DANGER: Wall Street's Dark Angel of Debt Now Selling Subprime Auto Loans

How do you make a $5 billion loan disappear in a matter of weeks?

That was Blythe Masters' job, back in 1994. Masters – a tall, lithe, 26-year-old strawberry blonde with an economics degree from Cambridge – had lots of fans at the investment bank JPMorgan, where she worked. She joined JPMorgan as a 19-year-old intern in 1987, following her freshman year in college.

Now... her bosses at JPMorgan needed Masters to make oil major Exxon's $5 billion line of credit disappear.

For decades, Exxon had faithfully paid JPMorgan millions of dollars in fees for the right to borrow up to $5 billion at any time. The arrangement seemed like free money. After all, Exxon was one of the world's largest and highest-quality businesses. Nobody could imagine a day when lending Exxon $5 billion would constitute taking a risk.

But that changed – overnight.

Just after midnight, in the first minutes of March 24, 1989, one of Exxon's largest tankers, the Exxon Valdez, smashed into Bligh reef in the center of Alaska's pristine Prince William Sound. The ship spilled an estimated 11 million gallons of crude oil – eventually covering 1,300 miles of coastline.

Exxon's first move? Blame the accident on a "drunken" captain. (That's despite the fact that the captain was actually sleeping at the time, and in accordance with company policy, the third mate was driving the boat.) Exxon's second move? Draw down its $5 billion credit line with JPMorgan.

And so, for five years, Exxon had been paying paltry sums of interest on a huge chunk of JPMorgan's loan portfolio. The bank badly wanted to sell the loan, but couldn't because of its size and Exxon's status as one of its marquee customers. This was a loan that JPMorgan simply needed to disappear, so it could put that capital to work in a much more lucrative way than paying for seals to be scrubbed.

It was Masters' job to figure out how. It turned out, the answer was obvious. Masters could use the evolving "swap" market to trade all of the risk of the loan, without actually selling the note. To regulators, a loan without any default risk "disappears." JPMorgan wouldn't have to keep any reserves against the loan. It could then expand its loan book by several hundred million dollars, increasing its return on equity. The bank could "have its loan and eat it too."

The idea that firms could "swap" obligations or income streams without actually making a sale wasn't new.

JPMorgan organized the first such swap in 1981 when computer giant IBM needed to move a hoard of Swiss francs and Deutsche marks. Rather than simply sell them for U.S. dollars in the foreign exchange markets, IBM traded obligations it owed on a group of foreign currency bonds with the World Bank, in matching denominations. The swap had the same economic impact as a sale: It left IBM holding dollars, not foreign currency. But the transaction avoided a slew of tax and regulatory problems.

This is the key point to understand: Swaps can be extremely complex transactions. But at their root, they are all attempts to replicate the economic outcome of a sale or an exchange, while avoiding tax and regulatory concerns.

The ability to avoid taxes and regulations made swaps very, very popular. By the early 1990s, the global swaps market was booming. Banks organized more than $10 trillion a year in swaps deals, meaning the market was as large as the U.S. economy. Swaps had become the single largest source of potential profit on Wall Street. And they were about to become an even bigger business, thanks to Blythe Masters.

At the end of 1994, Masters convinced the European Bank of Reconstruction and Development (EBRD) to assume almost all of the risk of loss associated with the Exxon credit line. (Pay attention to the "almost all" part of the deal. That will be important later in our story.) In exchange, the EBRD received a fee from JPMorgan. Assuming Exxon repaid the note on time, the deal would be profitable for EBRD. In the meantime, JPMorgan could free up a lot of capital and make a lot more, better-paying loans.

Remember, assessing risk and pricing accordingly – "underwriting" – is the key skill in successful lending. So Masters' swaps deal traded away the core expertise of JPMorgan's lending business. Lots of other lenders watched what Masters did and followed suit...

