Government Backed, Highly Liquid, 8X the Returns!

By Travis Johnson, Stock Gumshoe, January 23, 2009

Teaser ads that promise solidity, stability, government backing, and high dividends are all over the place these days … for good reason, one suspects, as they certainly appeal to the “where are we, and what am I doing in this handbasket?” crowd.

Today is no different — let’s take a look at an ad I’m seeing a lot of this week. It’s from Andrew Gordon of Investors Daily Edge for his INCOME service that promises, you guessed it, high income investments. If you want to take it for a spin, it will cost you $99 a year.

“GOVERNMENT BACKED… HIGHLY LIQUID… and 8 Times the Interest of a Typical Savings Account

“It’s not only billionaires who are using the financial crisis to get “insider deals”…

“Thousands of regular Americans are cashing in on a loophole for collecting up to $8,881 a month, backed by an “explicit” U.S. Treasury guarantee…

“The next batch of checks is going out on March 27, 2009”

Of course, we can look at this in an instant and realize that the copywriters are no dummies — saying that it provides eight times the interest income of a “typical” savings account nicely implies that this is an “atypical” savings account.

It is no such thing … but the “government backed” part is at least partly true and accurate, so that doesn’t mean it’s not worth a look.

So how can you get on what they’re calling a “distribution list” for what they call the “Payout Checks Guaranteed by the U.S. Treasury?”

Can we just pause for a moment to celebrate the copywriter’s art? It’s not unique, but this use of the word “list” is hugely effective — there aren’t many among us who don’t believe that somewhere there’s a “list” that some people get on to get preferential treatment, and I’ve certainly had my share of waiting behind the velvet rope and being told that I’m “not on the list.”

So who wouldn’t want to put themselves on this list? Get in on the secret that lets you get paid free money for no labor?

“… your payments are distributed by government-regulated companies who are mandated by Federal Law to pay you your share of this “insider deal.” That means you must be paid in full, and on schedule. It’s the law.

“The money is first accumulated in the accounts of special government-regulated companies. These companies must distribute this money on a regular basis to ordinary Americans who are on the distribution list. Many wealthy people are on this list. It’s “insider deals” like this that made them so rich.

“But this ‘insider deal’ is available to everyone — rich and poor.”

So, that covers just about all of us, I think — rich and poor. Do you want to get on this list?

All you have to do, I’m afraid to say, is buy shares of a Mortgage REIT.

Mortgage REITs, sometimes also called Finance REITs, are real estate investment trusts that own mortgages instead of properties — and in most cases, they actually just buy mortgage bonds, they don’t make loans directly.

And their payouts are guaranteed — at least, to the extent that they make money. Like all REITs, they have to pay out essentially all of their income (90%+) to shareholders as dividends in order to avoid paying corporate taxes.

And the government-backed part is also sort of real — Mortgage REITs are not themselves particularly backed by the government, but their portfolios are. Most of these companies hold largely agency bonds, which are mortgage bonds issued by Fannie Mae, Freddie Mac and Ginnie Mae, and with the government takeover of Fannie and Freddie there is now a more “explicit” (rather than the previous “implied”) guarantee of principal protection for those bonds. They still trade differently from Treasury bonds because of a fear that there’s still some hidden risk somewhere, but essentially I think most people understand that Fannie and Freddie bonds are guaranteed by the US Treasury now.

So how do they make money? Well, in general these companies borrow money short and lend long — they have to be quite leveraged to make money, so they borrow a multiple of their market capitalization and use that money to buy Fannie Mae (and other) bonds. Since they’re borrowing with short term facilities, let’s say for two years, and buying long term bonds with, for example, ten year durations, they make money by pocketing the spread between them. If they borrow at 2% and buy bonds with income yields of 4%, they make 2%. And if you make 2% on a portfolio that is ten times the size of your company’s market capitalization, you can generate income that looks like a 20% profit on the money that equity holders have invested in the company.

One of the primary risks of these companies is that they depend on a certain slope to the yield curve — so when the yield curve inverted a couple years back, many of them had trouble making money. If you borrow short and lend long you need to have an effective strategy for coping with times when your borrowing rate and your lending rate don’t necessarily behave in the way that you expect — when the yield curve inverts it means that the annual interest cost for borrowing for one year might be higher than borrowing for five years, so you might actually end up paying more in interest than you make from your portfolio. This is no surprise, of course, and good managements can and do work around it, and the business is not necessarily as simple and linear as I’ve outlined.

