Mortgage REIT to Profit From Lending Mess

THIS IS THE week we saw lines of bank depositors waiting to find out how much they'd lost. This is the week that started with the Treasury secretary sketching out another hastily assembled bailout, which his blank check/bazooka/fudgesicle most certainly is, even if President Bush can't stomach the word. This is the week that cost the shorts their shorts, thanks to bank earnings that bested dire expectations. Also, the SEC has just made clear that no one better say anything bad about financial stocks, or short them ever again. Finally, oil can now be had for just $130 a barrel. Ain't life grand?

I bring up all these symptoms of our mutual distress because I'm about to end my week in a most unexpected fashion: by recommending a stock tied to the mortgage mess. If you have cash earning next-to-nothing in an IRA and missed the short squeeze of the past two days, you could do much worse than buying Annaly Capital Management (NLY), a real-estate investment trust that buys Freddie Mac (FRE) and Fannie Mae (FNM) debt.

Yeah, I know: debt and housing, Fannie and Freddie — why not just drink some Drano and be done with living? Having managed to escape the brunt of this bear market by conscientiously shunning everything having to do with debt, or money, I hate venturing this far out on a limb. But if the whole tree doesn't topple, the branch should hold. And the potential reward justifies the risk.

I've been mostly bearish for a year now, and my best recent call was probably advice to short consumer spending, a strategy that would have earned 11% since the end of February (and 25% at the market's nadir earlier this week). I don't believe that housing has bottomed. I don't believe America is too big to fail. I just don't believe that it will.

Of course, unless we conquer our many problems in a jiffy, the sheen of prosperity is likely to fade, as loans are repaid — or not repaid. The stock market has acknowledged as much by making stingy CDs look like wise investments, year-to-date. And yet here we have a 15% yielder with pretty good odds of delivering that rate — and no one seems to care. The only way Annaly turns into a bad idea from here if the U.S. government, despite its AAA credit rating and its vast taxation powers, somehow allows the nationwide housing market and the dollar to collapse, or if the Fed lets inflation gallop out of control. I realize that all these are widely discussed worst-case scenarios. And that's precisely why Annaly is so cheap.

Another reason it's cheap is that the REIT has leveraged less than $7 billion in equity with $51 billion in mostly short-term debt. The leverage helps Annaly profit on the margin spread between borrowings in the repo market backed by Treasury bills and investments in the higher yielding agency (i.e., Fannie and Freddie) debt. But leverage isn't such a good idea if the market goes against you. Carlyle Capital had to be liquidated in March during a selloff in just such paper when it couldn't meet its margin calls. Of course, Carlyle was leveraged a greedy 31-to-1. Annaly, on the other hand, is at 8-to-1 and limits itself to 12-to-1 under the most aggressive scenario. And while it's conceivable that Fannie and Freddie debt could lose just enough value to annihilate Annaly without bringing on a financial apocalypse, that doesn't seem very likely, especially now.

When Carlyle went bad, agency debt was selling off because it was feared that hard-pressed Wall Street banks, unable to sell what they most wanted to be rid off, would begin dumping what they could, namely Fannie and Freddie notes. That threat receded once the Fed opened its discount window and offered to park some of the junk debt on its own balance sheet. More recently, Annaly and several competitors have sold off on fears that Fannie and Freddie would somehow lose access to the global credit markets, and thereby run out of liquidity. The Paulson fudgesicle suggests that won't happen either.

Ironically, the same doubts about Fannie and Freddie that have run down Annaly's share price figure to make the REIT more profitable in the near future. With spreads between agency debt and comparable Treasurys near historic highs, Annaly's margin has been getting fatter. Net interest spread, the difference between what Annaly earns in interest and what it pays, rose from 0.58% in the first quarter of last year, to 0.88% at the end of last year and 1.46% in the first quarter of 2008. "We expect earnings to accelerate materially in 2008 as NLY's portfolio and balance sheet are ideally positioned, in our view, to benefit from the current interest rate and mortgage environment," predicted Standard & Poor's in a recent report. S&P rates the shares a Buy.

I agree. Annaly is everything that most financials are not. Its balance sheet is transparent, liquid and reflective of its core mission and strategy. It employs less leverage than most rivals. Most crucially, its results aren't dependent on things getting better — Annaly will be fine as long as they don't go to pieces. In this economy, a 15% current yield on a balance sheet made up of debt the government can't let default looks like a bigger bargain than anything they have at Sam's Club.

I especially like NLY for Roth individual retirement accounts, where the combination of its status as a REIT and the Roth's privileged tax status produces that rare stream of income not taxed at either end.

So, to recap, the government chooses to pay extra, in a roundabout way, through Freddie Mac and Fannie Mae, for pretending that it doesn't have a central role in the housing market. The extra percentage point or so of yield to perpetuate this fiction accrues to the Central Bank of the People's Republic of China, and to trusts like Annaly. And if you siphon some of this hypocrisy tax into a Roth, you don't even have to pay taxes on it. Is this a great country, or what?

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