This was the first "credit default swap," or CDS, in history. It spawned a huge new market in credit. The CDS market, in turn, enabled the worst excesses of the last credit bubble. As I'm sure you can see, the key problem was, freed from regulators and conservative underwriting, the market quickly mispriced credit protection, allowing foolish investors to empower insane lending. And that's exactly what they did.

Going forward, more and more credit risk would be priced and traded in a regulatory black hole: There were no rules, and no major firm had its reputation on the line. As a result, Masters and her team set up structures that the world's largest banks would use to increase their leverage ratios during the massive credit bubble between 1997 and 2008. Leverage ratios rose from "normal" levels, around 10 times equity, to more than 50 times equity during the bubble. Masters created a financial "weapon of mass destruction."

For example, it didn't take long before Masters' team figured out a way to avoid having to find an actual buyer for CDSs. The market really got going after this innovation. It allowed banks to move credit risk off their balance sheets... by selling CDSs to themselves! To make it legal, banks would set up a special investment vehicle (SIV) – a shell company. They would fund this shell company with a sliver of equity (usually about 3% of the risk it was assuming). The SIV would borrow the rest of the capital it needed, usually from the bank itself. The shell company would then assume the risk of various loans the bank wanted off its book.

Does this seem like three-card monte or a shell game to you? Where's the risk? It's under this shell. No, it's not. It's under this shell. No, it's over here... Actually, we don't really know where the risk went. The important thing is that the regulators say we don't own it anymore. As soon as the risk is officially gone, we can make more loans.

These innovations and others just like them lie underneath one financial debacle after another between 1997 and 2008. For example, the giant fraud at Enron would never have happened without these innovations. Enron's SIVs were funded with Enron's own stock, and then used to facilitate the underwriting of its debts.

These ideas were also used to move the risk of massive telecom loans off the books of major banks, creating the worst excesses of the telecom bubble (and one of the largest bankruptcies in history – MCI WorldCom).

Finally, in ever-larger amounts, these financial tools were used to package, sell, and distribute the risk of wildly inflated mortgages and obviously fraudulent subprime mortgages.

CDSs have been the primary vehicle for creating credit bubbles over the past 20 years. But they're not all bad...

Investors who understand them, follow them closely, and trade them wisely, have created some of the largest fortunes in the history of capitalism. John Paulson, for example, bet on the right side of mortgage-security CDSs and made almost $30 billion for his hedge fund in three years. By keeping an eye on the CDS market, it has become easier to spot an emerging credit problem.

Consider General Motors, for example. We warned in March 2014 that GM's financial arm, GM Financial, had made far too many risky subprime auto loans. Incredibly, in our view, GM Financial's domestic loan book was more than 80% subprime. You might recall that the company rebuffed our warning.

But the CDS market clearly agrees with us.

Look how much the cost of insuring GM's bonds has risen since we published our warning.

The Big Risk Nobody Understands... Yet

You need to know one more thing about CDSs...

There's a part of these deals that no one talks about, a part that's more dangerous than anything we've yet to discuss.

CDSs were designed to transfer almost all of the risk of the loans. If all of the risk was transferred then the deal would no longer be a swap, it would be a sale. For legal and regulatory reasons, the residual risk of these deals has to remain with the actual owner of the note.

So in the case of the first big CDS deal Blythe Masters syndicated in 1997, JPMorgan swapped the default risk on $9.7 billion worth of loans to other investors, whose risk was capped at $700 million. These investors were on the hook for the first $700 million in losses on these bonds. This "credit protection" meant the remaining loans ($9 billion worth) were thought to be "super senior" – even safer than U.S. Treasury bonds. They were thought to be better than triple A.

And because these remaining loans were thought to be so super safe, financial firms had to hold little-to-no capital against the risk of loss. That meant that holding these loans was incredibly profitable. There was no cost to own them. Investments in these securities were almost always extremely highly leveraged – the kind of leverage that will wipe out entire banks or financial firms if anything goes wrong.

