The Big Checkup: Annaly Capital, Chimera, and Bank of America

This article is part of ourRising Star Portfolios series. You can read about the Dada Portfoliohere.

It's a good idea to check up on your stocks from time to time. At the real-money Dada portfolio I co-manage for The Motley Fool, we've taken several positions in the financial sector over the past half-year.

Here's how we're doing:

Source: Google Finance and Yahoo! Finance.

It's been an ugly ride for much of the industry over the past several months, but we were spared the worst of it because of our bullish bets on residential mortgage REITs, which tend to benefit from the current weak state of the economy, and bearish bets on companies tied to the worst of the ongoing mortgage and foreclosure fiasco.

About those REITs
Low short-term interest rates have been a boon for mortgage REITs, which make money on the spread between short- and long-term rates:

Source: Capital IQ, a division of Standard & Poor's, and the Federal Reserve Bank of New York.

Across the industry, we see large spreads between funding costs and portfolio yields:

Source: Capital IQ, as of latest quarter.

As you can see from the table, Chimera is a bit of a unique case. The company, which is managed by top-of-the-class Annaly, invests in the heavily eschewed non-Fannie/Freddie (read: toxic) mortgage market. This means a higher asset yield, but also a riskier portfolio and higher costs of borrowing that can make the stock more volatile than its peers, particularly if financial markets freeze up again. But the wider degree of freedom also gives the company the opportunity to capitalize on mispricings.

With unemployment continuing to linger, and almost no effort on the part of Congress to stimulate the economy, the Federal Reserve will likely be forced to hold short-term interest rates low for at least another couple of years.

Foreclosure woes
When we initially shorted Bank of America and Lender Processing Services, both stocks were cheap. Bank of America traded for just 0.6 time book value, while LPS had a price-to-earnings ratio of nine times and trailing earnings-per-share growth of 22%. But the market was missing the extent of the problems facing the industry with regards to mortgage documentation and improper foreclosures. Since then, shares of both companies have plummeted as more investors have caught on, AIG joined the Countrywide plaintiff pinata, and foreclosures began to freeze up, in part due to court rulings that, yes, you need valid documentation to take someone's house.

We still think both companies face a difficult time going forward, but we closed out Bank of America short once the stock plunged so far as to be valued as though the company had $60 billion in unprovisioned losses. That's not to say losses won't exceed that level -- they certainly could -- but it's not a bet we felt like making.

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At the time thisarticle was published The Motley Fool owns shares of American International Group, Bank of America, Chimera Investment, and Annaly Capital Management. The Fool has opened a short position on Lender Processing Services. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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