The Twelve Days of Christmas: How to Make a Fortune Thanks to the U.S. Government

Editor's note: We don't publish many "prediction" issues at Stansberry & Associates, but we can confidently say 2008 will be the year of the virtual bank. Long-time readers of Steve Sjuggerud's True Wealth know how incredibly safe and profitable these investments can be when the time is right. Steve feels this idea is so big, he's agreed to let us publish his most recent True Wealth commentary on virtual banks. Read on for...

How to Make a Fortune

Thanks to the U.S. Government

Originally published in the September edition of True Wealth

"Steve, your loan is what I call a slam-dunk loan. Sure we'll take it."

– my friend Jim, the CFO of a local bank

I'm buying an old house on the ocean here in Florida...

I wasn't in the market for one... But the thing just came up on the market here at a good price. You don't find lots this size at this price, so I snapped it up. I then called my friend Jim...

"Jim, here's the deal... I have no debt, my current house is paid for, and you know the assets I have. The new place needs some work. So I would like to borrow money for about two years. In two years, I'll sell my existing home and move into the new one after it's been renovated. We'll use the proceeds of selling our old home to pay off the loan from you. Can your bank lend me the money?"

Jim didn't think twice. He called it a "slam-dunk" loan. He knows it really is a no-risk loan for his bank. He's not stupid... He will gladly take the free money from me, in the form of no-risk interest. "You've got the assets. You simply need a bridge loan 'til you move in. No problem at all."

Jim also said: "Steve, I'll do the best I can for you... But as your friend, I recommend you shop around to see how you can do. If you can get a better deal, then go for it."

I took his advice. I called Doug at Bank of America. Apparently, I have Premier Banking status with Bank of America. I'm not sure what that entitles me to, except that Doug politely gives me a call every three months. The call goes something like this:

"How ya doin', Steve? Everything okay? If there's anything we can do for you... you know, if you ever need a loan... let us know."

Doug has called me for years now, trying to lend me money. This time around, I called him. "Doug, I'm buying a place on the ocean. I wanted to get a quote on a mortgage from you."

Doug could hardly contain himself... The day had finally come! I was asking for a "jumbo" mortgage from him! (A jumbo mortgage is a mortgage of more than $417,000. This number is important... because on loans below that amount, banks can easily transfer all their credit risk to government agencies. Above that number, banks can't transfer the risk as easily.)

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It took Doug a while to get back to me. When he did, he was dejected. He quoted me a rate. But he knew it wasn't competitive.

"What's going on?" I asked. "You know what assets I've got... And you know you have no risk with this loan."

"I know Steve... But I was told that we're not doing any jumbo loans now," Doug said. I could tell Doug was more upset than me. He's wanted a loan from me for years. And now, the day that loan lands at his feet, he's not allowed to pick it up and take it.

Think about this for a minute... Bank of America – America's second-largest bank – won't do a slam-dunk loan... It is unbelievable! Bank of America won't do an over-collateralized, no-risk loan.

What's going on? I'll tell you...

Some "suit" in a corner office at Bank of America decided the bank wasn't going to do jumbo loans. Not only that, this suit decided to call in as many loans as possible, regardless of quality. "Simply get out, at any price," the suit told his minions. So Doug, with his head held low, can't do a loan. What business is Doug in again? What business is Bank of America in?

It's not just Bank of America... it's every major financial institution in America. It's like the suits held a convention... and they all decided the same thing: "Call in all loans, period." So, for the last few weeks it's been like someone yelled "fire" in a crowded theater... And in this case, the bankers didn't look for the fire, and they definitely didn't make an orderly move for the exits.

When Bank of America won't do a no-risk loan – when Bank of America won't take free money – the situation on Wall Street is no longer rational.

Meanwhile, my friend Jim – the local bank CFO – is not a "suit in a corner office." He is the opposite of Bank of America. He has fewer than a dozen employees, and he wears a golf shirt to work.

Unlike Bank of America, Jim is willing to take all the free money coming his way. He'll take my no-risk loan. He doesn't have a suit above him, telling him "no loans, no matter what." This bank is his bank. He is a founder and shareholder – and those are important facts because they mean that Jim is risking his own money... and his future. But you know what? He's got free money from me for his bank staring him in the face. He'll take it!

What should you do now? You can play this in two ways...

You can play it like the Bank of Americas out there and join the rush for the exits, trampling the smaller guys doing the same rush, just to make sure you survive.

Or you can sit back and play it like Jim, the local banker. Jim is able to take advantage of the comical behavior of the suits from the big banks and brokers. He is able to take the free money that the big banks are turning away – free money like the interest on my loan.

This month, we've got a few free-money opportunities staring us in the face... Should we act scared like Bank of America? Or should we act like Jim and scoop them up?

 I say we scoop them up!!!

