Bitterness over the financial bailouts seems to have waned a bit, but there’s certainly a strong vein of anger to mine … and that’s exactly what copywriters are paid to do.
This time, it’s in an ad for Jim Nelson’s Lifetime Income Report — and this is the investment idea he’s got for you:
“This is easily the safest double-digit dividend play on the market today.
“It’s assets are 100% backed by the U.S. government…
“And yes, as I write this, it pays 17.25%, which you can lock in if you act quickly.
“What’s more, it keeps on paying at least as long as this recession lasts…
“And when you’re done, you can “flip” this move for as much as 56% more gains.”
And he goes on to explain this “bailout loophole” a little bit …
“I call it the ‘Bailout Loophole.’
“And, even though millions of Americans know nothing about it…Are you getting our free Daily Update
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“It could easily be one of the best ways for you to cash in thousands of dollars in extra “bailout” income checks… each and every year that it takes America’s economy to recover.
“Including as much as $17,500 or more for this year alone. This is perfectly legal.
“In fact the “loophole” I’m about to show you was actually ordered by Congress, in special mandate HR-3221. And the assets behind this play have the FULL backing of the United States Treasury.
“Just about the only other income-producing assets backed by a more solid government-guarantee are U.S. Treasury notes, still considered one of the safest investments in the world.”
OK, so the HR 3221 they’re talking about is not this year’s bill, but the bill from the last Congress — that was the housing “rescue” act from last July that formalized the increased assistance for Fannie Mae and Freddie Mac and included the new homebuyer tax credit along with a bunch of other stuff that let realtors start breathing again.
The HR 3221 for the current Congress, by the way, is about student loans, not quite as sexy … but then again, in the previous Congress HR 3221 was a proposal to cut the duty on insecticides, which makes student loans look like Marilyn Monroe.
So yes, this is all about housing, and 100% guarantees from the federal government, and high dividends … which means we’re once again looking at Mortgage REITs.
Mortgage REITs are Real Estate Investment Trusts that hold real estate debt instead of actual property — they raise investor capital, lever it up with short term debt, and buy mortgages (or occasionally, make direct mortgage loans themselves), then, like all REITs, they are required to pay out the vast majority of their income as dividends to shareholders.
The margin between what it costs them to borrow and what they can make from income from the mortgages they hold is their income — it’s a tight margin of often just a couple of percentage points, but since they’re borrowing a big chunk of money that can turn into a double digit yield for investors.
Mortgage REITs, sometimes also called MREITs, had a very tough year last year, as one might imagine — but, in many cases, there’s still a solid underlying business for these guys, especially given the government’s expanded role in the housing market, and they’ve all bounced back nicely in 2009. So which ones does Nelson think we should buy?
Let’s take a quick look at how he explains their business first:
“Turns the Government’s ‘Free Money’ Program Into Your Own Private Bailout
“Here’s an even simpler way to visualize this.
“Imagine someone gives you a wad of cash — almost interest free — and tells you to park it an income-paying savings account. You get to keep all the money above the tiny cost of carrying the loan.
“Would you take that offer?
“Of course you would.
“Especially if the accounts paying you income were fully government-backed.
“Well, this ‘loophole’ opportunity isn’t an account. But what it does do is almost that simple.
“See, the moment Congressional Mandate HR-3221 earmarked billions of dollars for buying up income-paying assets… plenty of Americans saw red… but a handful of smart investors saw a once-in-a-lifetime opportunity, instead.
“In fact, a chance to claim back piles of that bailout cash — legally — using extremely cheap loans to invest in those newly government-backed, income-bearing assets.
“Like the example with the account above, this means they get to keep all the interest above the almost invisible cost of the loans as income.
“In turn, the alliance doles out that income to its own shareholders.”
And of course, there’s a rush!
“One word of warning…. You’ll want to move fast. Because right now, the payouts run about 17.5% on every dollar involved in this play. If you wait too long, the size of that payout could start going down.”
