One of the Best Contrarian Bets of 2008

I used to argue with bond traders for a living...

I worked as an accountant at Citigroup for four years. I worked with dozens of different equity traders, bond traders, futures traders, and currency traders during that time. I analyzed their portfolios – or "books" – for them.

I had only one job to do: Figure out how much money each trader had made or lost the day before and report that number to management.

Every morning at 8 a.m., I'd download their portfolios onto a spreadsheet and spend the next 10 hours crunching the trades. When I'd finished, I took my work to the trading desk and asked them to "sign off" on their profits and losses.

Calculating the daily profit movements in these books was a nightmare. For a start, the books had as many as 10,000 open trades. Also, most traders filled their portfolios with exotic bond derivatives that were awkward to value.

As a result, the daily profits and losses took wild swings. One day, a trader would lose $1 million. The next day, he'd make it all back again. The volatility made it difficult to agree on the numbers with the traders at the end of the day. Of course, they only complained about the losses.

Most of the books were a struggle. But the one book I loved to work on belonged to a trader named Lawrence.

Lawrence's portfolio took me about five minutes to prepare each day. I never needed any extra backup. And Lawrence never argued with me over the final tally.

Lawrence ran the "corporate" book at Citigroup. His strategy was simple. He collected tens of thousands of loans made to American corporations, bundled them together in one portfolio, and collected the interest. That's it. No futures, swaps, or complicated credit derivatives.

Lawrence's portfolio made the same profit every day... about $30,000. There was no volatility, no surprises, and no arguments. His book always generated about $30,000... every day. On Mondays, the profit would triple... to $90,000... because Lawrence's book even cranked out profit over the weekend.

Collecting thousands of loans and bundling them all together is one of the secrets to finance. The diversification eliminates the risk without hurting the return.

Think about this: Lawrence held Enron and WorldCom bonds in his portfolio when both companies collapsed. What happened to his portfolio? Absolutely nothing. The positions were so small as a percentage of the total portfolio, I couldn't even tell they'd blown up from the numbers.

Normally, regular investors like you and me can't invest in these bank loans. Only huge institutions, such as Citigroup, have access to this market. But I've found a way for us to get in...

Every company needs to borrow money at one time or another. But to get your loan, you have to convince the bank you will pay it back. The best way to convince lenders is to show them your excellent credit rating from a credit-rating agency such as Fitch or Moody's.

However, not every company can have an excellent credit rating from an agency. So companies provide collateral instead. They call loans backed by collateral "secured" loans. When a company pledges valuable collateral against a loan, the bank will be happy to lend because it has cover if a company can't pay the loan back.

Seniority is another way to convince a bank to lend you money. By giving a loan seniority, you're telling the bank that you'll pay the loan back to the bank before anyone else receives your money. Would you lend to a person that already owed money to 10 other people? Probably not. But if that person signed a contract guaranteeing you'd be the first person paid back and no one else would get a penny before your loan was repaid in full, then you might accept. This is a senior loan. Companies pay off their senior loans first.

According to S&P's Leveraged Lending Review for the third quarter of 2007, the 12-month default rate in the senior secured loan market is 0.55%. So far this year, only two companies in America – Movie Galley and Pope & Talbot – have defaulted on senior secured loans.

The last three months have been the worst three months for the banking industry since the Great Depression. The problem started when housing prices started to fall, and some homeowners defaulted on their mortgage payments. Financial firms and hedge funds owned these mortgages. To increase the size of their positions – and their returns – these financial firms had borrowed trillions of dollars from Wall Street banks.

When the banks realized what was happening in the housing market, they stopped financing these leveraged-mortgage speculations. They called in their loans. It was like removing oil from an engine and watching the gears grind to a halt.

To pay back the money to the banks, these firms had to sell off pieces of their portfolios. Problem was, everyone ran for the door at the same time, and prices collapsed... even though nothing was necessarily wrong with the underlying assets. In fact, they had to sell some of their best holdings.

Today, investors can buy these best holdings through senior secured loan ETFs like the ones I described in the December 19 DailyWealth. Most are offering these valuable assets for 91 cents on the dollar.

You get an even better deal when you can pick one up for a substantial discount to its net asset value. I think if you jump on this idea right now, you'll make close to 10% yields on one of the best contrarian bets of 2008.

Good investing,