How to Profit in the New Credit Crunch

I can't believe it...

The new credit crunch is here. It just arrived. And unfortunately, this time it's even worse than what we saw in mid-August of 2007.

That means it's really bad now, as mid-August 2007 was downright terrible...

Back then, the U.S. banking system nearly seized up... Big banks decided they just wouldn't lend money – regardless of credit quality or the interest rate they could charge. Even worse, they called in loans they had already made... even the rock solid, AAA loans. So the market prices for bundles of super-safe loans crashed.

The crazy part was, these super-safe loans were fine. The recent history of the share price of Thornburg Mortgage tells the story... Thornburg crashed in August of 2007. Then it nearly doubled. Now, in a sign of the return of the credit crunch, it crashed again yesterday, to new lows.

I am shocked. Thornburg hardly takes any credit risk, and hardly has any loan losses. It makes safe home loans to rich people. And it buys AAA-rated bundles of loans.

When the credit crunch hit back in August, panicked investment banks that lent Thornburg money demanded their collateral back immediately.

The company was forced to sell $22 billion worth of good-quality mortgages at a loss, to satisfy panicked creditors. The total loss was $1.1 billion on those mortgages. These were good loans! But the investment banks forced the company to sell at any price, demanding their collateral back immediately.

At a conference in late 2007, the CEO of Thornburg explained how the company survived it all... The worst financial market storm it had faced in its 15 years. And he explained how it fortified its defenses after that crisis. It has become more conservative, by dramatically reducing its leverage. The CEO said the company "can withstand a shock three times worse than the August storm."

As the August crisis passed and banks came to their senses, shares of Thornburg nearly doubled to $14 by last month. As recently as Thursday of last week, the CEO of Thornburg said on Bloomberg that the company will be profitable in the first quarter (now), and for the balance of 2008.

Then bang... The investment banks started demanding their collateral back again, at any price. Once again, Thornburg is forced to sell high-quality assets, at a fire-sale price.

What's going on? The credit crunch that clobbered Thornburg in the first place has returned. Surprisingly – and unfortunately – it's worse than before. When I say it's worse, I mean that prices on bundles of quality mortgages are lower today than they were in August of 2007. And the "spreads" between the interest rates they pay and safe Treasury bonds are higher. It's worse!

I can't believe myself. While I think businesses like this should be fine once the storm passes, we can't know right now if they'll even survive the storm. Mortgage companies and banks – which have both leverage and exposure to real estate – are in a purgatory right now.

While those with leverage and real estate exposure will suffer, I expect one group will do well... the Business Development Companies (BDCs). By charter, these companies can't have more debt than equity. And they usually don't have much exposure to real estate.

Since banks are afraid to lend, BDCs have more opportunity – and they can charge a higher rate of interest.

I wrote about BDCs last week. They're incredibly cheap. And they're positioned as the best risk-to-reward bet you can make right now.

The new credit crisis is here. The best way to participate is to buy the companies that can finance America... yet have no leverage or real estate exposure. That's the BDCs!

Check 'em out, if you haven't already.

Good investing,

Steve