How to Make Money Like a Bailed-Out Bank

In the aftermath of the financial crisis in 2008, big financial institutions have turned out to be the biggest winners from the government's responses to the mortgage meltdown. But savvy investors are discovering ways to reap their own profits from the government's policies, even in areas that few investors truly understand.

Toxic assets and you
One such moneymaking opportunity comes from "toxic assets," or mortgage-backed securities that lost huge amounts of value during the financial crisis. As The New York Times describes, the program involved a partnership of public funding and private capital to help investors buy up bundles of unwanted toxic assets from banks. The program involved the government lending as much as 85% of the value of the assets, and further matching each dollar of private funding with a dollar from the government as well. That essentially allowed investors to make a leveraged investment in toxic assets of over 12 times their capital contribution.

Although the Treasury believed that investments through these programs would eventually be broadly available to average investors, that hasn't turned out to be the case. Just a handful of institutional investors, including General Electric's (NYSE: GE  ) GE Capital division, AllianceBernstein (NYSE: AB  ) , and BlackRock (NYSE: BLK  ) , were selected to participate in the program. For the most part, these funds were open only to accredited investors with high amounts of wealth, and as you might expect, they've performed quite well, with GE's and BlackRock's programs each returning 20% or more.

But if you want a more direct way to own toxic assets, a handful of closed-end funds have participated in the program. Open to all investors, closed-ends trade on stock exchanges like ETFs, but they often sell at discounts to the net value of their assets (NAV). All three of the closed-end funds in question -- two from Nuveen and one from Legg Mason (NYSE: LM  ) -- trade at discounts from 1% to 3% to NAV.

A smart investment?
All three of these closed-ends are less than a year old, so it's early to draw conclusions about their performance. In a strong market for bond funds generally, the closed-ends have posted decent but not spectacular performance overall -- certainly nothing to rival what GE and BlackRock have seen.

Meanwhile, other investors are starting to take advantage of opportunities in mortgage-backed securities outside the government's toxic asset program. There are several ways to do so:

  • Mortgage REITs Annaly Capital (NYSE: NLY  ) and Hatteras Financial (NYSE: HTS  ) use a business model involving buying mortgage-backed agency securities with short-term borrowed money. With a relatively steep yield curve and near zero short-term rates, profits have been strong, and shareholders have received huge dividend payments from these and similar institutions.
  • Investors are looking more toward asset-backed securities that aren't linked to agencies Fannie Mae or Freddie Mac. Annaly spun off Chimera Investment (NYSE: CIM  ) specifically to hold non-agency securities. Some traditional mutual funds are also turning to the non-agency market for lucrative investments.

Is it a smart investment?
So with an increasing number of opportunities to participate in mortgage-backed securities and toxic assets, should you jump on board? Given the popularity of mortgage REITs, a lot of the money in the space has already been made.

Similarly, the closed-end funds pay healthy monthly distributions. But they come with relatively high expenses of 1.25% to as much as 2.30%. Even with good returns, it may prove difficult to overcome such a high cost hurdle.

Toxic assets may indeed prove to have been the value investment of the decade. But the early promise of the government's public/private partnership to involve regular investors in any profits from toxic assets hasn't reached its full potential. Despite the ways in which ordinary investors can participate, just be careful to make sure you're not walking in just as the party's about to end. Still, as long as low short-term rates are supporting the market, you should still be able to find good opportunities.

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True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Dan Caplinger never got his own bailout. He owns shares of Chimera Investment. BlackRock is a Motley Fool Inside Value selection. The Fool owns shares of Annaly Capital Management and Legg Mason. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy couldn't be happier about the death of TARP.


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