And he squeezes in a nice reference to the NY Times, to make us all understand that this is something real:
“The New York Times recently called these special shareholder alliances ‘hidden gems’ that can ‘rise above the rubble and even thrive as the economy falters.'”
Well, OK, so that’s fine … as long as 18 months is “recent” for you — that article in the NY Times appeared in February of 2008 … and incidentally, if you had read it and gotten excited about Annaly, the focus of the article and the most prominent name in this sector, you would have lost 25% of your money within about a week, and the shares still have not recovered to that level (though if you adjust for the hefty dividend, the stock is trading right now for about the same price you would have paid before the article ran — it fell to a dividend-adjusted $12 or so shortly thereafter).
And Mortgage REITs have actually been coming out of the woodwork over the last year or two — there have been recent IPOs and I’m sure there are more planned, since folks see dollars in those agency mortgages (agency mortgages are Fannie Mae, Freddie Mac and Ginnie Mae mortgages — the ones that carry federal backing).
So which one is Nelson touting here? Well, it must be one that focuses entirely, or almost entirely on agency mortgages, since he mentions the federal backing over and over, with the solidity that implies.
And the only specific clue that he gives is that the income yield from this investment is currently running about 17.5%, and that it trades at a about 1.23 times book value.
That helps to narrow it down slightly, though there’s no guarantee since, though it’s still being actively mailed out, the letter was actually signed in July 2009. Most of these investments had their big moves earlier this year, but they’ve still moved a bit since mid-Summer.
Still, if we’re making an educated guess here I’ll tell you that I expect this is …
Capstead Mortgage (CMO)
Capstead, like Annaly (NLY), is one of the older players in this business, which makes them feel a bit safer than the Johnny-come-latelies. But they are also a bit riskier than Annaly, which is why their dividend yield is tracking at right around 17.4% while Annaly’s yield is at about 13.7% (both trade at about the same ratio to book value, a bit below the teased 1.23X).
Why riskier? Well, Annaly has a reputation for very solid management of their portfolio, and they have reported hedging against possible interest rate changes … and I don’t know if they really are better at hedging or not, but Wall Street thinks they are, and trusts them more than the other mortgage REITs. That’s the basic reason that they trade at a bit of a premium to their brethren — they’re also much larger, and better at communicating with investors.
Capstead has also had a long history of managing mortgage assets, but they focus more on adjustable rate mortgages, and they have tended to use a little bit more leverage than some of the other players in the business.
Both have seen their leverage levels drop lately, not because they’re borrowing less but because the demand for mortgage bonds has recovered, thanks in part to the government’s continuing backing, and theFed’s purchases of mortgage bonds, so they can now write up the value of their portfolios a little bit more.
There are several other businesses in this sector, too, some new, some old — the subprime guys (Novastar Financial) and jumbo originators (Thornburg Mortgage) got destroyed over the past couple of years, but the somewhat more conservative REITs that focused on agency mortgages are, while down from the highs, relatively unscathed. Some of the other survivors include MFA Financial (MFA), Hatteras (HTS), Anworth Mortgage Asset (ANH — this is the other one that’s near a 17.5% yield right now), and American Capital Agency (AGNC — managed by ACAS, which scares a lot of people right now) … and there are plenty of newer ones that are recently IPO’d, or in the wings ready to be launched by a number of private equity and investment management firms who smell the money in the water.
So what does a wise investor do? Well, read through the filings of a few of these guys — and if you do invest, make sure that you understand how they make money. There’s nothing magic about their huge yields: they borrow money short, and lend long, and that leverage turns what is generally a current margin of 2% or so into big money.
Capstead, for example, has leverage right now of about 6:1 — meaning that for each dollar they’ve raised from investors like you who buy shares, they borrow $6 from someone else.
That $6 of borrowing is almost all extremely short term — not overnight loans like Bear Stearns was counting on to stay in business each morning, but generally loans that are for 30 days or so. As you can imagine, if you only want to borrow the money for 30 days, and you have a good credit rating, the interest rate is extremely low, something on the order of one half of one percent. Now, they can’t survive on just this extremely short term lending or they’d be on the verge of collapse, so they also have interest rate swaps and longer term debt, much of it with big commercial banks.
