Like Money in the Bank With These 'Nonbanks'

NEW YORK ( TheStreet) -- The traditional banking sector is bracing for downgrades in the weeks ahead, and it's enough to keep the stock market spooked for a while longer.

Moody's Investors Services recently indicated that it's likely to reduce the credit ratings on close to 17 big banks by the end of June.

Sources tell me that this will include five or six of the largest financial companies in the U.S. If the downgrades occur, it will most likely raise the cost of debt issuance and curtail some of their more lucrative activities.

Names including Bank of America ( BAC) , Citigroup ( C), J.P. Morgan Chase ( JPM), Goldman Sachs ( GS) and Morgan Stanley ( MS) have been mentioned as possible downgrade targets.

This is adding to the general economic angst that investors are feeling as the stock market tries to recover from May's over 6% correction and the fallout from the European debt crisis.

The worry about the European Union and its currency dissolving, beginning with the Greek election next Sunday, makes the potential for a downgrade of big U.S. banks more ominous.

The SPDR S&P Bank ETF ( KBE) and The Financial Select SPDR ETF ( XLF) were falling on Monday. The credit downgrades have been bantered around since February, so investors are not totally surprised by the weekend headlines on the topic.

But until this situation is rectified and the scope of these downgrades are finally announced, it will cast a pall of gloom on the banking sector.

So let's focus our investing attention on the "non-banks" that can make their money in similar style to the big money-center banks without the looming downgrade stigma.

By borrowing money at or close to the Federal Funds Rate (0%) and investing it in government-guaranteed bonds that pay 2% or 3%, these companies can generate huge profit and operating margins.

When these publicly traded "non-banks" are doing this "spread" trade with hundreds of millions of dollars they make enough money to pay some mighty generous dividends to their shareholders.

The leading example of these "non-banks" is Annaly Capital Management ( NLY). It has chosen to be structured as a Real Estate Investment Trust (REIT) for federal tax advantages.

The company invests primarily in mortgage pass-through certificates, collateralized mortgage obligations, agency callable debentures and other mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans.

Annaly Capital also invests in Federal Home Loan Bank, Federal Home Loan Mortgage Corporation and Federal National Mortgage Association debentures.

As a REIT the company would not be subject to federal corporate income tax, provided it distributes at least 90% of its taxable income to its shareholders.

At the current price of around $16.70, NLY has a yield-to-price of 13.17%. It has paid this kind of yield or more for 15 years going back to 1997. With a trailing 12-months profit margin of 63.40% and operating margin of 70.59%, there are many reasons to believe its success will continue.

Annaly and Hatteras Financial ( HTS), another "non-bank" that does virtually the same kind of business as NLY, take almost no credit risk since they invest 100% of assets in government-guaranteed investments.

They are well-managed companies because their officers know what they're doing and know how to do it with precision and consistency.

The chairman and chief executive for NLY has serious health issues that might have caused some investors a little anxiety. He's considered the Steve Jobs of his industry by many who know and respect him.

In a May 22 press release, NLY announced Chairman, President and CEO Michael A.J. Farrell has completed his treatment program and that his cancer is in remission.

This is great news for the company and its shareholders. Farrell himself own 2,594,392 shares of NLY currently valued at over $43,326,000. Obviously he is a big believer in his company.

"There are no certainties in life, but I feel good and have been given an encouraging prognosis," said Farrell. "I look forward to continuing my work and, along with my very capable management team, remain committed to our mission of delivering strong, income-based returns to Annaly shareholders."

Farrell continued: "Looking ahead, I believe there are many risks in the marketplace, including slow economic growth, uncertainty in Europe and the future of monetary policy. Our management team has maintained a relatively conservative operating profile that is designed to prepare us for this environment and position us for a wide range of outcomes. I believe it has set us on a path to continue to generate attractive risk-adjusted returns over the long-term."

The news release characterized the company's principal business objective as generating net income for distribution to investors from its investment securities and from dividends it receives from its subsidiaries.

I'd enthusiastically encourage you to familiarize yourself with this company by perusing its impressive website. Since the company's inception it's paid out over $7 billion dollars in dividends, and as long as the Federal Reserve leaves interest rates at close to 0%, it should be able to continue.

Hatteras Financial pays a 12.38% dividend and is selling close to its 52-week high. It invests mainly in single-family residential mortgage pass-through securities issued or guaranteed by U.S Government agencies or U.S. Government-sponsored entities, such as Fannie ( FNMA) , Freddie Mac ( FMCC) or Ginnie Mae.

The Hatteras Financial website is also helpful and reveals plans and commitments towards investors. Hatteras Financial became a publicly traded company and began operations in November 2007.

Due to their business models, both NLY and HTS are likely to benefit from the number of homes needing refinancing under the latest version of the government sponsored Home Affordable Refinance Program (HARP).

For the more risk-tolerant you might want to look at American Capital Agency ( AGNC). It has been paying a dividend of more than 15%.

AGNC invests in residential mortgage pass-through securities and collateralized mortgage obligations for which the principal and interest payments are guaranteed by government-sponsored entities or by the United States government agency.

The risks of all these mortgage and debt-based REITs are that the Federal Reserve would unexpectedly raise short-term interest rates or that the economy as a whole gets much worse.

Neither is likely, and what is more likely is the Fed will be as accommodative as ever with easy money policies that are geared towards indirectly benefiting companies like these.

At the time of publication, Marc Courtenay was long NLY.
At the time of publication, Marc Courtenay was long NLY.