A big concern...

A big concern... Another subprime bubble, already?...

As I was doing research for my newsletter this month (to be published this evening), I came across a statistic that was so shocking it literally made my jaw drop open. I couldn't believe it.

As you know... I write these Friday Digests personally. I do so because I'm grateful for the trust and interest you've shown in my business and for the support you provide to us. My goal is to tell you what I would most like to know, if our roles were reversed. Sometimes this requires me to tell you about things that will also be published in our subscribers-only newsletters. But in certain cases, I believe the repetition and focus are warranted. In this case, they are crucial.

There is a huge and imminent threat to our economy looming. The emerging problems relate to souring subprime lending... the exact same set of problems that tanked our economy only six years ago.

The new subprime lending bubble is in the automotive sector. I had no idea how pervasive subprime loans had become in auto lending. I couldn't believe the amount of money involved or the role subprime lending has played in the auto sales boom we've seen since 2010. You would think people would know better, so soon after runaway subprime mortgage lending tanked our entire economy. But, no.

You won't be surprised to learn that things got out of control after 2011, after Wall Street firms started buying up auto-lending groups. The exact same thing happened in housing after Wall Street began buying up home mortgage firms from 2004 to 2006.

Before we get to the numbers... you need to understand that big Wall Street firms have a special knack. They're great at taking a reasonable idea – like lending money against well-collateralized, long-lived assets (homes and cars) – and turning it into a farce. What happens next is always a tragedy.

As with mortgage lending, car lending used to be a simple and safe business. Local and regional banks (or finance companies) would provide loans to customers with good credit and a substantial down payment. The term of the loan didn't exceed the useful life of the car. Under these conditions, auto loans are extremely low-risk. Losses on auto loans have historically been extremely low – less than 2%. Auto loans even performed well in the Great Depression.

But Wall Street created a farce. Warburg Pincus, Centerbridge Partners, Kohlberg Kravis Roberts, Blackstone, and Perella Weinberg are a few of the big Wall Street firms that bought auto-lending companies over the last few years. They changed the terms – extending auto loans up to 84 months (seven years), lowered the down payments (on leases they're next to nothing), and radically lowered the credit scores required to qualify.

The result has been a huge surge in auto loans – especially subprime auto loans. Since 2010, auto lending is the only kind of consumer credit not guaranteed by the government that has seen an increase in outstanding debt. (Student loans are the other kind of debt that has grown, but in that sector, essentially all of the loans are made by the government.)

And so today, Americans owe $783 billion against their cars and trucks. Unbelievably, 34% of this debt is now owed by subprime credits.

Here's the even more shocking part... Another 10% – $77 billion – is owed by "deep subprime" folks, those with credit scores below 550. Businessweek quotes Morgan Stanley analyst Adam Jonas pointing out the obvious: "Perhaps more than any other factor, easing credit has been the key to the U.S. auto recovery."

How big is the problem? More people than ever before are borrowing money to buy cars. A record 84.5% of shoppers who acquired a new car in the last quarter of 2013 used financing, either a loan or a lease. They're borrowing more than ever on each purchase – more than $26,000. And the average duration of these loans is now 61 months. All of these stats are all-time records.

More people are borrowing more money over a longer term than we've ever seen, according to information-service company Experian Automotive. And more of these loans than ever are owed by subprime credits. Used-car lending is at a peak, too. Almost 60% of all used-car loans are subprime.

If subprime auto lending were in jeopardy, we'd see a few warning signs. First, the Wall Street firms that have been investing heavily in the space would be selling. They would be getting out of the market, as fast as possible.

And so... in January we saw a group of Wall Street's leading private-equity funds unload Santander U.S. Consumer (a leading auto lending company) via an initial public offering.

We've also seen a big uptick in the amount of subprime auto loans that are being securitized and sold to other investors – separating the risks of the loans from their underwriters. In total, Wall Street packaged and sold $17.2 billion worth of car loans last year. That's the most since the go-go credit year of 2005.

These securitizations move credit risk away from the car companies and finance companies and onto investors – the same thing that happened in the housing bubble. This separates the underwriter of the loan from the consequences of a default. Securities tied to subprime auto loans represented 27% of transactions in 2013. That compares with 4% in 2009.

As the amount of subprime lending has soared, credit quality in these auto securitizations has collapsed. The average score for loans in bond deals completed in 2013 year fell to a FICO score of 578. The Federal Housing Administration won't give a mortgage to anyone with a FICO score less than 580, and it's a government-backed lending institution that's charged with providing the poor with credit. And right now, the average credit in a Wall Street auto loan package is below that level. What do you bet happens next?

Last month, the percentage of car loans more than 30 days late that are a part of packaged securities (where the underwriter sold the loan) spiked to 7.6% – the highest rate seen so far since the beginning of the boom in 2010. Outright defaults are surging, too, now up to 6.9% from a cyclical low of 4.2%.

Defaults will, of course, continue to follow late payments higher. Likewise, the repossession rate, which follows defaults, is also moving higher. It's currently at 2.8%. That's the highest recorded since Experian Automotive started tracking the data in 2006.

The surest sign that trouble is brewing? The government denies there's anything to worry about. Remember Bernanke telling us that the subprime mortgage problem was "contained"? Well, last August, just before default rates, repos, and loan losses started to spike higher, the New York Federal Reserve studied the huge rise in subprime auto lending and concluded nothing was "disproportionate or unusual" about it.

