Trade Recommendations from the FDIC

I do a lot of reading during the average week.

I read a couple of newspapers every day along with several industry journals for the banking and real estate industry, and a steady diet of academic papers, SEC filings, and reports from various government agencies.

After work, you’re far more likely to find me reading a novel or biography than watching TV (unless it’s baseball season, which sadly it isn’t).

Both of my parents were big readers. I inherited the habit and have stuck with it my whole life.

I credit much of my success in life and the markets to this voracious reading habit.

Some of the best information I find comes from reports issued by the various government agencies, particularly the regulatory agencies.

These folks are observing the financial world at an almost microscopic level, and I find that I get a much clearer view of the economy and markets when I add their information into my analysis.

It’s a potent combination that can lead to the discovery of wildly profitable strategies and opportunities, like these…

Real Value in Real Property

Recently the FDIC Risk Report hit my inbox, and as usual, I came away with some solid information that we can use within our current numbers-driven framework to spot some opportunities in the financial markets.

Although the FDIC is considering risk at the bank level, those risks and concerns also apply to the broader economy.

In the first piece of useful information, they offer data that supports my position that there aren’t any huge risks to intelligent commercial real estate lending.

Growth may be slowing, but commercial lending is mostly in good shape.

Rents and occupancy rates have continually improved, and so far there are no signs of any meaningful widespread delinquencies.

Lending on office, multifamily and industrial properties is a very healthy business and should continue to provide decent returns for lenders in the years ahead.

Information is Valuable

Why should you care about that?

After all, you’re not a bank or high-flying CRE Lender, so why on earth should you care about Commercial Real Estate lending conditions?

You shouldn’t, unless you’re looking for a stable source of double-digit returns on your money.

Then you should care very deeply, because you can buy commercial lenders right now and enjoy high-yields with a solid upside.

A few weeks ago, I introduced you to Starwood Property Trust Inc. (NYSE:STWD), a real estate investment trust that makes commercial real estate loans and also directly owns some real estate.

It currently has a yield of almost 8% and trades at about 80% of what I estimate the collection of loans and assets is worth.

Starwood is one of those investments that you should consider buying every time the market sells off, and plan on never selling.

You, too, will become a high-flying CRE lender, collecting massive cashflows every quarter for the rest of your life.

The Problem on the Horizon

The report also took note of something I have mentioned several times as one of the most significant risks to the financial markets right now.

The FDIC found that, “The share of bonds rated BBB, the lowest investment-grade category, was 49 percent of all investment-grade bonds in 2018, up from 33 percent in 2008. This category of debt presents a source of risk because should these borrowers encounter challenges, some could be downgraded to high-yield or ‘junk’ status.”

These “fallen angels” would then face higher borrowing costs, and their downgrade could disrupt the high-yield credit market.”

The amount of BBB bonds that could be downgraded if the economy continues to grow at a very slow rate is three times the size of the junk bond.

Many institutions and pension funds are not allowed to own bonds rated below BBB, so when an issue is downgraded, it’s an automatic sale.

There is not enough capital in high-yield to soak up the supply, and that’s is going to cause some severe disruption if it occurs (or more like when since it seems almost inevitable to me).

That disruption could lead holders of Junk Bond ETFs to sell, and then we have a big problem. We have more supply than the markets can handle from downgraded bonds, and now new selling is coming for ETFs as shareholders panic, and there are simply no buyers to be found.

I am usually a buyer of junk bonds in bad markets, and I can tell you that a seller’s least favorite phrase at such times (and my favorite) is “Sorry- the market for that is no bid.”

There are no buyers to be found, and prices will collapse.

Crunch time: This could be just the beginning of America’s big pension crisis

A Play for the No-Bid Bond Market

This sets up a Black Swan trade in SPDR Bloomberg Barclays High Yield Bond ETF (NYSE Arca:JNK).

We are going to go to the options chain and go out as far as we can.

In this case, that’s January 2022.

Then we go down the list until we find a put option trading $1 or so in this case that’s somewhere around $70 strike price.

Remember, we do not need the ETF to fall all the way to the strike – although in this case, I would not rate it as an impossibility if junk markets go No-Bid. We just need prices to move quickly in the direction of the strike.

The rise in volatility would cause the option price to explode, giving us a chance to double or triple our money.

It is true that I read a lot because I love to read.

However, it’s equally true that I read a lot because it makes me money.

In this case, the FDIC has pointed out a low-risk way to collect high-yields in a low-rate world and given us an idea for a potential Black Swan opportunity.

That’s not bad for 30 minutes or so invested in reading the report!

To the Max,

Tim Melvin

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