So, the broad strokes of the teaser are rooted in fact, at least. Not bad. And these companies probably did get beaten up more than the deserved over the past six months, since almost anything related to real estate, financial companies, mortgages or even the stock market has taken a relentless beating — if there are companies that are particularly good at managing these kinds of mortgage portfolios, perhaps they’re worth a look.

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And of course, Gordon teases us that he’s identified a few such firms. Here are the clues:

“‘Insider Deal’ #1: is based in New York, and with only 39 employees it made $393 million in 2007. The company had to distribute 90% of that money to participants. It currently pays a 18.6% dividend, and sells below book value. Based on data reported in Yahoo Finance, from October 1998 to June 2003 this “insider deal” returned an amazing 617% in capital gains, plus 413% in dividends…Get involved now and you could collect your first paycheck on March 27, 2009.”

This one is Annaly Capital Management (NLY), which I’ve always been told is the class of the industry — the ad is probably a bit old, so the yield is now about 13% and the shares are off their lows (and it now trades a hair above book value, not below). The stock dipped below $10 last year, but is now just below $15. This has been a favorite of many investment newsletters for their conservative management style and consistent returns, including Jack Adamo over at Forbes among many others (quick comments here if you want to read more). It was also a Jim Cramer favorite for quite a while, though I have no idea whether he’s a fan these days.

“‘Insider Deal’#2: is based in North Carolina. This company started operations in one year ago, but its experienced management team has worked together for over ten years. If you act quickly you can lock-in a generous 21.4% dividend, and a price well under book value. Pick up this ‘insider deal’ now and earn a 40% plus return in the next 24 months. That’s not counting the ample capital gains it’s likely to return. If you sign up today you’ll get your first paycheck by April 3, 2009.”

This is Hatteras (HTS), and they did indeed go public last April, one of the few successful IPOs last year. The shares are actually trading right around their IPO price at $24.50, with an indicated yield of close to 16%. I don’t know anything else about them, save that I think they’re the only NC-based mortgage REIT, and they do employ the same strategy of managing a leveraged portfolio of government-backed mortgage bonds. Like NLY, these guys are also trading a bit above book value at the moment, not below.

“‘Insider Deal’ #3: is located in New York, and it’s been in business for over ten years. This company makes a fortune thanks to this government loophole. It currently pays a 17.2% dividend, and sells for 20% below book value. During a recent 2 1/2 year period this “insider deal” paid 193% total returns…including 59% in dividends. Scoop this up now, and you’ll get your first paycheck on April 26, 2009.”

This is a bit more of a guess, but I imagine this one must be MFA Financial (MFA) — until changing the name at the beginning of this month it was called MFA Mortgage Investments (same ticker). The company has been around since 1997, so a bit over ten years, and it must be perceived as a bit riskier since it does indeed trade at a discount to book value (now a 10% discount, no longer 20%). The effective yield at the moment is a hair under 14%. They are based in New York, and they do follow essentially the same strategy of buying government-backed bonds and using leverage.

There are a few other companies like this if you’re interested in doing some research — Carla Pasternak has several times touted the preferred shares of Capstead Mortgage, for example. Be careful, there are a variety of companies in this sector and not all of them are particularly conservative or focused on government-backed bonds (some loan or invest directly in individual commercial mortgages, or buy property as well as mortgages, for example, and they don’t all use the same amount of leverage).

And there is also, if you like the general idea of this sector but don’t want to review individual stocks, an ETF for mortgage REITs, iShares FTSE NAREIT Mortgage REITs (ticker REM) — it doesn’t have a huge amount of volume, but those three companies teased by Gordon (if I’m right on all of them) are by far the largest positions in the ETF. Annaly itself makes up about 30% of the ETF, and together NLY, MFA and HTS represent about half of the fund’s holdings — the reported yield is 22%. There was a useful little quickie of an article in Investopedia about mortgage REITs back in October that called attention to this one when it had a 17% yield.

So … do you hold a mortgage REIT? Like buying the bonds yourself? Think we should stay away from these guys, or rush to embrace them? Let us know with a comment below.

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