Call me a cynic, but when I see a looooooong ad presentation about financial armageddon, I skip right through the stuff about collapse and anguish and falling standards of living and economic crisis, and look for what the ad copywriter is trying to sell.
Because frankly, everyone knows there’s a debt bubble. Everyone knows that after interest rates languish below the rate of inflation for a long time it has to eventually stop. And everyone knows that interest rates that are pushing zero are a lot more likely to be higher than lower in the future.
Unfortunately, no one knows quite when interest rates will go up.
Which is a problem.
Because the financial doomsayers and pundits have been lamenting the ridiculously low and unsustainable interest rates for many, many years. We even saw several teaser pushers talk about the fact that the debt bubble was about to pop and the US dollar collapse back in early 2008, before the financial crisis (a crisis that, as they tend to do, sent investors running for bonds … and brought interest rates down even further).
Over the last three years, the ETF representing 7-10 year treasury notes (ticker IEF) is up about 20% — that’s not as good as the broader market, which is up almost 35% during that time (represented by SPY, the S&P 500 ETF), but it’s certainly not a burst bubble. At least, not yet.
And financial catastrophe is the prediction we’re seeing today from Marc Lichtenfeld as he tries to sell his new newsletter service, which is called The Oxford Income Letter. Let’s see what he’s talking about, shall we?
The armageddon bit is probably going to sound a bit familiar to you, we’ll deal with that first:
“The 3-Minute Event That Will Change Financial History
“A ticking debt bomb buried deep in the world markets is getting ready to blow on Thursday, April 4…”
Oops, I was looking at the earlier version of this ad from a few weeks ago. Sorry, it’s no longer April 4 when the ticking time bomb will blow — which is a relief, because that’s today. It’s now June 12, so back to the spiel …
“A ticking debt bomb buried deep in the world markets is getting ready to blow on Wednesday, June 12…
“… the herd is plowing mountains of money back into stocks, like it was 1999 all over again.
“But what they might not know is this.
“Just over the horizon lies an event that will disrupt this rosy equation.
“Like most ‘black swans,’ only a few brave investors will see it coming and prepare in time.
“It will come suddenly too – like an earthquake – in a single three-minute blast. And it will change everything.
“But what exactly am I talking about?
“We’re about to witness the historic moment when some $93 trillion very suddenly rush out of certain investments, and into others.
“Ironically, the ongoing bull market in stocks will hasten this event’s arrival.
“Some investors will get very rich. Others will get crushed – especially when it comes to their ‘safe’ holdings.
“But you don’t have to be one of them – not this time. I’ve created this report to ensure that you come out on the winning side.”Are you getting our free Daily Update
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What’s he talking about? Well, the $93 trillion number is a reference to all of the Federal, State, Municipal and individual debt in the United States, which is clearly unsustainable for the long run and maybe even unserviceable, eventually, with a GDP that’s in the neighborhood of $15 trillion.
We know that the debt is unsustainable as the debt service becomes an ever larger part of the federal budget and of the economy … so the question is how the markets react to that — we’ve known it to be unsustainable for decades now, and it becomes less so every year that new folks get added to the Social Security and Medicare rolls as recipients rather than payers.
Short term interest rates aren’t going anywhere anytime soon, at least not unless the Federal Reserve smells a real whiff of serious inflation coming, so it would be in the longer-term rates that the problem rears its head first. That means, and I’m paraphrasing Lichtenfeld’s ad here for the most part, that the problem will arise in the benchmark US 10-year note, the note that drives much of the longer-term interest rates around the world.
When we say “problem” regarding bonds, we mean that prices of those bonds drop because the bond buyers (the lenders) start to demand higher interest rates in exchange for the duration and credit risk that they’re taking on. And since Lichtenfeld is trying to sell a newsletter, and his publisher wants you to subscribe right this minute, while you’re thinking of it, there’s some urgency added … in this case, the urgency is that Lichtenfeld says the next Treasury auction of 10-year notes will fail, with the news cascading around the world in three minutes and bringing massive change to the global economy almost in the blink of an eye.
Oh, did I not mention the name of the letter yet? He’s pitching a new letter that they’re launching right now called The Oxford Income Letter. Don’t know anything about it yet, since it’s new, and Lichtenfeld has generally been around the investment newsletter world as more of a biotech guy than a dividends and income guy in my experience, but it’s relatively inexpensive and Oxford certainly has several income investing analysts who are probably involved as well.
