed to a level of danger that individual investors should to assume with share ownership Investors Alley Corp. All rights reserved. Any reproduction, copying, or redistribution, in whole or in part, is prohibited without written permission from Investors Alley Corp., 41 Madison Avenue, 31 st Floor, New York, NY or All data, including equity prices and yields current as of when this report was published. For complete terms and conditions governing the use of this publication please visit

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