This is how AIG went bust. This is why GE Capital and dozens of major European banks came so close to insolvency. When the losses on bond packages far exceeded the amount of credit protection that had been sold, the result was a financial catastrophe the scope of which hadn't been seen before in modern capitalism.

Now... having seen all of this happen in just the last few years... and having set up so many of the original structures that enabled these catastrophes... where do you suppose Blythe Masters works today?

You might guess JPMorgan. After all, these credit-enhancing tools led the other banks to blow themselves up, but not JPMorgan. Instead, JPMorgan survived and was able to purchase the remnants of both Bear Stearns and Lehman Brothers.

No, she doesn't work at JPMorgan anymore. She left the bank after running JPMorgan's commodities group, which was sold in 2013.

Since July 2015, Blythe Masters has been the chairwoman of Santander Consumer USA, the largest holder and underwriter of subprime auto loans.

Find the credit bubble, and you'll find Blythe Masters.

The Largest Legal Transfer of Wealth in U.S. History Starts Now

We are in the early stages of a great debt default – the largest in U.S. history.

We know roughly the size and scope of the coming default wave because we know the history of the U.S. corporate debt market. As the sizes of corporate bond deals have grown over time, each wave of defaults has led to bigger and bigger defaults.

Here's the pattern.

Default rates on "speculative" bonds are normally less than 5%. That means, less than 5% of noninvestment-grade, U.S. corporate debt defaults in a year. But when the rate breaks above that threshold, it goes through a three- to four-year period of rising, peaking, and then normalizing defaults. This is the normal credit cycle. It's part of a healthy capitalistic economy, where entrepreneurs have access to capital and frequently go bankrupt.

If you'll look back through recent years, you can see this cycle clearly.

In 1990, default rates jumped from around 4% to more than 8%. The next year (1991), default rates peaked at more than 11%. Then default rates began to decline, reaching 6% in 1992. By 1993, the crisis was over and default rates normalized at 2.5%. Around $50 billion in corporate debt went into default during this cycle of distress.

Six years later, in 1999, the distress cycle began to crank up again. Default rates hit 5.5% that year and jumped again in 2000 and 2001 – hitting almost 8.7%. They began to fall in late 2002, reaching normal levels by 2003.

Interestingly, the amount of capital involved in this cycle was much, much larger: almost $500 billion became embroiled in default. The growth in risky lending was powered by the innovation of the CDS market. It allowed far riskier loans to be financed. As a result, the size of the bad corporate debts had grown by 10 times in only one credit cycle.

The most recent cycle is the one you're most familiar with – the mortgage crisis.

Six years after default rates normalized in 2003, they suddenly spiked up to almost 10% in 2009. But thanks to a massive and unprecedented government intervention, featuring trillions of dollars in credit protection, default rates immediately returned to normal in 2010. As a result, only about $1 trillion of corporate debt went into default during this cycle.

You should know, however, that the regular market-clearing process of rising, peaking, and normalizing default rates did not occur in the last cycle. A massive, unprecedented intervention in the markets by the Federal Reserve stopped the default cycle in its tracks. As a result, trillions of dollars in risky debt did not enter default and were not written off.

Over the last six years, this "victory" against bankruptcy and the credit cycle has led many government leaders and their economic apologists (like Paul Krugman) to declare victory. What they won't admit is that the lack of a debt-clearing cycle has resulted in a weak recovery and an economy that's still heavily burdened by unsustainable debts.

What happens next should be obvious to everyone: The big debt-clearing cycle that was "paused" in 2009 will make the next debt-clearing cycle much, much larger – by far the biggest we've ever seen. When will that happen? Six years after default rates last returned to normal. In other words... right now.

Here's another way to time the next debt-clearing cycle.

At the end of 2014, only 1.42% of speculative corporate debt had gone into default for the year – near a record low. The only better year for speculative corporate debt in recent history was the top of the mortgage-debt boom in 2006. As you know, two years later, disaster struck. A new low for defaults in 2014 points to 2016 as the year when corporate debt will begin a new default cycle.