Or, in his words:
“The Powder Keg Buried Deep Inside the Global Debt Markets
“The event has nothing to do with Washington defaulting on its $16 trillion debt.
“Nor am I predicting another crash in stocks.
“You might call it a powder keg hidden deep inside the world’s debt markets. The event will occur here, inside this non-descript office building in New York City.
“It will take only three minutes to spread worldwide.
“But its impact will last for generations….
“When bonds tank, interest rates must soar – it’s inevitable.
“But what most folks don’t realize is: This event won’t happen in an orderly fashion….
“The great bond bubble will come with a sudden force, like an earthquake. And only those who have reinforced their portfolios will survive.
“Just days from now, a single three-minute ‘tremor’ will trigger the ‘debt quake.’
“Eight times per year, the Treasury Department holds an auction for 10-year Treasuries.
“Participants include sovereign governments like China and Japan. They also include the big banks and Wall Street institutions, like Bill Gross’s PIMCO.
“The government might auction off $20 billion worth of Treasuries at a time.
“If demand soars, prices for the bonds soar – and the government can get away with paying very low interest rates.
“But if demand plummets, Washington must jack up interest rates to attract enough buyers.
“Until now, that hasn’t been a problem. The world has sought safety first. And Treasuries have enjoyed a 30-plus-year bull market as a result.
“But the biggest bond buyers on earth are getting nervous now.
“Take China, for example.
“China is the single biggest player in the market for U.S. Treasuries.
“During a single nine-month span ending last year, China quietly sold off $136 billion dollars worth of Treasuries.”
(Just to be fair, the chart Lichtenfeld uses to illustrate that China point indicates that Chinese Treasuries holdings topped off in 2011 and are in decline, which they were for several months to end 2011 — the chart is not that much of a straight line right now, both China and Japan hold more in Treasuries in January 2013 than they did in January 2012, though Chinese holdings are still below the peak level, from before they started actively diversifying more.)
So how does this three minutes happen? Here’s how Lichtenfeld puts it:
“The Spark That Will Set the Treasury Tinderbox Ablaze
“The Three-Minute Event will come in the form of a simple announcement.
“What most people don’t realize is: Announcements, more than any other force, impact Treasury prices and interest rates most directly.
“A recent Economic Policy Review study was crystal clear. Each of the 25 sharpest price changes and each of the 25 greatest trading surges can be associated with a just-released announcement.
“The study further states:
“The market’s reactions depend on the surprise component of a given announcement and on conditions of market uncertainty.”
That’s exactly what we’re about to witness inside the benchmark 10-year Treasury market.
“My research indicates something amazing – something not seen in decades, if ever.
“I’m talking about a virtual failure of an upcoming auction for 10-year notes.
“Now let me clarify. I am not saying nobody will show up for this auction.
“I’m saying almost no major players will show up, willing to pay the government’s asking prices.
“The resulting lack of demand will cause bond prices to tank – and interest rates to soar….
“It will trigger a chain reaction of sell-offs from Moscow to London, New York to Beijing.
“In short, the world’s ‘safest’ investment is about to become its riskiest.
“Those who don’t prepare could get wiped out – even the ripple effects will destroy millions of retirement dreams.”
So … whaddya do?
Lichtenfeld was predicting that the next auction of 10-year notes, which will be on April 10 (They announce the auction on April 4), will start the ball rolling (and now, according to the latest version, he’s moved it out two months to the June 12 auction — presumably our “three minutes” of crisis will skip the May auction, which is tentatively scheduled for May 8).
Maybe the ball is already rolling a bit, since the yield has been on a gradual move up since it bottomed out below 1.5% last Summer (yield is around 1.78% now for a 10 year note, which has fallen a bit in the few weeks since the first version of the ad ran), though it’s beyond me how you can confidently predict exactly when and how the world will demand higher interest rates. And of course, it’s been a lot longer than three minutes since the yield bottomed out.
I do, however, think it’s important to hedge your bets — I think holding any treasuries with durations beyond five years is a little silly at this point, but if we’re talking about prescience it’s also worth noting that I thought buying 10-year treasuries at a 4% yield was ridiculous and they couldn’t possibly get much lower, and that was more than five years ago. Back then, as now, even published CPI rates, which I think understate the real inflation impact for most people, meant that if you lent money to the government for ten years you were essentially saying that you were willing to lose purchasing power on that money for ten years in exchange for the government’s “risk free” promise to return your nominal investment at the end.