Let me describe the situation now... Imagine that all the U.S. banks and financial institutions are sailing across the Atlantic. Each different company has its own boat. Out of nowhere, the 100-year storm hits. Some smaller, less-prepared boats go under immediately (the smaller, risky mortgage companies). The bigger boats (the Bank of Americas) immediately start battening the hatches.

All the boats know that the storm will end someday and that some boats will survive. We can do our best to determine which boats are best equipped to survive the storm. But the part we can't determine is how long the storm will last. All we know is, it will end!

Since we can't know how long the storm will last, we can't know how much risk to take.

But – you're not going to believe this, but it's true – some boats are protected. No matter what happens, they'll be fine. It's a strange quirk... but some government agencies have guaranteed that some financial firms will have no loss whatsoever.

If you're a long-time subscriber, you know the businesses I'm talking about... They're what I call "virtual banks." Businesses like our recommended Annaly Capital Management (NYSE: NLY)... and like this month's new recommendation.

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 – 100% of what Annaly invests in is guaranteed by government agencies. So, Annaly has no credit risk – the government agencies are stuck with it.

(Splitting hairs... Annaly will tell you it has virtually no credit risk. It says there is an implied guarantee that the government would bail out the government agencies. But there is no explicit backing.)

Of course, Annaly is already on our recommended list. As I write, the shares are up this morning after the Federal Reserve made its surprise cut of the discount rate – the rate at which banks can borrow from the Fed. (Annaly also announced another piece of news... it will be buying stock in what I'd call a "vulture" fund, which swoops in and picks up the loans, like mine, that Bank of America wouldn't take. Annaly's stake will be less than 0.1% of assets and less than 1% of equity, so it's basically meaningless, except you can't say it's 100% guaranteed anymore.)

I am aware of only one decent-sized company that comes close to Annaly in having a guaranteed portfolio... and that is this month's recommendation – MFA Mortgage Investments (NYSE: MFA). And MFA is a much better bargain than Annaly, which trades at a significant premium to its book value. With MFA, you're able to buy in at a discount.

MFA is very similar to Annaly... Roughly 90% of its investments are in guaranteed government-agency securities. The rest are in AAA-rated bonds. Even though MFA has next-to-no credit risk, scared investors marked its share price down from a high near $8 in April to $6 on Wednesday.

In short, Annaly and MFA make money on the spread between short-term interest rates and mortgage rates. Typically, since they're investing risk-free and borrowing risk-free, they only make a small spread – say 0.5% (which is 50 basis points). And since they don't see much risk, they typically use something like 10 times leverage, which brings their returns up to 5%. They both pay out just about all that return in the form of dividends.

The potential returns here can get silly, fast... For example, if the Federal Reserve cuts rates by half a percent, then the spread for these companies widens to roughly 1%. Multiply that by 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 they're paying 15% dividends, then everyone will want to own them, so the share prices could double.

Sounds crazy, but that's what happened between 2000 and 2002... Shareholders in boring Annaly doubled their money.

Even before the Fed cut the discount rate today, and even before things got really bad this week causing mortgage rates to tick higher, MFA was already making good money...

Two weeks ago, on a conference call, MFA CEO Stewart Zimmerman talked about the spreads he's able to earn now. "Recently we've been able to buy certain assets that approach at or about 70 basis points. So we have in fact seen spreads widen. So we have been able to see opportunities, and we've had some powder dry to be able to take advantage of those opportunities."

Like Annaly, MFA is conservative. On that same conference call, the CEO said: "We're not looking to be heroes. We are simply going to continue to do what we've told people we were going to do. Stick with the types of high-quality assets and continue to be lower-leveraged. I think that's going to earn us some very good rewards as we continue to look over what 2007 might incur."

MFA's book value per share was at $7.33 at the end of the second quarter. I expect MFA will trade at a nice premium to book, particularly if spreads start to widen. MFA would soar to $9 a share if it trades at around 1.2 times book. This is not much to ask. I expect it will trade higher than that as this cycle gets going. And while you wait, you'll be collecting dividends of 5%, at worst.

As of noon today, shares of MFA are at $6.80. I am willing to pay up to $9 eventually... But please, use a limit order with this one. The higher the price you pay, the lower your total return will be. Your upside from here is likely up to 1.4 times book value when things are perfect for MFA in the cycle that's just starting for them, plus 5%+ per year in dividends. Today, the Fed is signaling to us that it will be willing to cut interest rates. As those rate cuts come, MFA's dividend yield will soar.

Action to take: Buy shares of MFA Mortgage Investments (NYSE: MFA) up to $9. Use a 25% trailing stop.

Buy MFA now. Make sure you use a limit order, as this stock only has a market value of about $600 million.

Good investing,

Steve Sjuggerud

P.S. For more on a risk-free trial subscription to True Wealth click here. It's easily the best deal you'll ever find in financial publishing.

Editor's note: While MFA Mortgage ticked above Steve's conservative buy-up-to price of $9 last week, investors can still keep an eye on this stock to pick up shares on dips around $9.

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As of 06/25/2013