Mortgage Bonds - How To Make 19% Dividends From Bonds

Last week, I told my 12% Letter readers to invest in mortgage bonds. I can just imagine their reaction when they read my advice…

“Tom, you want me to invest in mortgages?! Are you crazy? Aren’t they the terrible investments that have been causing problems for banks and the economy in general?”

Well… Yes, that’s true. Between 2002 and 2008, Wall Street’s real estate machine cranked out $5 trillion of these mortgage bonds and sold them to investors all around the world. (For perspective, the total market cap of the S and P 500 is only $10 trillion.)

Wall Street firms thought these mortgage bonds were excellent investments too. Firms like AIG, Bear Stearns, Lehman, and Fannie Mae kept billions for themselves. Then the housing bubble popped, homeowners stopped making their mortgage payments, mortgage values collapsed, these bonds crashed, and it wiped out Wall Street.

So what exactly is a mortgage bond?

Specifically, it’s a bundle of mortgages Wall Street turned into a financial security during the last real estate boom. If you took out a loan to buy your house, your mortgage is probably inside one of these bundles somewhere. On Wall Street, they call these bonds “residential mortgage-backed securities,” or “RMBS.”

Here’s the thing: When a company goes bankrupt, its stock quickly disappears from the stock exchange. It’s different for a mortgage bond. A mortgage bond is a bundle of thousands of loans made by banks against people’s houses. Some of these loans might be paying as expected. Others might have defaulted. A few might be in bankruptcy. Some might have been resolved for cash. In short, unwinding these mortgage securities is a nightmare… and it’s going to be years before these mortgage bonds are split open, unwound, and liquidated.

In the meantime, these bonds are rotting on Wall Street balance sheets, dragging down earnings and preventing banks from making new loans.

In general, bonds have been fantastic investments over the last 12 months. Junk bonds are up over 50%. Corporate bonds are up almost 20%. Muni bonds are up over 10%. Even the government-guaranteed mortgage bundles issued by Fannie or Freddie… known as “agency” MBS… have rallied back up near their pre-crisis levels.

Mortgage bonds are the only bonds that haven’t rallied anywhere near their pre-crisis levels. Because of how complicated they are, the RMBS market remains frozen and the average mortgage bond is still trading near 60 cents on the dollar… a 40% discount.

That’s why I advised my readers to buy these bonds.

Unfortunately, individual investors can’t buy them directly… only institutions can buy mortgage bonds directly. But you can buy stock in companies that specialize in managing portfolios of these bonds. They call these companies “mortgage REITs.” Mortgage REITs buy millions of these bonds, hold them in large portfolios, and then pay out their earnings to shareholders as dividends.

With even modest leverage, the returns can be huge. The one I recently recommended to my readers, for example, pays a 19% dividend right now.

It may take awhile, but eventually the non-agency RMBS market will thaw. When that happens, our bonds will catch up with other types of bonds, and we’ll see capital gains and even bigger dividends.

The risks here are that home prices could take another large step lower and millions more homeowners could stop making payments and walk away from their houses.

But I think this is a low probability. As long as the government is printing money, injecting liquidity, and guaranteeing loans, the real estate market isn’t likely to fall much farther.

That’s not to say I’m bullish on real estate now. It’s just that we’ve already seen a huge crash, and there’s a difference between thinking the downside is limited and expecting prices to soar. Prices could fall, but I don’t expect another waterfall decline like we’ve seen over the past few years.

In the meantime, we’ll enjoy the massive dividends, and as far as we’re concerned, the market can stay frozen forever.

If you don’t think this idea is crazy and you want to invest in mortgages, you should start your search with Yahoo Finance’s industry browser for the mortgage REITs.

The problem is, most of these companies focus on the mortgages issued by Fannie Mae and Freddie Mac. These “agency” MBS aren’t good deals right now. You want to avoid these REITs and focus only on non-agency mortgage REITs.

Good investing,