Crazy can stay crazy for a long time.
So what does Lichtenfeld think we should do to make money when this crisis happens? He mentions a couple of the standard ideas that we hear touted a lot, including the short treasury ETFs (like TBT or SHV), but he also says that he has a spread play that he thinks is even better. Here’s how he describes it:
“The Perfect Way to Play the Debt Bubble – Revealed
“I’m not talking about stocks or options, or even some kind of exotic bond play.
“I can almost guarantee you’ve never even heard of this unusual investment.
“They are extremely rare. Yet you can now find them listed in a tiny niche on the New York Stock Exchange.
“They’re called spread trusts.
“They’re generating millions for some of the world’s richest investors already. But very soon, the Three-Minute Event will hit. The spread between short- and long-term rates will explode. And these income-producing investments could easily double or triple in value… while spinning off huge, double-digit income along the way.”
OK, so double digit income sounds nice. As does “exploding in value.” So what are these things? No, they’re not really called “spread trusts” by anyone else … the deep dark secret is that they’re called … wait for it … Mortgage REITs.
Oh, these again.
Lichtenfeld describes them like this:
“These trusts make money by playing the spread. The wider the spread goes, the more money they make.
“Here’s how they work…
“First, they borrow money at short-term rates, which track the Fed Funds rate. (Bernanke has promised to keep these rates at the “zero bound” through 2015.)
“Second, they turn around and lend that money out at long-term rates (which track the 10-year Treasury rate)…
“So, for example, you take out a 30-day loan of $10 billion… at 1% interest.
“Then you turn around and lend that $10 billon out, collecting 5% interest… for three years.
“Along the way, you pocket the “spread” between the two rates… every year!
“With short-term rates at the zero bound, spread trusts are making a killing.
“And when long-term rates start soaring, they stand to make even more.”
And that’s more or less true, thought that last sentence is more troublesome … and there is certainly risk in these investments.
Mortgage REITs and similar leveraged investment pools got crushed during the financial crisis not so much because of the spread in interest rates changing (long rates fell fast even as short rates fell, but short rates were low enough already that the spread between the two tightened at times, meaning less room for profit), but because they rely on rolling over those short-term investments. They have to be able to keep borrowing that short-term money to fund the long-term bonds they’re buying.
Which means there are more moving parts to these portfolio managers than just “spread goes up, we make money” — they all have slightly different strategies and portfolios, but at heart they are leveraged pools of mortgage bonds (most of the difference comes in what kinds of bonds they invest in — fixed vs. adjustable, or govt. guaranteed vs. private, or commercial vs. residential, etc., and in how much leverage they use).
So if interest rates spike up on the long end much faster than they do on the low end, they can buy higher-earning bonds and earn more — but book value should be expected to fall, because the bonds they hold suddenly become less valuable, which means that unless they hold them to maturity they have to sell them at a capital loss when they’re rolling over the portfolio to buy the next bond. On the flip side, rising rates mean less refinancing, so they don’t lose money when folks refinance their mortgage before the lender has had a chance to hold it long enough to make it profitable.
That means the book value of these mortgage REITs can certainly bump around a lot, which can mean the stock price fluctuates a lot … but many of them have certainly done quite well, paying out massive dividends over time thanks to their borrow short/lend long leverage. Of course, Mortgage REITs didn’t exist the last time we had a real long-term rising rate environment, so I’m not sure what will happen if we’re going to see interest rates return to the 1960s-1970s levels and spike up with real inflation — but Annaly (NLY), the Godfather of the modern mortgage REITs, did see relatively decent and smooth performance (as long as you look very long term, maybe standing back from the chart a few feet and squinting a little) during the mid-2000s when 10-year interest rates (and mortgage rates) did climb a bit.
So I think there’s probably more uncertainty with what happens to Mortgage REITs in a rising rate environment, but as long as it’s gradual the best of them ought to be able to cope — particularly if the Fed keeps short term rates very low and continues to keep the market awash in liquidity, which will at least theoretically enable folks like the mortgage REITs to continue to get easy and cheap short term refinancing even if the value of their portfolio (those long bonds that are worth less when rates rise) is gradually dropping.