Martin Fridson, the world's foremost expert on the high-yield bond market, says his "base-case scenario" is for between $1.6 trillion and $2 trillion in defaults in high-yield bonds over the next three to four years. We believe default rates will be a lot worse, simply because the market has grown so much, thanks to things like CDS credit protection and the securitization of subprime consumer lending.

Now, before you panic... here's an idea you'll see us repeat again and again over the next three to four years.

What's happening – rising default rates, rising interest rates on corporate debt, and falling stock prices – doesn't need to be a crisis for you, personally.

Instead, this period could be the best opportunity that you will ever get to buy great assets and great businesses at great prices.

You don't need to think of this coming crisis as the "end." Instead, think of what's happening as a badly needed reckoning. It's simply a house cleaning. Nothing much will change. The best assets and best businesses will still be here after the storm. The only real difference will be who owns them.

What's coming is the greatest transfer of wealth in history. Over the next few years, trillions of dollars' worth of businesses, land, resources, and intellectual property are going to exchange hands – legally, but unwillingly.

Investors who have been frugal and cautious will be rewarded. Investors who have been greedy and foolish will be punished.

But who will be first to fail? The poor, of course.

Our Early Warning Signal: Subprime Loans Going Bad

You may wonder what we mean by unsustainable debts.

Let's use a real-life example: Johnathan and Marcelina. These are real people. They live in the Bronx. They've struggled to get back everything they lost during the last financial crisis. Finally, Mercelina declared bankruptcy in 2012, and they started over.

Soon after she declared bankruptcy, Marcelina got a solicitation in the mail. The pitch? Re-establish your credit, plus buy whatever car you want. She took the bait... and Marcelina and Jonathan now own a 2011 Hyundai.

Thanks to a 20%-plus interest rate on the loan, their monthly payment is $600. By the time their loan is satisfied, the couple will have paid more than $30,000 for a 10-year-old Hyundai. They're skimping on groceries today so that they can afford the car payment. But it's only a matter of time before they either lose a job or simply mail back the keys because they would rather go out to eat.

Here's what stories like these look like, from the standpoint of financial researchers. The core problem for America's consumers is that income hasn't kept pace with consumption. The result? Soaring consumer debt loads.

Since the mortgage crisis of 2008, the two kinds of personal debt that have continued to increase the most are student loans – which offer all kinds of ways to avoid repayment – and auto loans. The growth in auto lending has been spurred forward by a complete collapse in lending standards, including subprime lending to people with zero income and zero credit histories.

People like Dana.

Dana (her real name) hasn't worked since she left her job as an administrative assistant at the New York City Police Department. She's on food stamps now. Despite this, an employee at a Long Island car dealership convinced Dana she could afford a $31,000 loan for a late-model BMW. According to a well-researched exposé in the New York Times, Dana thought she was simply co-signing for her daughter, claiming, "I looked him in the eye and said, 'I don't have any income.'"

As crazy as it sounds, some investors have gotten rich by helping originate and service these loans. Just look at the chart of Credit Acceptance Corp. (Nasdaq: CACC). Since the market bottom in late 2008, this stock has gone from less than $15 per share to more than $260. This company is the poster child for the subprime auto boom. (You won't be surprised to learn that the founder, Donald Foss, and his family are selling stock.)

How is this possible? How have so many people gotten so rich making car loans to people who so clearly cannot afford cars?

Cheap capital is the primary answer. As you'll see, this kind of lending simply isn't possible without the Federal Reserve's rock-bottom interest-rate policy. Even small increases in funding costs would rapidly drive these companies out of business. They're already charging borrowers the highest interest rate allowed by law. In a sense, this regulatory burden means these businesses have the equivalent of fixed retail prices. On the other hand, they have highly variable costs. They're going to boom when capital is cheap. And they're going to collapse when capital is dear.

The other major enabling factor in this boom was the creation of specialized securities, called subprime auto asset-backed securities – or subprime auto ABSs, for short. There are now more than $20 billion worth of subprime auto ABSs.

