How to Profit from Fannie's Troubles

If the government takes over Fannie Mae and Freddie Mac, shareholders will be wiped out...

But I've found a nifty investment that could profit handsomely from the takeover. Better yet, it's a win-win investment for you. Even if the government doesn't take over Fannie and Freddie, you can still make a lot of money here. Let me explain...

Earlier this year, U.S. Treasury Secretary Hank Paulson "virtually guaranteed" the debt of Fannie Mae and Freddie Mac. In essence (though not specifically), he said shareholders are not protected... but bondholders are.

Paulson's position makes sense politically... You see, countries like China and oil-producing nations hold huge piles of Fannie Mae and Freddie Mac debt. To save face on the international stage, Paulson vowed – with the might of the U.S. Treasury behind him – those bonds are good.

So the play for us is in stocks like Annaly Capital Management (NLY)...

You see, Annaly only holds bonds guaranteed by government-sponsored entities like Fannie and Freddie. And Annaly has weathered the financial storm just fine...

Take a look at the company's dividends. By law, Annaly must distribute nearly all of its earnings directly to shareholders. So if Annaly had any trouble, it'd appear in the dividends. But what do we see? Annaly's dividends increased every single quarter of the credit crunch:

While the Citigroups of the world were gasping for air, drastically cutting their dividends – if not suspending them altogether – Annaly was increasing its dividend.

Truth be told, the credit crunch is actually good for companies like Annaly...

Annaly makes money on "the spread." It borrows money at one rate and invests it at another rate... hopefully a higher one.

Right now, that spread is awesome... The Fed has cut short-term rates to 2%. Annaly borrows at close to that rate. Meanwhile, Fannie and Freddie bonds, which Annaly holds, are yielding closer to 5% – a full three percentage points higher than the fed funds rate!

Annaly can't quite capture all that. But it can capture a two-percentage-point spread out of it. (At least that's the spread it was earning at the end of its most recent quarter.) The last time Annaly saw spreads like that was late 2001 to late 2003. Between capital gains and dividends, investors made safe, easy, triple-digit returns in Annaly.

Right now, Annaly uses seven times leverage. So if you multiply that seven times the 2% spread, Annaly is earning a 14% return on equity (this math is rough, but you get the basic idea).

Traditionally, Annaly's only traded close to its book value when there has been no spread to earn, like in late 2000 and late 2005. But now, it's trading close to book value. So it should be able to cover a 14% dividend yield. Fourteen percent!

It's so cheap now because people were worried about Fannie and Freddie. I think, with Treasury Secretary Paulson's guarantee, Annaly should be OK. Stockholders of Fannie and Freddie may be in trouble. But bondholders (like Annaly) are fine.

Surprisingly, we don't have a real defined uptrend here yet. So it's possible I'm missing something. But here's the way I see it...

If the government takes over Fannie and Freddie, that will reassure investors. It'll cause the interest rates on those bonds to fall, and Annaly will have an instant capital gain in its portfolio.

If the government doesn't take 'em over, you earn a safe 14% dividend. That's worth considering to me!

Good investing,