The Next Financial Horror Show Is Closer Than You Think

The next financial horror show is closer than you think... Zombies, covenant creep, and shadow banks... It will get ugly when credit is suddenly denied... A risky high-yield market you've probably never heard of...

Have you ever been denied credit?

Maybe you were trying to buy something at the local hardware store and your credit card was declined. "The machine must be acting up," you might have thought to yourself.

Or maybe you've been denied a loan. It's embarrassing, and it leaves you with a sick, unpleasant feeling in your stomach.

Now imagine that you needed that loan just to stay afloat... to keep up with your bills and pay the minimum balances on your credit cards.

That's the situation facing hundreds of companies in corporate America. Suddenly – and without warning – they'll be denied credit. The companies in the worst financial shape will have nowhere to turn for help.

When this happens, it will bring both the bond market and stock market to their knees.

Today, I (Mike DiBiase) will explain why this will happen – and much sooner than you might think...

Over the past several months, I've warned Digest readers about the dangers of record-breaking share buybacks and shared the key warning sign that will cause this historic bubble to pop.

The stock market has marched higher without pause, gaining back all of its fall 2018 losses and then some. Today, the S&P 500 and Nasdaq Composite indexes are at record highs. Corporate earnings are expected to rise this year, and the economy appears healthy.

It's easy for investors to be complacent right now. But most folks are forgetting that one of the hidden forces behind this record-breaking bull market is debt.

Following the last financial crisis, corporate America deleveraged – but it didn't last long...

Since then, companies have borrowed massive amounts of money. Today, corporate America is more indebted than ever before, owing a record $9 trillion.

But these companies didn't put that money toward investing in new factories, equipment, or technologies. Instead, they borrowed money simply to buy back their own stock.

Buybacks are the single largest source of demand for U.S. stocks. They bid up stock prices by increasing demand for shares while at the same time reducing the supply.

This strategy has also made these same companies much more leveraged and risky.

Many are now in danger of going broke. And yet, if you turn on CNBC or read the front page of the Wall Street Journal, nobody else is talking about how dangerous this is.

Today, there are more 'zombie' companies in corporate America than ever before...

A zombie company is a company that doesn't make enough money to even pay for the interest on its debt. These zombie companies are like the walking dead. They have no hope of ever paying off their debt.

The only thing keeping them alive is banks with low lending standards that are willing to extend them credit. This practice is known as "extend and pretend" because the banks are kidding themselves that the zombies will be able to pay back the principal of their loans. Without the banks rolling over (or refinancing) their debt, these companies would cease to exist.

According to a study by the Bank of International Settlements ("BIS"), the number of zombie firms has increased sixfold since the mid-1980s. The BIS estimates that one in six U.S. companies is now a zombie.

Imagine how many zombies there would be if companies had to pay reasonable interest rates... or if the economy hadn't been humming along. The number would likely be two times higher.

If banks suddenly denied credit to the zombies, a tidal wave of American companies would go bankrupt. The result would be skyrocketing default rates... massive credit losses... bond investors rushing for the exits... and the economy grinding to a halt.

'Extend and pretend' is propping up the entire U.S. economy...

This game can't go on forever. I believe its end is near.

We're getting close to a situation where banks will be better off denying credit. Denying credit is a simple financial decision for a bank. When a bank can make more money by refusing credit than by extending a loan, it will cut off credit to the zombies.

You see, banks can still recover most of their loans when they force a company into bankruptcy. Bank loans are secured and are senior to all other debt. That means they get paid first when a company goes bankrupt. That's why they recover far more of their investment than other creditors.

According to credit research and ratings agency Moody's, banks recover between 80% and 90% of their loans in bankruptcy. They'll gladly force a company into bankruptcy if that's more than they think they'll get by kicking the can down the road and watching the company get weaker and weaker.

But other corporate lenders further down the credit ladder – like bond investors – won't fare nearly as well. Historically, they've recovered only around $0.40 on the dollar of their investment in bankruptcy. And this time around, they'll get much less than that.

The credit protections built into many types of less-senior corporate debt have deteriorated...

Covenants are rules in the credit documents that protect lenders by preventing companies from taking certain actions. Loans with weak protections are called "covenant lite."

You can judge the quality of lending standards by the covenants that govern them. And as you might guess, loan covenants have steadily weakened since the 2008 financial crisis.

The deterioration of these covenants is known as "covenant creep." As the Fed kept lowering interest rates, investors rushed into riskier, higher-yield investments... And as more dollars competed for these investments, investors threw credit protections to the wayside.

