The Most Direct Play on the Fed's Rate Cut
By Dr. Steve Sjuggerud
September 20, 2007
Oh boy... It's finally arrived...
"Virtual bank" season is here again. I'm excited, as it takes years for it to come around. But it just arrived, thanks to the rate cut by the Federal Reserve.
The last time we entered virtual bank season, shares of Annaly (NLY) brought home a triple-digit total return. It looks like it could happen again.
In last month's issue of True Wealth, I called shares of Annaly a "strong buy." When I wrote that, the shares of Annaly closed at $14.03. Now, they're at $16.40. That's a 17% gain in a little more than a month. There's more upside to come in virtual banks...
Like traditional banks, Annaly borrows money at a low rate and reinvests it at a higher rate. That's all it does. But Annaly does a few key things that are completely different from traditional banks...
First of all, Annaly has no storefront. You can't walk in and get a loan from Annaly – there's nowhere to walk into. Second – and this is the important part – Annaly only buys in 100% government agency-guaranteed investments. So, Annaly has no credit risk – the government agencies are stuck with it...
Virtual banks like Annaly make money on the spread between short-term interest rates and mortgage rates. When they're investing risk-free and borrowing risk-free, they only make a small spread – say 0.5%, or 50 basis points. But they use something like 10 times leverage. That gives them total returns of up to 5%. And they distribute most of their returns as dividend payments.
While 5% doesn't sound exciting, the potential returns here can get silly, fast... For example, since the Federal Reserve cuts rates by half a percent, the spread for these companies widens to roughly 1%. Multiply that times 10, and they're paying 10% dividends. If banks are afraid to lend and mortgage rates rise by 0.5% as well, then they're paying 15% dividends.
And if the Fed cuts rates by 0.5% again, then they're paying 20% dividends. Once they're paying huge dividends, then everyone will want to own them, so the share prices could double.
My friend, with the first rate cut from the Federal Reserve, we're on our way.
It's virtual bank season again. If the Fed keeps cutting, then the returns these stocks can make will be comical, just like they were in 2000 to 2002.
When the cycle is right for virtual banks, you really want to own these things. And the cycle is right now... Get on board.
Good investing,
Steve
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