These securities package together thousands of subprime loans, worth hundreds of millions of dollars – in some cases, more than a billion dollars. Grouping large numbers of loans together and adding significant amounts of "credit protection" – extra cash put into escrow to cover any potential credit losses – gives conservative investors a safe way to own subprime auto loans. Despite the risks of individual loans going into default, not a single subprime auto ABS defaulted during the last credit crisis.

These kinds of securities organize the loans they hold into categories – or "tranches" – based on risk. Because their recent history is free of default... the upper tranches of these securities, which have large amounts of credit protection, are considered even safer than triple A. Banks and other financial institutions can invest in these securities while holding almost no reserves for losses. So these investments are almost surely highly leveraged. And that means any losses to subprime auto ABSs could pose a serious threat to the financial system, despite the relatively small ($20 billion) issuance.

You should know that this idea – that before the end of this credit cycle, subprime auto ABSs will end up in default – is very controversial. Even among our staff, only I (Porter) think this is possible. Explain this to anyone at a major credit desk on Wall Street, as we did while writing this month's letter, and they will think you're a fool – or simply stupid. No one believes a subprime auto ABS will default.

I argue that during the subprime mortgage boom of 2004-2007, mortgage traders on Wall Street all claimed subprime lending against homes was perfectly safe. Housing prices never go down, they claimed. And that was true too... at the time.

But market participants in a credit boom always forget that underwriting standards heavily influence the nature of the market that is created.

When underwriting for mortgages was firm, when down payments were given, and when buyers had good credit, there was little risk that home prices would fall. They hadn't been wildly inflated by loans given to people who couldn't possibly repay.

But after a decade of loosening lending standards and several years of making loans that didn't really have to be repaid on time... to people who didn't really have any income... the exact opposite was inevitable. Housing prices had to fall because the owners of a significant number of houses couldn't possibly afford them. Losses went from being impossible to inevitable.

As you'll see, that's exactly what has happened with subprime auto lending.

The Subprime Auto Collapse of 2016

We first warned investors about the problems looming in subprime auto lending last year.

At the time, we recommended shorting General Motors (NYSE: GM), and avoiding Santander Consumer USA (NYSE: SC) and America's Car-Mart (Nasdaq: CRMT), a publicly traded, subprime-only seller of used cars.

We wanted to short GM last year because it's a low-margin manufacturer of low-quality cars that's deeply in debt. And despite the massive auto boom, the company's cash flows have all been spent paying off various governments and unions. You can summarize the situation by simply saying GM is a company run by communists, designed to support retirees, not shareholders (see the March 2014 issue for details).

GM is also, through its wholly owned subsidiary, GM Financial, one of the two largest owners of subprime auto loans. It's a company that's never seen a bad idea it couldn't make worse!

The other large public player in subprime auto finance is Santander Consumer USA, which was recently spun out of a private-equity fund and sold to the public (enjoy it, fellas!). That should tell you quite a bit about this industry... Its major investors include the world's worst automaker and a bunch of poor suckers who just got handed a bag of crap. What could possibly go wrong?

To be fair, the sector also includes a couple of well-managed, privately owned players (including one owned by the private-equity firm Blackstone) and a few smaller public firms, such as Consumer Portfolio Services (Nasdaq: CPSS) and the aforementioned Credit Acceptance Corp. But it's fair to say that nearly everyone who understands this market is selling.

In addition to the family owners of Credit Acceptance, Santander Consumer's legendary founder, Tom Dundon, is among the sellers. He started the company (previously known as Drive Financial) when he was 22 years old. He built it into the leading business in the space, making a fortune in the process. Although we don't know him personally, he doesn't seem like the kind of guy to just play golf. But he recently took a $1 billion buyout by dumping every share he owned (enjoy it, fellas!). When Dundon walked away from the business he spent his career building, the board handed the reigns to a lieutenant – and Blythe Masters.

