Jim Nelson

For the first time since the Enron debacle, Americans finally joined hands to hate something worthwhile. Instead of worrying about the Ten Commandments on a courthouse’s steps or a Super Bowl halftime show’s costume malfunction, we had a legitimate outcry from America’s poorest 95%. AIG was greedy and people got pissed. Some even took to the streets. Hell, we even got a congressman to condone suicide for these dirtbags.

At the time, I got excited. I thought real action was coming. Unfortunately, my initial prejudice against fellow Americans held up. They are lazy, gullible, and apathetic. If I touched a nerve there, prove me wrong. I’m about to show you a significant flaw that has already made a small group of people serious money. If you want in, it’s time to man up.

Further Perversion of MBS Ridiculousness

So far, the U.S. government has piled up more than $2 trillion worth of debt to finance bailouts for banks, insurance companies and even the struggling auto industry. And unless you are the CEO of one of these companies or worth enough to make sweetheart deals like Warren Buffett, you haven’t received a dime of this money. That’s all right, because the government’s overreaction to this recession left an opening for gutsy investors.

As you know, mortgages have been the central problem in today’s economic meltdown. From there, greedy financial product creation boards went crazy. You’d have to be living under a rock not to hear the terms “collateralized debt obligations” and “credit default swaps.” These are the real doozies in today’s market slide.

However, the most important term in today’s financially-minded world is “mortgage-backed securities.” You see, it’s not the mortgages that caused the system to fail. It was the mortgage-backed securities, or MBS. These securities are not a new development in the financial world. In fact, they’ve been around longer than most of the “too-big-to-fail” banks Washington is bailing out.

During the last Depression, in 1938, President F.D. Roosevelt helped create the National Mortgage Association. Later, the word “federal” was added to the beginning. This organization, now called Fannie Mae, was created to bundle mortgages together and resell them as – you guessed it – mortgage-backed securities.

Wall Street’s further perversion of this already perverted “asset class” is a story for another day. But these “securities” are important today because the actions of the last 9 months of government intervention combined with plenty of MBS ridiculousness created an enormous opportunity for income investors.

You see, 2008 was a tough year for Fannie and her brother, Freddie Mac. Both companies’ shares lost about 98% of their value. The highly incompetent and worryingly scared Bush Administration took them over. In a very important piece of legislation, these two government-sponsored enterprises (GSE) were placed under the authority of the brand-new Federal Housing Finance Agency (FHFA).

In September, the FHFA took extraordinary action by placing Fannie and Freddie into a federal conservatorship. This conservatorship, backed by the U.S. Treasury, was designed to guarantee all GSE-backed securities. This September announcement means that the U.S. Treasury is obligated to pay anyone holding a Fannie- or Freddie-backed MBS. That’s a 100% guarantee by the U.S. Treasury. In a moment, I’ll tell you why this is important…

The Pseudo-Bank Loophole

The financial industry is full of penniless banks, uninsured insurance companies, and toxic assets. But it also includes about five pseudo banks that are in the perfect spot to take advantage of the collapsing market and the U.S. government’s desperate attempts to save it.

These companies are called mortgage real estate investment trusts, or REITs. If someone would’ve come up to me and asked me what I thought about a mortgage REIT a few weeks ago, I’d have laughed at them. But after I did some research, I found a bailout loophole that this small sector uses to make a few people very rich.

These mortgage REITs buy mortgage-backed securities from Fannie, Freddie, and occasionally Ginnie Mae (Government National Mortgage Association) at about a 5% yield. Until Bush’s ridiculous Fannie/Freddie bailout, the only government-backed securities came from Ginnie. Now, after the September conservatorship announcement, Fannie- and Freddie-backed securities are backstopped by the U.S. Treasury. That means whoever holds securities originally bundled by Fannie, Freddie, or Ginnie will get paid.

I can’t stress this enough… Until the U.S. government declares bankruptcy or the Chinese army overtakes Fort Knox, these securities are as safe as Treasury Notes. But here’s where it gets interesting…

Multiplying the Spread for Government-Guaranteed Income

The five (or so) pseudo banks that receive this “government-guaranteed” income from mortgage securities are still financial companies. And what do financial companies do? They leverage the hell out of any debt they can grab.

Here’s how it works:

Mortgage REIT A buys a bunch of government-backed MBS from Fannie. In turn, he receives a AAA+ credit rating because his portfolio is 100% backed by the U.S. government. He takes his credit rating to Lending Banks X, Y and Z. These banks give REIT A a bunch of 90-day, $100 million loans at 2% interest to buy more mortgage securities from Fannie. And we repeat, again and again.

When all is said and done, REIT A is leveraged 6-to-1. Its income comes from the 3% spread between its borrowing rate and the yield on the MBS. Multiply that by its leverage ratio, and REIT A grosses 18%.

Because of an obscure law that publicly traded realty companies cut decades ago, REITs aren’t taxed (so long as they pay shareholders all of their earnings through dividends). Therefore, with everything else equal, REIT A’s shareholders receive an 18% dividend yield.

With interest rates artificially held down by the Fed, and government-supported mortgage yields artificially held high to promote more MBS buying, we get a spread (and thus, income) that’s extremely large. And with these companies required to pay shareholders all of their earnings, we get an extraordinarily large dividend yield.

Finally, because of the mortgage mess, shares of these companies are undervalued. While most financial companies deserve their shares driven into the ground, these mortgage REITs don’t.

Investors with big cojones have already taken advantage of this. The spreads are even larger and safer now. If this is new to you, I suggest you check it out before investors jack shares back up – deflating the dividends’ effect.

Sincerely,
Jim Nelson

April 6, 2009

Jim Nelson

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