The Leverage Hangover

 | Sep 12, 2011 | 2:30 PM EDT  | Comments
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nly

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ivr

As Greece gets closer to default, the markets get more volatile. I say default because in every sense of the word, Greece is essentially insolvent. Like a dying patient on life support, the dilemma is when to face facts and pull the plug.

It's likely that the markets will experience a shock if Greece officially becomes insolvent. It's a testament to the globalization of the markets that a nation with a 2010 GDP of approximately $300 billion can wreak such economic havoc.

Ultimately, the problem comes down to leverage. The world got drunk on excessive leverage over the past decade and now it's time to deal with the hangover. Hangovers are painful, and how excessive the binge was will determine how long the hangover lasts.

Over the past two decades, the use of leverage became more and more excessive. The bust in 2008 was merely the beginning of the hangover. While relapses like Greece are bound to occur, remember that, at least in the U.S., the credit issue is significantly better today than it was three years ago. If investors focus on the big picture and stick to looking at potential pricing inefficiencies, they are likely to find interesting opportunities.

Though mortgage-backed securities are still despised in the U.S., there are some potentially interesting situations developing the space. Real estate investment trusts that focus on MBS warrant a closer look. Chimera Investment Corp. (CIM), a $3 billion REIT, has shares trading this afternoon for $2.85, or 5x current earnings, and its yield is a whopping 18.3%. Its price-to-book ratio -- nothing to hang your hat on considering the assets -- is 85%, nonetheless.

The fantastic yield, along with a very attractive price-to-earnings multiple, is Mr. Market's signal that he does not see those two variables lasting very long.

Chimera isn't the only candidate. Annaly Capital Management (NLY) yields 14.6% and sports a PE of 6.6. Invesco Mortgage Capital (IVR) yields 23% with a PE of four.

The key risk is that low rates spur a refinancing wave that would ultimately reduce the yield on MBS, thus reducing cash flows to Chimera. But rates have been low for quite some time, and refinancing levels haven't had a significant effect yet. For obvious reasons, banks have been extremely tight with lending.

The other risk is the government sponsoring some sort of refinancing program for underwater mortgages. If that happens, the investment scenario would likely change. But the government has mulled over this idea since 2009 and seems hesitant to act. It's highly improbable to expect these yields for many years but if they remain secure, yield-hungry investors will bid the share price up.

On the other hand, a very secure dividend, a 4.3% yield to be exact, is available from Intel (INTC), which trades at 9x earnings. That yield is more twice the return on 10-year U.S. Treasuries, yet many investors are opting to park money for 10 years at 1.9% instead of a cash-gushing, debt-free, tech titan that will likely increase the payout in coming years.

Investors are naturally preconditioned to assume it's 2008 all over again, and are quick to loathe equities. Sure, stocks may underperform in the short run, but continued volatility increases the probability that they will significantly outperform in the long run.

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