Two things to watch. Keep an eye out on the weakest players in the market. Here's an example. Bentonville, Arkansas-based America's Car-Mart (CRMT) is a small ($300 million market cap) regional used-car dealer. It sells almost exclusively to subprime borrowers. It holds $300 million worth of subprime auto loans on its books. This company could serve as an indicator of trouble for bigger firms, major banks, and even our economy as a whole. Remember, in 2012, auto sales made up half of the economic growth in our economy, but they were being driven by loose lending policies and subprime loans.

Keep an eye on used-car prices. The Manheim used car index is the gold standard of national used-car prices. (See the chart below.) It looks to be weakening, which is a sign that recovery rates on repossessed cars might be at risk. That could cause loan losses to soar.

As we know from the recent housing bust... when subprime lending goes too far and becomes too large a percentage of total lending, it can cause overall credit quality to collapse. In the car business, that could cause huge problems going forward, problems big enough to harm our entire economy.

I cover some of these details in the current issue of my newsletter, Stansberry's Investment Advisory, which we're publishing this evening. If you're a subscriber, please read it carefully. There's a firm I'm recommending as a short sell that holds more than $20 billion in car loans... and almost 90% of these loans are subprime.

If you're not a subscriber, you can find out more about signing up here.

New 52-week highs (as of 3/13/13): Activision Blizzard (ATVI), Cameco (CCJ), Callon Petroleum (CPE), NovaGold (NG), Royal Gold (RGLD), and ProShares Ultra Utilities Fund (UPW).

In today's mailbag, more folks write in telling us how they've fared in the current bull market. Send your comments to feedback@stansberryresearch.com.

"Right after the first of this year, I sold just enough shares of each one of the gainers in my portfolio to recoup my original buy-price. Money beyond that, essentially profits, is still in there working for me at zero risk. I'm now sitting on a large percentage of cash. The positions in my portfolio which are currently losers are my hedges; mostly gold stocks I anticipate will soar as the rest of the market tanks. I recently sold 3 naked puts, and one covered call; all two to five months out; the puts are on stocks I want to own, at prices I believe is fair; for this I gained nearly $700.

"I just did the math on my wins/losses dating back to 2007, when I first:

"Considering that I had (for a short time only) as much as $100K working in the market [in 3 accounts: IRA, regular, and global], I am pretty happy with the results. I show a net gain of $8K; meaning that I have gained $8K more than I've lost in the stock market since 2007. In the meantime, I have learned a LOT about this fun game called investing, paid substantial dues, but have noticed more trades turning up on the plus side of the ledger, thanks to learning from the many [many] hours of reading hundreds [nay, thousands] of S&A newsletters and Digests, plus other S&A recommended reading. I am now buying only dividend stocks, holding my winners longer, adhering to my trailing stops; utilizing my head more, and my gut less, when making investment decisions.

"For me, S&A has been the beacon in the fog leading to sound investment techniques. I'll never know what my balance sheet would look like had I not first subscribed, but I believe it wouldn't be as pretty as it is now. Thanks to you, Porter, Steve, Dan, Matt, Tom, and Doc; I feel like I'm just finally getting started." – Paid-up subscriber Jim Geiger

"My portfolio is up about 35%. It is 100% in WDDG's. I owe you guys a bunch. Thanks!!!" – Paid-up subscriber Jim Carpenter

"I have done extremely well since 2009 with the investments I have made. The majority of my stock picks have come from your various newsletters. My downside though, is that I have not been fully invested. I have maintained a 40-50% cash position through it all because I tend to be risk averse. I got killed in 2007-2008 by being too aggressive. As they say, bull markets 'climb a wall of worry' and I am worried." – Paid-up subscriber William Holbrook

Regards,

Porter Stansberry
Baltimore, Maryland
March 14, 2014

How to make 14% a year with McDonald's...

Editor's note: In yesterday's Digest Premium, DailyWealth Trader editor Amber Lee Mason pointed out that shares of McDonald's were rallying in the face of bad news – or "acting well." As she explained, shares rose despite disappointing earnings. Today, she shows how to generate a safe 14% a year with the fast-food giant...

McDonald's CFO Peter Bensen helped to boost the company's share price on Tuesday... At a retail conference, he discussed plans to spend $5 billion this year (about 5% of the market cap) on shareholder rewards, including share buybacks.

Back in November, I recommended buying shares of McDonald's and selling the December $97.50 calls. On expiration day in December, shares were trading below our strike price... So traders kept the cash premium and held onto their shares. Then in early January, I recommended selling another round of covered calls on those same shares... with the same result.

If you've followed my advice on McDonald's, you earned an income of $4.21 per share (or 4.3%) from call premiums and dividends... while the stock went nowhere. If you haven't taken a position in McDonald's yet, you have a great opportunity to earn quick income.

Right now, you can sell the April 19, $97.50 put options for about $1.35.

If McDonald's is trading below $97.50 at the close of trading on April 19, put-sellers will end up buying shares. At that point, you'll start collecting the company's 3.3% annual dividend... And you can turn around and sell covered calls to generate even more income.

But if McDonald's just stays above $97.50, put-sellers will get to keep the $1.35 free and clear. That's a 1.4% payout on your purchase obligation. In just five weeks, that comes to 14% annualized.

Most of the time, bad news is bad news. Most of the time, shares will fall. Like I said, that's the natural order of things.

But occasionally, you'll see a situation where a stock can shrug off bad news and rally. It's a good sign. And that's what we have with McDonald's.

– Amber Lee Mason

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As of 03/13/2014

Please note: Securities appearing in the Top 10 are not necessarily recommended buys at current prices. The list reflects the best-performing positions currently in the model portfolio of any S&A publication. The buy date reflects when the editor recommended the investment in the listed publication, and the return shows its performance since that date. To learn if a security is still a recommended buy today, you must be a subscriber to that publication and refer to the most recent portfolio.

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