“The Secret of the ‘Fed Trade'” (Black Market Income)

OK, you can stop asking now — because we’re just about to finish up with our latest multi-part series, covering the “loopholes” from the “Black Market Income” teaser for Stansberry’s 12% Letter.

This letter pitches the idea that they have a secret website that “Wall Street” doesn’t want you to see — all about how to generate income from your portfolio without going through brokers, or by using special tricks, tools and investments that regular brokers won’t tell you about.

Some of it sounds quite ridiculous in the hands of a master copywriter, since these guys can make the most mundane investments (like dividend reinvestment plans) sound like you’re whipping your horse alongside Jesse James, with a rifle across your lap, trying to catch the Wells Fargo stagecoach … but that doesn’t mean we should dismiss the actual underlying income ideas, that all depends on what interests you. You can see the first “Black Market Income” story here, which covers the first handful of “loopholes,” and my followup here that covers the mysterious “Toronto 13% Income Secret.”

So what’s the last one? They call it “The Secret of the ‘Fed Trade.'” Sounds very “in-the-knowy,” yes? Perhaps there’s a special way to profit like the big banks have done with help from the Federal Reserve? Let’s see what they’re pitching …

“This is probably one of the most exciting ‘loopholes’ we’ve ever come across….

“… during certain times in the economic cycle – like right now – there’s a way to get as much as $1,200 per month… thanks to the U.S. Federal Reserve.

“We call it the ‘Fed Trade’ – because it plays off one of Wall Street’s most lucrative moneymaking operations… the carry trade.

“Essentially, to grease the wheels of the economy during downturns, the Federal Reserve literally gives away trading money.

“Big banks and hedge funds take this ‘free money’ and invest it in high-yielding investments… Giving them an almost guaranteed stream of profits….

“… we’ve found a little-known ‘loophole’ via the stock market that lets you take full advantage of the ‘Fed Trade’ – without paying Wall Street’s ridiculous fees and commissions. And right now, it’s paying nearly 15% in dividends.

“All you need is about 5 minutes… access to the Internet… and less than $20 to begin with.”

Sounds pretty irresistible, no? So what is it? Is the Fed really going to give you trading money?

Well, maybe we can call this a “sorta” … what’s being teased here are … drumroll please! … mortgage REITs.

“Awwww…..,” the call goes up from the crowd, “we know all about those!”

I know, dear readers — but there just ain’t that many secrets out there. Mortgage REITs are indeed one of the cleanest ways to play the “carry trade” or, if you want to be more specific, play the “yield curve.” They basically take a load of equity cash that they raise by selling stock, then borrow heavily against that at low institutional short-term interest rates (which are indeed being kept crazy low by the Federal Reserve), and using that large leveraged pile of cash to buy mortgage bonds, usually government-guaranteed debt from folks like Fannie Mae, Freddie Mac, Ginnie Mae, etc.

Historically, the big opportunity of this carry trade has been the same as the opportunity for banks — borrow short and lend long, and long-term interest rates are almost always higher than short term rates so you get to pocket the difference. Profitability depends on your ability to manage the fluctuations in interest rates.

Throw in the fact that your “lending long” part, for a mortgage REIT, means buying mortgage bonds, and you get a few other wrinkles — the debt, if it’s government-connected, is guaranteed, so you don’t have default risk, but mortgages can be repaid early if folks refinance; or you might have fixed rate mortgages in your investment portfolio and see your profits compress if your short-term borrowed money gets more expensive with rising short-term interest rates, which would mean managing that portfolio to either incorporate more adjustable rate mortgages, or trading in and out of bonds to maintain profitability, or reducing your level of leverage (the amount of short-term money you borrow), which substantially cuts the size of the portfolio and your potential profits.

So that’s why institutions do the “carry trade” at this level and individuals don’t — there’s a lot of management to be done to keep a portfolio stable or growing, and to maintain profitability, particularly if you’re in a changing environment where interest rates are moving around a lot on both the short and long side, or when there’s substantial regulatory change in mortgage bonds or rates or policies.

So which mortgage REIT are they teasing? Well, it’s not clear — pretty much all of them trade for less than $20 a share, so that one clue doesn’t do us much good. There are differences among the ten or so decent-sized mortgage REITs, many invest primarily (or exlusively) in government-guaranteed residential mortgages, but some focus on non-agency (ie, “private,” non-government) mortgages, or on commercial mortgages (which are a whole different beast — shorter terms that often don’t include much principal repayment, and not as much government involvement).

When you’re talking about the plain vanilla agency mortgage REITs, though, it’s hard to avoid focusing first on Annaly Capital Management (NLY), which is the big daddy of the group. NLY yields about 14% right now and is priced at just under $18 a share, and that would be my best guess for the current suggestion from the 12% Letter folks, in part because many of the Stansberry editors write about Annaly from time to time, but it’s just a guess — it could also easily be the smaller firms like Capstead Mortgage (CMO, yields about 13% now), MFA Financial (MFA, yields more like 11%), Hatteras Financial (HTS, 14%), Chimera (CIM, managed by Annaly and with also about a 14% yield), or American Capital Agency (AGNC, 19% yield). Those are just a small sampling, a few years ago there were probably only a half-dozen reasonably viable mortgage REITs, but the low short term rates of recent years and the success of firms like Annaly has brought seemingly dozens of new competitors out of the woodwork, so there are a lot of stocks to choose from.

I’d have a hard time betting on anyone to do better than Annaly at this point, given their long experience at managing through fluctuating interest rate environments, but that’s partly just my outside perspective as someone who hasn’t been invested in many of these stocks or studied them carefully, that perspective leads me to think the biggest and most experienced fund is a safer bet. I’m not an expert on bond portfolios (which is what these are — it might be more helpful to think of them as highly leveraged bond mutual funds) and it’s certainly po