News Analysis date published New: 
Monday, June 25, 2012 - 11:30
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Monday, June 25, 2012 - 11:36
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Monday, June 25, 2012 - 11:30

The Closest Thing to "Free Money" I've Ever Seen

Monday, June 25, 2012 11:30 AM

I have a deal for you. I am willing to lend you funds at around a quarter of a percent for a short term, say a month. I will not raise the rate each time you come back to take out a new loan and I will not interfere with how you use the funds.

The only thing I ask in return... well, I won't ask anything in return. It's pretty close to free money. Deal?

The Federal Reserve extended this offer to a select group of investment companies and has guaranteed its continuance with its most recent policy meeting. The central bank lowered its growth and inflation estimates for the U.S. economy, meaning that rock-bottom rates are here to stay until well into 2014. Also importantly, the Fed will continue to reinvest its incoming funds into mortgage-backed securities (MBS), which will help support the housing market.

It's a great deal if you can get it -- and you can!

Not directly of course, unless you have an inside track to Bernanke & friends at the Federal Reserve, but you can participate through shares of mortgage real estate investment trusts (mREITs).

mREITs: Making money the easy way
These companies borrow money backed by their assets at a one-month rate of around 0.29%, and then invest the loan in higher-yielding mortgage securities, usually paying around 2.6%. Now this spread of 2.3% is not so enticing until you understand that mREITs use leverage to borrow between seven and 10 times the amount of assets they possess. This can allow a $10 billion company to collect $2.3 billion in interest income, a 23% return.

In addition to the great rate on funding, these companies are exempt from federal taxes as long as they pay out at least 90% of income to stockholders.

With a stabilizing housing market and little growth elsewhere in the economy, mortgage-backed securities are receiving a lot of attention. Especially from some of the smartest investors in the world. PIMCO's bond guru, Bill Gross, borrowed a record $88 billion in January to bet on MBS, which is now 54% of his flagship Total Return Fund. Warren Buffett and Fortress Investment Group are at odds over who will buy Residential Capital's mortgage portfolio when it goes to auction.

With a high safety of capital and a great income return, these next two mREITs are two of the biggest holdings in my portfolio right now.

1. Annaly Capital Management (NYSE: NLY) is the benchmark against which most mREIT investments are judged. The largest mREIT out there, Annaly only invests in agency mortgages. These are backed by a guarantee from government-sponsored enterprises Fannie Mae and Freddie Mac, which means that credit risk is almost entirely removed. The shares pay a dividend yield of 13%, and the stock itself has gone up an average of 3% a year for the past three years.

Annaly is one of the most conservative choices, only leveraging its equity by about six times. This will allow the company to maintain or increase its dividend by taking on more leverage, even if interest rate spreads decrease.

2. Two Harbors Investment Corp. (NYSE: TWO) pays a dividend yield just over 15% and the stock has gone up about 2.3% a year since trading began in 2009. Unlike Annaly, Two Harbors invests in non-agency mortgages as well, which pay a higher interest rate but also include some credit risk. The company's leverage ratio is extremely low at just 4.2 times and makes the shares safer than peers. Book value increased 7% in the first quarter, and even with an 11% increase in price, the stock trades for just 1.1 times book value.

Risks to Consider: Unfortunately, free money does not come without risk. With the high amount of leverage, if interest rates were to jump quickly, these companies could face margin calls and have trouble raising money.

Also, the SEC is looking at REITs to see if they should retain their ability to use unlimited leverage without regulatory oversight. With these companies becoming an increasingly large part of the mortgage market, some people fear that a collapse would pose a systemic risk to the economy. While headline risk is possible, I doubt mREITs will ultimately face any real scrutiny. As the government looks to get out of the mortgage business, reducing its mortgage holdings in Fannie and Freddie, the industry will need to pick up the slack. This will be compounded when the Fed eventually unwinds its trillion dollars in mortgage holdings.

Action to take --> The profit model for mortgage REITs is alive and well for the next couple of years. Even as rates increase, possibly in 2014, these companies should provide a good income yield. Still, overall portfolio exposure probably should not be higher than around 40% of your overall fixed-income allocation.

Joseph Hogue owns shares of TWO, NLY.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.