Don't Invest in a Bank Stock Without Reading This First

Don't Invest in a Bank Stock Without Reading This First

This earnings season, banks have repeatedly beaten the street with exceptionally strong earnings. But with regulatory changes run amok, the most complex balance sheets in the business world, and a reputation among consumers only slightly better than Congress, is an investment in a bank today anything more than a speculative gamble?

Does anyone really know what they're getting with a bank stock investment?
What is an investment in a bank, really? What are the assets? For most banks, the assets are a combination of mortgage loans, commercial loans, with some earnings power from advisory, wealth management, cash management, and other services. By and large though, it's an investment in mortgage and commercial loans.

But here's the problem, banks tend to make the business really complicated. Sometimes this enhances the business, increasing revenue and profits, improving products, and more generally, adding value to the business world. But by venturing into the complex and sometimes murky waters of complex finance, banks oftentimes shoulder undue risk (think back to the derivatives bets of 2007 for a quick reminder).

Oh, and don't forget the several thousand pages of new regulations being digested industry-wide.

It begs the questions, is there a way to invest in bank assets without worrying about the FDIC, the OCC, the CFPB, the Federal Reverse, Congress, the Basel Committee, Dodd and/or Frank? Is there not a way to get similar investment allocation without blindly putting faith in a trillion-dollar black box of a balance sheet?

Yes, actually, there is.

Again, banking is fundamentally about loans, and it's possible to invest in bank loans without investing in banks.

Commercial loans
Commercial loans can loosely be divided into two general categories: those secured by real estate and those not secured by real estate. For our purposes here, we'll ignore the loans not secured by real estate. Those, practically speaking, are hardly better than unsecured loans, and even at 10%+ interest rates, the risk outweighs the reward.

But with intrinsic value galore, loans backed by commercial real estate are well worth our attention. So how to get exposure without the banking hang ups? The easiest solution is through a Real Estate Investment Trust (a REIT) with a commercial real estate focus.

These entities receive special tax treatment for the service they provide to everyman investors like you and me. So long as they pay out 90% of taxable income in the form of shareholder dividends, and as long as more than 75% of gross income comes in the form of rental income (along with a few other technical rules), these entities pay exactly zero corporate income tax. No taxation without representation, and no double taxation whenever possible!

One such company is RAIT Financial Trust . This company invests directly in commercial real estate, has operations in property management, and also has a finance business that makes loans secured by commercial real estate. The company has $3.7 billion of assets under management as of Q1. Of the company's real estate investments, 61% are in multifamily properties and 26% are in office buildings, with the remainder primarily in retail buildings. Geographically, the company is well diversified with approximately one third of its investment in each of the Southeast, Central U.S., and West. The company currently reports a dividend yield of 6.7%.

Brookfield Property Partners is another option when considering the commercial space. The company is a spin off from Brookfield Asset Management and today holds all of the commercial real estate formerly held by the combined entity. Geographically, this REIT offers an international allocation, with retail, multifamily, and office properties in North America, Europe, and Australia. The company is highly leveraged, though, with about 20 times more debt than it has in cash. The company's first independent quarterly report since the spin-off is scheduled for August 1.

Banks are arguably best known as mortgage companies. When someone decides to buy a home, they go to the bank. It was true for Jimmy Stewart back in It's a Wonderful Life, it was true in the chaos of 2005-2007, and it remains true today.

But, signing documents at the loan closing table is not always the end of the road for the freshly printed loan documents. Banks will take hundreds of these loans and then sell them to investors in the form of a now all-too-familiar mortgage-backed security.

Who buys these securities? Potentially very wealthy individuals, hedge funds, sovereign wealth funds, the U.S. Treasury, and, potentially, a mortgage-focused REIT. And that is exactly how we will invest in mortgages and bypass the bank.

Mortgage REITs (mREITs) are, fundamentally, very similar to other REITs. The only truly material difference is that mREITs only, or nearly only, invest in mortgages. Some choose to invest only in mortgage securities issued through government-sponsored entities, while others choose to invest in government-issued and non-government issued securities.

American Capital Agency is a mREIT that invests exclusively in government-issued mortgage securities. The company has a market cap of nearly $9 billion and sports an impressive dividend yield of 19%. American Capital funds its investments with short term borrowings, putting it at risk for changes in the interest rates. If short-term rates rise faster than long-term rates, the company's earnings will be squeezed. This fear has sent the stock price markedly lower since May, dropping from $33 to the low $20s in just over 60 days.

Chimera Investment Corp. is another mREIT, one that invests more broadly than American Capital Agency, taking positions in government-issued, non-government issued, and also commercial securities. Because of the same interest rate concerns mentioned above, Chimera has been in the crosshairs of short sellers of late. The decline in stock price has not been as pronounced, however, with Chimera losing about 10% versus the 30%+ decline for American Capital. Chimera currently has a dividend yield of 12%.

Save the gambling for Vegas
The only thing certain about the future of banking in the U.S. is uncertainty. Loans, of the pure and unadulterated variety, have proven to be a profitable and safe investment for thousands of years. Before clicking "Confirm" on your next bank stock investment, consider sidestepping the risk, complexity, and regulators with a combination of commercial and mortgage REITs.

If you're eyes lit up when you saw the incredible dividend yields offered by these REITs, you'll want to read The Motley Fool's new free report "5 Dividend Myths... Busted!" In it, you'll learn which stocks provide premium growth and whether bigger dividends are better. Go beyond the rhetoric and learn the what really matters when evaluating a dividend. Click here to keep reading.

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