We think the folks selling have a lot more brains than the folks buying. And so, we expect all of these stocks to do poorly over the next year. To spill the beans, in this issue we're recommending you sell short both Santander and GM. The other stocks mentioned are likely to suffer too, but they're thinly traded, and getting shares to short will likely be difficult.

Let's review how these businesses work and why they could all go out of business in the next 12 to 18 months.

How to Make Loans to People with No Money

The key to subprime lending is to charge borrowers a lot of money – as much as the law will allow.

You must do this because subprime borrowers are very unlikely to pay you back. And you also probably figure you'll get away with it. After all, your clients don't have a lot of options and aren't math wizards.

We've analyzed the business models of all of the publicly traded subprime auto lenders. They all operate within very similar metrics: They all maintain operating margins that represent about 2%-3% of their loan books. That means if their funding costs increase – say, if the prime rate were to go from 2% to 4% – their profits would disappear. Let me show you this in detail, working the actual numbers.

Below are the most recent numbers from Santander Consumer and GM Financial. By the way, GM doesn't make it easy to get these numbers. We have to create them by combining disclosures about the size of its subprime portfolio and then "pulling" these figures out of its other numbers.

Amazingly, Santander is able to earn 19% interest on its subprime loan book – an outstanding figure. Its parent company is a large Spanish bank, so it also has favorable access to credit. Right now, it pays only 2% for the money it uses to fund its subprime loans. That produces a massive 17% interest-rate spread.

GM has a slightly different model. It pays a bit more for capital (3%), but the real difference is that it's only earning 12% interest on its subprime loan book. That's probably because GM Financial solely exists to fund the purchase of GM vehicles. By subsidizing these loans, GM hopes to sell a lot more cars (and it has).

The other big difference (right now) is how much bad loans are hurting these businesses. Santander's bad loans have cost it 11% of its portfolio this year – a huge expense. GM's bad loans have cost it far less. That's probably because about two years ago, GM made a concentrated effort to improve its underwriting and move away from deep subprime lending. But even so, 71% of its loan book is still subprime.

The key to our short position is that despite the large interest rates these companies charge, their operating margins are tiny and could easily be wiped out. If these firms see a material increase in their funding costs – if interest rates increase in our economy, as the Fed says it's planning – then their profits will disappear.

We expect funding costs to rise, especially as credit risk increases across our economy and the credit cycle turns. This risk alone is plenty of reason to short these stocks. These companies' profits are purely a function of a credit boom that's been engineered by the Federal Reserve to spur consumer spending and bail out the auto industry. When the credit cycle turns, these firms will disappear.

But another factor is even more dangerous for these firms (and for the investors who hold their ABSs). Loan losses are going to soar in these portfolios because of material weaknesses in underwriting and regulatory actions that have weakened the companies' ability to repossess cars.

A big part of the recent subprime lending boom (see chart below) was an expansion in the duration of these loans. Expanding the duration of the loans from less than 60 months to more than 80 months reduced the size of the monthly payment, making cars more "affordable." This brought weaker and weaker buyers into showrooms.

This change to the loan structure and the acceptance of "deep subprime" clients with credit scores below 550, or without any credit scores at all, means that both delinquencies and losses on bad loans are going to rise. Of course, nobody knows exactly how much they'll rise, but the initial signs aren't good.

Ratings agency Standard & Poor's (S&P) reported on August 31 that across all subprime lenders with access to the ABS market, delinquencies – loans more than 30 days past due – hit a record low at the end of 2011, representing an average of 6% of lenders' loan books. By year-end 2014, average delinquencies were 10% of creditors' loan books.

So far, average loan losses haven't grown by as much. They were sitting at 8% as of the end of 2014. That seems like good news. But it's not.

Delinquencies on loans are highly correlated with eventual loan losses. Folks who pay late are much more likely to default. Historically, the industry has been quick to repossess cars from clients who didn't pay. That's changing now. As S&P reports:

This Time... It's 'Deferment'

These companies have invented new ways to avoid categorizing a loan as delinquent.

