Take The Government To The Cleaners
by Tom Dyson
July 20, 2006

“I agree with the idea in principle, but we can’t wait a generation for our investments to pay off. We need income now…”

I gave a speech to a small group of private investors in London the other day. Many of them were approaching retirement age. Their stocks pay meager dividends, they told me, interest rates are terrible and they don’t have time to buy and hold. They wanted to know what to do with their savings to earn money now.

I suggested an idea to the group that Steve Sjuggerud calls, “taking the government to the cleaners.”

A warning: this play is seasonal. It doesn’t work all the time. Right now, it won’t work. But it could start working anytime. That’s why you need to know about this, because when the conditions are right, you can make 20-40% returns on your money in a year, safely.

Here’s how it works:

The government wants every American family to have access to affordable homeownership. It’s the basis of prosperity, they say, and a symbol of the American Dream. So they provide tax incentives and cheap loans to low- and middle-income families.

Corporations like Fannie Mae and Freddie Mac are one of the tools they use to push this agenda. With the government’s sponsorship - and using the retail banking network as a conduit - these firms own the vast majority of American mortgages. They take these mortgages, package them together into huge portfolios, and sell them into the market as mortgage bonds.

The important point is that these mortgage bonds are considered risk free. They are underwritten by giant enterprises and backed by the government. They cannot default. The government takes all the risk.

Thing is, you’re not going to make the 40% returns I promised buying a risk-free mortgage bond... you’ll make more like 6% at today’s rates.

So how do we do it? We buy stock in companies that specialize in this business. They’re called “mortgage REITs.”

Mortgage REITs borrow money from Wall Street and invest the funds in mortgage bonds. Because they use their risk-free bond portfolios as collateral against the loans, Wall Street gives them great low interest rates. Here’s a hypothetical example:

Mortgage REIT XYZ has $100 million dollars in assets. They borrow another $900 million from Wall Street at 2%. Then they invest the full sum - $1 billion – in 5% risk-free mortgage bonds.

This business is very efficient. They are no expensive office leases, payroll expenses or overheads. XYZ receives $50 million a year income from their portfolio and pay $20 million on the loan, leaving profits of around $30 million to pay back to shareholders.

It’s as simple as that. For a firm with $100 million in assets, that’s a 30% return on capital. 

Ah – I’m sure you see the problem here. The profitability of this business is entirely dependent on the spread between the rates they earn and rates they pay to borrow the money.

Right now, loan costs are around 4.4%, while mortgage bonds only pay 4.8%. The two rates are very close to each other and mortgage REITs are not making any money. Due to the thin spread, some of the mortgage REIT stock prices we monitor have fallen 30-50% in the last 18 months.

At other times, this spread can get wide enough to drive a truck through - like it was in 2002. Not only do you make great dividend income – often higher than 10% - but stock prices go up as other investors discover the opportunity.

It’s not time to invest in these companies yet. But the spread is turning around. If it can climb above 1% – and stay there – we’ll buy stock in mortgage REITs for an easy double-digit dividend and plenty of upside in the stock price...

It’s the perfect play for income-conscious investors… and we’ll let you know when it’s time to buy.

Good investing,

Tom   

Editor's note: Tom Dyson is a regular contributor to DailyWealth, a free investment newsletter focused on the world's best contrarian opportunities. We write with a simple belief in mind: You don't have to take big risks to make big money with your investments.

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