That's right -- the stock I'm thinking of currently boasts a whopping 17% dividend yield. Recently, it's been borrowing money at virtually zero interest rates and investing the proceeds into higher-yielding government-backed securities. Perhaps you think I'm referring to a mortgage REIT, such as Annaly Capital Management (NYSE: NLY) or American Capital Agency (Nasdaq: AGNC) -- but I'm not. Have you looked at the American Depositary Receipts of Spanish lender Banco Santander (NYSE: STD)?
Which is more risky?
Maybe you think I should have my head examined. A Spanish bank -- at this juncture? Don't you read the papers? If those are the questions that are popping into your head, here's one for you: Are you absolutely certain Banco Santander is riskier than Annaly or American Capital -- not to mention mortgage REITs with a broader investment mandate such as Chimera Investment (NYSE: CIM)? As I see it, all are exposed to tail risk, whether it takes the shape of a run on the Spanish banking system or a dislocation in the U.S. repo market.
Even some of my fellow Fools display a casual nonchalance regarding the risks associated with Annaly. A few days ago, one of them wrote: "Annaly Capital will mint money for as long as the Fed holds short-term rates near zero, which makes this stock potentially the ideal recession play." I see it quite differently.
This is the front-runner
But back to our Spanish lender, Banco Santander. Do you believe all Spanish banks are toxic? Here are three points to ponder:
- Santander is Spain's largest bank, which gives it wider access to international financing than its peers. (Banco Bilbao Vizcaya Argentaria (NYSE: BBVA) also has good access.)
- In 2011, Latin America was Santander's largest source of profits -- greater than Continental Europe and the U.K. combined. This is not the result of losses elsewhere (all geographies were profitable); the distribution of group profits has been trending this way for some time.
- Finally, among the top eight Spanish banks, Santander has the next-to-lowest proportion of problematic real-estate-related exposure relative to total loan exposure (3.4%), according to Goldman Sachs estimates (Bankinter boasts the lowest, at 3.6%).
Santander is a cut above; Goldman made this clear in its May 8 report, writing: "We see [Santander]([Conviction List] Buy) and BBVA (Buy) as the only realistic avenues for investing in Spanish banks given their diversified business mix, strong profitability and adequate capitalization."
The shares are hardly risk-free, to be sure. In a report dated Feb. 1, Morgan Stanley described three scenarios for Santander -- base, bull, and bear. The bear case assumed "Recession in Spain with real estate losses equivalent to Ireland, -10% growth in Brazil and UK contraction" (Spain, Brazil, and the U.K. are the bank's top three markets, in that order). Under that scenario -- to which they assigned a 30% probability -- the broker gave a price target for the shares of 4.50 euros (on the date of publication, they closed at 5.77 euros). On Tuesday, the stock closed at 4.58 euros on the Madrid Stock Exchange.
From bear to base
Sure enough, since Morgan Stanley's report was published, Spain has slipped into a double-dip recession and Ireland now looks like a perfectly sensible benchmark for real estate loan losses. Likewise, Brazil's contribution to group profits fell nearly 12% in the first quarter, while the U.K.'s dropped 41%. What was a bear scenario four months ago is now the base scenario, the shift displaying the speed with which events can overwhelm investors' baseline assumptions.
Macro jitters
Banco Santander shareholders continue to face a number of macro-related risks:
- Real estate losses could exceed the bank's provisions.
- Dilution/wipeout of the existing equity if the bank were forced to recapitalize itself on disadvantageous terms.
- A partial euro breakup could disrupt interbank (i.e., funding) markets.
Mortgage REITs also face macro-related risks, but these are less well understood, and much less well publicized:
- A possible disruption of repo markets linked to botched "fiscal cliff"-related negotiations between the White House and Congress at the end of the year or due to a dramatic deterioration of the eurozone crisis.
- As over-the-counter derivatives move onto centrally cleared exchanges, clearing houses will require investors to put up collateral against these trades. This could create excess demand of high-quality collateral, i.e., the same securities on which repo markets are based. It remains to be seen how this might impact this market.
Spotting a speculation
As Ben Graham and David Dodd wrote in the classic Security Analysis, "an investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."
Will Santander cut its dividend? I don't know, but a dividend yield of 17% suggests that the market thinks it will. At 17%, the yield is unlikely to be just part and parcel of an "investment operation." Santander is a speculation, but so is Annaly or American Capital, and yet people who wouldn't dream of investing in the former are happy to own the latter. Aversion is the bedfellow of opportunity, while nonchalance lies down with risk.
If you want to invest -- rather than speculate -- in financials, you can't afford to miss "The Stocks Only the Smartest Investors Are Buying."
