Double Digit Profits From Quantitative Easing
Ken is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Quantitative easing (QE) is a term with which many American adults may be familiar, but might not really understand what it is and how it can impact them.
What is QE and its effect?
QE, as it's applied today, is the action being taken by the Federal Reserve Bank (the Fed) to buy large portions of new debt being issued by the Treasury Department to finance the government’s deficit spending. The effect of this practice is to keep short-term interest rates low by diminishing the supply of government notes available to investors in the public market. At the consumer level, low short-term interest rates mainly affect the interest paid to customers on bank deposits and CD’s. At the commercial level, it determines what banks pay for the money they borrow to conduct ongoing operations. QE is nothing more than the government creating conditions that allow banks to obtain funds for lending at a lower cost.
Why should you care and what should you do?
You should care about QE and its impact on interest rates because it reduces what you will earn on your basic savings. You should also care because it creates the opportunity for certain entities to profit enormously by borrowing money at a low cost and lending it at much higher rates. You can become angry and let emotion drive your reaction, or you can simply position yourself to profit from a situation over which you have no control by purchasing shares in institutions that will benefit the most from this practice. After all, if a bank can borrow money for 0.5% per year and loan it out at 4%-8% per year, it's making profit of 3.5%-7.5% on every dollar it loans. Unfortunately, out of that profit, banks must also cover the losses from those borrowers who default on their payments, thus reducing the banks’ profits. But, what if you could find a way to eliminate the risk of default and still charge the same interest rate?
Big government to the rescue
There's one category of lending within which the government is so anxious to ensure activity that it's willing to guarantee lenders will never experience losses. That area is the home mortgage industry. As of December 2012, Propublica.org reported that 90% of all home mortgages originated in the United States are guaranteed by the U.S. government (read taxpayers). Did you know that you're on the hook for 90% of the mortgages being issued if the borrowers default? Don’t get mad because that will accomplish nothing. Analyze the situation and position yourself to profit from it.
There are businesses that are built around taking advantage of the low borrowing rates available in the short-term market and using that money to buy home mortgages that are guaranteed by the federal government. Best of all for investors, they can borrow five to six times as much as the actual amount of capital they have.
Don't get angry, make a profit
There's a category of investments called mortgage REITs that exist for the purpose of borrowing money at low short-term rates and using it to buy mortgages guaranteed by the federal government that pay higher long-term rates. But, they apply leverage to borrowing and lending practices and can generate returns that are five to six times higher than the existing spread between short and long-term rates. The mortgages that are guaranteed by the government are called agency-backed mortgages.
How do you take advantage?
I've identified four businesses engaged in this segment of the mortgage industry, all of which pay dividend yields between 10.64% and 14.67%. They are Annaly Capital Management (NYSE: NLY), Two Harbors (NYSE: TWO), Arlington Asset Investment (NYSE: AI), and New York Mortgage Trust (NASDAQ: NYMT). The table below shows some key fundamental information regarding the valuations of each one.
Why invest your money here?
Annaly and Arlington only invest in agency-backed mortgages whose principle and interest are guaranteed by the federal government. This means that the government carries virtually all of the risk. These businesses borrow money at current short-term interest rates, currently under 1%, and use it to buy these government-insured mortgages at rates between 3.5% and 4.5%. While a difference of 3% to 4% between borrowing costs and interest earned doesn't sound like much, these entities can borrow five to six times the level of their actual capital, which multiplies their return by that amount. In other words, rather than making 2.5% to 3.5% on available funds, the leverage they employ through borrowing allows them to multiply those returns five to six-fold! Because these businesses require virtually no infrastructure or physical facilities and very few employees to operate, almost all of this leveraged spread is income. Best of all, these businesses are structured as real estate investment trusts, so they're required to pay out almost all of their earnings in dividends to shareholders in exchange for not paying corporate income taxes.
Two Harbors and NY Mortgage Trust are structured the same way, but have some of their capital invested in non-agency mortgages. These are mortgages that collect a higher rate of interest, but are not fully guaranteed by the government. This puts a bit more risk into these businesses. As long as the spread between short-term and long-term interest rates remains above 2.5%, these investments should continue to do very well and pay attractive dividends.
Conclusions and actions
When large numbers of yield-starved investors begin to discover the reality of this opportunity, the prices of these shares will soar as demand outstrips supply. For investors looking for high-yield income-producing stocks with almost no risk, Annaly and Arlington fit the bill perfectly. Arlington further benefits from a price to book of 0.74 against assets guaranteed by the government. The exposure to some mortgage obligations that aren't fully government-backed gives Two Harbors and New York Mortgage Trust a bit more risk.
Annaly and Arlington will both remain attractive investments until the spread between long and short-term rates begins to shrink. Investors will need to watch for a decrease in the interest rate spread, but that should be some time in coming and those who watch for it will have ample time to react. Buy now and collect large profits from quantitative easing, whether you agree with the policy or not.
Ken McGaha has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!