For example, GM Financial will grant customers a "deferment." As the company states in its regulatory filings: "We, at times, offer payment deferrals to consumers. Each deferral allows the consumer to move up to two delinquent monthly payments to the end of the loan generally by paying a fee."

This policy allows the customer to keep driving the car (without paying for it), and it allows GM Financial to avoid labeling the loan as delinquent. By the end of 2014, GM Financial had given deferrals to almost 24% of its existing outstanding accounts. (And interestingly, the company also disclosed that 4% of its accounts have been deferred three or four times. That's just after explaining that it limits deferments to only twice.) GM Financial has also disclosed that it expects 50%-60% of all of its loans be given a deferment at some point in the life of the loan.

Santander allows clients to move up to three payments to the end of the loan. Again, once it grants a deferment, the company doesn't report any of the loan as delinquent to the credit rating agencies. But Santander admits in SEC filings that more than 25% of its loans are deferred at least once. The total value of the loans that have been deferred by Santander at least once is more than $7 billion.

So... here are financial firms... that have to borrow essentially all of the money needed to fund their businesses... that then turn around and lend it to people for very long periods of time (more than 80 months in some cases)... that are allowing billions worth of these loans to go unpaid, but not reporting these deferrals as delinquent.

That's going to end badly.

The numbers of loans that are going even beyond these deferrals into delinquency is increasing rapidly. S&P reports that looking at delinquencies from the subprime loans made in 2011 and studying the rate at which those loans went bad, the 2013 vintage of subprime loans is going delinquent at a much faster rate. The number of 2013 loans that are more than 60 days delinquent is 86% higher than 2011 loans were at the same point: 4.5% of 2013 subprime loans versus only 2.4% of the 2011 total.

Once you realize these folks were almost surely also given a month or two... or three... or four... of deferment, you can see that these loans are seriously in default and will almost surely cause credit losses.

Our bet is that this big increase in delinquencies will continue with the 2014 vintage of subprime loans. But even assuming that 2014 loans are "only" as bad as the 2013 vintage, this sharp rise in delinquencies should cause loan losses to spike higher. A 50% increase in loan losses would wipe out the profits of both Santander Consumer and GM Financial.

As the chart below shows, the trend in net losses is heading higher…and a 50% increase is not unprecedented – it would simply be a return to 2009 levels.

We think loan losses are heading much higher. And we believe loan losses will increase by more than the increase in delinquencies.

For decades, the maximum car loan term was 60 months. This started to change about 10 years ago. Over time, the average term on a new car loan began to gradually extend. Currently, the average term on a new car loan for subprime and deep subprime borrowers is 72 months. That's up 14% in just five years. And loans of 73-84 months now make up 26% of all used car loans.

These longer loans are a new development. Lenders have no historical data to model what credit losses are likely to be across the life of an 84-month subprime loan. (Here's a hint: It's not good news.)Santander Consumer claims it uses detailed algorithms to forecast defaults. Really? How is that possible? When it comes to 84-month loans, what information could these "complex algorithms" possibly be based on? Such estimates require huge amounts of data, history, and experience – three things that don't exist when it comes to 84-month car loans.

No, we don't have any "complex algorithms"... But we have some common sense.

It is a basic fact that borrowers who owe less than their collateral is worth – those who have "equity" – are much better payers than borrowers who are "underwater" (those who owe more on the loan than the asset is worth).

How much equity does a subprime borrower have in his car when he has an 84-month loan and an annual interest rate of 20% or more? The answer is none. In fact, it takes five years of steady payments before a subprime borrower has any equity in his car. As a result, we believe credit losses on 72- to 84-month auto loans will be much worse than expected.

And what about recoveries? One of the core tenants of subprime auto lending is that you can't lose money on these loans because the collateral can be repossessed quickly and re-sold. Obviously, that's changing too.