They then invest that money — the $1 from you and the $6 from lenders — in agency adjustable rate mortgages that might pay something like 4.5%. They manage that portfolio, which costs money, and they deal with stuff like prepayments, which also cost them money, and with fluctuations in the interest rate — when ARM rates reset they can go down as well as up, so sometimes the margin expands, sometimes it contracts.
And whatever they make on that portfolio of mortgages above and beyond the cost of borrowing is their gross profit, often referred to as the spread — right now it seems to be around 2% or so. The income they record all goes almost directly to the shareholders, since this is a REIT and they can avoid taxation only if they pass their income through to you, and in Capstead’s case they’ve actually been paying a slightly higher dividend than they’ve been earning … but that’s actually the case with most of these firms, who are very motivated to keep the dividend stable and, if possible, growing, since their share prices almost always get whacked when they cut the dividend.
So where’s the risk? Well, it’s true that agency mortgages are about as safe as you can get these days in the debt markets, aside from Treasury bonds … but that safety doesn’t mean you are guaranteed a fat profit. The most important thing for mortgage REITs is the yield curve — the difference between short and long-term interest rates. You might remember several years ago that the yield curve actually inverted for a while and was nearly flat for a long time, with 30-year rates almost identical to 2-year rates, and to even shorter term notes.
That’s the worst possible environment for a mortgage REIT — if a firm like Annaly, which holds almost all fixed rate bonds, sees their cost of borrowing jump to 4% but their bonds are still unchanged at 4.5%, they’re going to almost instantly become unprofitable. They plan for that by adjusting their portfolio to conditions in the markets, and by using interest rate swaps going out nine months or so, but if there are big, longer-term changes they may well be sunk.
On the other hand, if mortgage rates drop a lot these REITs also suffer — that’s because one of the risks of holding a mortgage bond is prepayment if the mortgage holder refinances or sells the house and pays off the debt. This is not a huge risk right now, because interest rates probably can’t drop that much lower and many people already refinanced last Winter if they could, and there aren’t that many houses being sold … but it is a risk. If mortgage rates drop substantially, more people refinance, and then the REIT has to buy more bonds, but they’ll probably be at a lower rate, so income drops.
That’s the basics — I’ve always liked Annaly myself, because of their clear shareholder communication and their solid reputation for managing the portfolio effectively through some rough markets, but they do pay a lower yield than Capstead, and they might have more risk if we enter a period of steadily rising mortgage rates (thanks to CMO’s focus on ARMs) … but all of these companies carry risks, focusing too much on the lack of a default risk, thanks to the government guarantee, might mean that we can forget the real risk that the interest rate firmament may not always be as friendly to their business plans as it is right now, and that changes in their profitability can come more quickly than we might expect.
I do not, of course, give advice, and I don’t own any of the stocks mentioned above … but if I were buying Mortgage REITs my inclination would be to look first at Annaly and next at Capstead and Hatteras, and think about holding a portfolio of these stocks instead of a single name — CMO and NLY might actually be a good pair, given their somewhat different agency portfolios. And if you like the income specifically you might also look at the preferred stocks, which provide a more certain dividend — Capstead’s series B preferred (CMO-PB) yields just under 10% right now, pays monthly (the stocks pay quarterly) and has been repeatedly touted by Carla Pasternak, another dividend-focused newsletter editor; Annaly’s series A preferred (NLY-PA) yields a bit less (Annaly also has a series B preferred, but it’s convertible so it’s not primarily a yield investment right now).
And whatever you choose, if you’re interested in learning more about this business the Resource Center that Annaly provides on its website is worth a look — they provide monthly commentary on the markets and do a much better job of explaining the basic business plan than I can.
Oh, yes — and to put $17,500 into your pockets this year, as teased, you’d have to either start with $100,000 in CMO (or one of its competitors) and count on the dividend staying stable, or get some pretty dramatic capital gains on top of those juicy dividends. Always possible, but I would hold off on spending that $17,500 just yet.