I don’t know if they’ll be able to continue to pay out 11% yields forever, but they can certainly do it right now. And I don’t mean to pick on just Annaly, since I don’t know if that’s the one Lichtenfeld is touting, but they have also cut the dividend many times over the years — it rises and falls as their performance does, so you can’t compare these to the steadier dividend growers or “dividend aristocrats” … they have higher yields than most stocks because folks are at least a bit nervous about them.
Which of the mortgage REITs is Lichtenfeld touting this time? He does provide a few clues, though they’re limited:
“Spread Trust Bonanza #1: This East Coast spread trust is currently paying 15%-plus dividends. It deals only in government-backed securities. During the most recent three-year reporting period, it has exploded cash flows from $2.5 billion to nearly $40 billion… an increase of 1,468%!”
Not enough clues to be 100% certain on this one, but the Thinkolator comes in with a pretty high degree of certainty in saying this is American Capital Agency Corp (AGNC). It does indeed yield 15%, you can make those cash flow numbers fit with the filings, and it holds only government guaranteed securities — which doesn’t help with interest rate risk, but it does get rid of the threat of default (I suppose opinions could differ on that).
It’s also one of the larger mortgage REITs, with a market cap of around $10 billion — which I think puts them second only to Annaly (NLY) in size. Though do keep in mind, the equity in these companies is very, very small — they are primarily debt spread players, so the lever up tremendously with that short-term money and turn that $10 billion in equity into a portfolio of $85 billion in bonds.
What’s the next one?
“Spread Trust Bonanza #2: Vanguard Group… BlackRock… T. Rowe Price… All are quietly starting to pile money into this Southern trust. It yields over 10% already, and it’s poised to spin off huge capital gains in the coming months. In just three years, cash flows have more than tripled, from $2.7 billion to $7.8 billion…”
Well, we’re forced to do a bit more of a guess here … but the best guess from the Thinkolator is that this is probably Hatteras Financial (HTS). Is “Southern”, you can make those cash flow numbers fit, and the institutional ownership, including from those big fund families, has risen lately (they have higher institutional ownership than the really big mREITs like NLY and AGNC). I don’t know the HTS management strategy, but they’re even a bit more levered than the big guys with debt at 10X equity, and they do carry roughly a 10% yield right now.
“Spread Trust Bonanza #3: Our ‘swing for the fences’ spread trust has exploded its dividend payouts… for five years running. Cash flows have soared for three straight years, to more than $1.3 billion. But this little trust could double or triple very fast…”
Well … this one I don’t know and don’t want to hazard a guess. From what I can tell by looking through all the significant mortgage REITs, there are no standard mortgage REITs that have consistently raised their dividend for five years in a row, almost all of them have had to cut their dividends … and most of them cut dividends not just during and following the financial crisis, but also more recently. So if you’ve got a guess about this “spread trust” that Lichtenfeld says is a “Swing for the fences”, well, fell free to toss it out with a comment below — I suspect that it’s not a standard mortgage REIT, but beyond that I don’t know.
So there you have it — we’ll look at the cancer drug he teases in a different piece, since he pitched that as one of the ideas in this “Three Minute Event” teaser ad, but it sounds like his favorite play on rising long term rates is a bet that long term rates and short term rates will both rise in a way that enables the mortgage REITs to profit enough from the spread that they can handle the depleting book value as their portfolios become less valuable. I’m less confident than he is in that playing out so nicely for mortgage REITs, but with yields mostly in the 10-15% neighborhood it’s clear that investors are being awfully cautious about mREITs anyway. My concern is probably a little more mainstream than his optimism — which would mean that you might have a better chance of beating the market if you listen to him, since betting on the same outcome that everyone else is betting on is rarely profitable.
There are lots of other folks who’ve touted mortgage REITs over the years, and some who are publicly still saying good things about them — Steve Sjuggerud comes to mind, I’m pretty sure he’s still positive about Annaly as one good example of what he has been fond of calling “Virtual Banks,” though probably every adviser and pundit has different things they’re looking for as warnings for when it might be time to get out of these high yielders. With my personal worries about future fluctuations in interest rates, and perhaps rapid ones, I’m not comfortable enough to own any of them personally right now — but that’s been true for quite a long time for me, so I’ve missed some nice hefty dividends.
If you’d like more background on mortgage REITs, there’s a good piece from the Wall Street Journal here that provides a nice quick overview of the current situation.