All these deferrals and extended lending periods mean the reclaimed cars are going to be older and more beaten up when they're sold. Also, as defaults rise, more used cars are going to be auctioned, which will push down the prices of used cars, hurting recoveries and making loan losses larger than expected.

For all of these reasons, we believe loan losses will increase more than the increase we've seen so far in delinquencies. We think loan loss could increase 100%-150% in the 2014 and 2015 vintage of subprime auto loans – and it could even be worse.

If that happens, the industry will be facing loan losses equal to 20% or even 25% of its total outstanding loans. That will be catastrophic for companies like Santander and GM Financial. Even in the best of times, they exist on very small operating margins. The losses don't even have to grow as fast as delinquencies have grown to wipe out these firms' profits. If the size of the loan losses grows by just 30%, it will erase all of their profits.

Losses of the magnitude we expect, 20%-25% of their portfolios, would be large enough to hurt the speculative-grade tranches of ABSs.

If there's a single default in a subprime auto ABS... you can turn out the lights on this entire form of lending. Nobody will put up the capital for subprime auto loans if investors begin to lose money holding credit-protected securities. There will be no way to fund the loans. It's good-night, Lucy.

Shorting stocks is hard. So we're careful about what types of businesses we will consider shorting. We look for at least one of three qualities: We short "frauds" (like Yelp!), we short impossibly indebted companies that have no hope of repaying their debts (like "old" GM in 2007), and we short obsolescence (like Kodak in the early 2000s). We've had a fair amount of success by sticking closely to these three strategies.

With GM and Santander... we actually think we've found stocks to short that combine all of the qualities. In our view, subprime auto lending is an obsolete business because it can only exist during periods of artificially low interest rates. And sooner or later, the interest rate policy must return to normal (though we don't know when that will happen).

As for fraud... remember, we aren't necessarily alleging fraud in a technical or legal sense. We mean that if a company lures investors in using deceptive or misleading numbers, it will eventually be uncovered and come crashing down. And we have no doubt Santander Consumer and GM Financial are manipulating their numbers to mislead investors.

Do you think car salesmen won't fudge someone's income on a credit application? It's certainly misleading for GM Financial to claim its customers are only allowed two deferrals on their loan payments... when its annual report lists the number of customers who've actually been given three or four deferments.

The amount of fraud is probably shocking because it's big enough and obvious enough to interest politicians. Last year, in the wake of some provocative reporting by the New York Times, the Justice Department began investigating whether auto loans with improper documentation are being packaged for securitization. This investigation, which has targeted both GM Financial and Santander specifically, continues.

As for debt, these companies are highly leveraged. Santander’s debt-to-asset ratio is 85% and GM Financial's is 80%. Both can currently pay their debt and interest... as long as interest rates remain near zero percent. But if the cost of capital rises just a little, it will overwhelm this business model.

The truth is, some people will always want what they can't afford. And some people will always try to borrow money they can't pay back. Over the last 40 years, many people in our country – especially our political leaders – have pandered to these fools. They promised people benefits they didn't earn. They promised wealth without savings. They promised income without labor. And most of all, they promised people they could have loans without any credit.

What we've ended up with is a whole boatload of bad debts.

For a long time, Americans went for these ideas whole-hog. But those days are nearing an end. Already, consumers have pared back credit-card balances and mortgage loans. A reckoning is coming next in auto and student loans.

Going forward, we believe gaining access to credit will become more expensive and difficult. We may yet see a return to an older way of doing business. Consider what J.P. Morgan – the man who founded the bank – told Congress more than 100 years ago: "The first thing is character. Money cannot buy it. A man I do not trust could not get money from me on all the bonds in Christendom."

In a world like that, subprime auto lending is completely obsolescent.

Sell short shares of General Motors (NYSE: GM) and shares of Santander Consumer (NYSE: SC).

Be aware... these positions will likely be volatile. Do not put more than 5% of your portfolio into these positions. Use a 25% trailing stop loss.