When this debt does go bad – and it will go bad – investors will be left holding the bag.

And another high-yield market is just as risky – and even bigger – than high-yield bonds...

The leveraged loan market recently hit $1.6 trillion, according to Bloomberg, double the amount at the end of 2008.

These are loans that banks make to companies with poor credit... But they're nothing like secured loans and lines of credit that sit atop the credit ladder.

They're more like high-yield – or "junk" – bonds. Investors like these loans because of their floating interest rates. As interest rates rise, these loans pay more interest.

You might be wondering what all of this has to do with you...

It turns out, you might own some of these leveraged loans without even realizing it.

You see, banks don't hold on to these risky loans for long. These loans – called collateralized loan obligations (or "CLOs") – get packaged up and sold to institutional investors like pension funds, hedge funds, and mutual funds.

What's troubling is that there is no direct oversight of the leveraged loan market. And it's not just banks that are extending these loans and repackaging them.

"Shadow banks" have emerged to get into the game. Shadow banks are investment companies like broker-dealers and private equity investment funds. They tend to focus on the middle-market, smaller companies that the bigger banks won't bother with.

Yield-hungry investors have been snatching up these loans in droves, ignoring the similarities to the subprime mortgages that triggered the last financial crisis.

The risk of leveraged loans has grown faster than high-yield bonds...

The number of covenant-lite leveraged loans has soared... Today, more than 85% of leveraged loans are considered covenant-lite, up from just 17% in 2007.

Former Federal Reserve Chair Janet Yellen sounded the alarm on leveraged loans last October. She's worried about "the systemic risk associated with these loans."

How soon could this all blow up?

To know the answer to that question, pay close attention to the so-called "yield curve" – the difference between long- and short-term interest rates.

As regular Digest readers know, most of the time, long-term rates yield more for the trouble of tying up your money for longer durations. But when that relationship flip-flops, the yield curve is said to have "inverted."

You can measure the yield curve in a number of ways. The most common is the "10-2 yield curve" – the difference between rates on 10-year U.S. Treasurys (which yield 2.54%) and two-year Treasurys (which yield 2.3%). The difference is just 24 basis points (0.24%) right now. In other words, the yield curve is extremely close to inverting.

That doesn't happen often, but when it does, it spells trouble. An inverted yield curve preceded the past seven recessions. You can see the latest three instances in this chart...

When the yield curve inverts, banks tighten credit...

Banks borrow money at shorter-term rates and lend money at longer-term rates. So when the yield curve inverts, they're forced to pay more in interest than they're able to charge for their loans. So they issue far fewer loans... and zombie companies that rely on banks to refinance their debt suddenly get cut off and go bankrupt.

The last time we saw this was in 2006. Before that, banks had been loosening credit. After the yield curve inverted, they immediately began tightening. By 2008, more than half of all banks were tightening. Credit dried up and kicked off the last financial crisis.

Every quarter, the Federal Reserve conducts a survey to determine whether banks are tightening or loosening credit.

Last quarter, banks began to tighten for the first time since 2015...

Back then, the yield curve stood at 145 basis points. Banks tightened credit when oil prices collapsed, but quickly loosened it once again as prices recovered.

But this time, the yield curve is dangerously close to inverting. Some other yield curves (like the 10-year Treasurys versus the three-month Treasurys) have already inverted briefly.

The next Fed survey should come out this week. Pay close attention to this report. If this tightening trend continues, I believe it will trigger the next financial crisis.

The crisis will begin in the less-regulated markets like leveraged loans, where we've seen crazy rates of growth... then will quickly spread to the high-yield corporate bond market... and then into the stock market. Share prices of highly leveraged companies considered safe today will crash.

We're not there yet...

But make no mistake, a crisis is coming. It could be far worse than what we saw in 2008. And if you wait until the signs are obvious to take shelter, it will already be too late.

The time to prepare is now. That's why we're holding a special event next month...

On Wednesday, May 15, at 8 p.m. Eastern time, Porter will sit down with legendary investor Jim Rogers to explain exactly what you can do now to protect your savings – and even profit – while most folks are panicking. Click here to learn more and reserve your spot now.

New 52-week highs (as of 4/29/19): Blackstone (BX), First Trust Nasdaq Cybersecurity Fund (CIBR), Alphabet (GOOGL), Ingersoll Rand (IR), KLA-Tencor (KLAC), MarketAxess (MKTX), NetEase (NTES), Travelers (TRV), and Vanguard S&P 500 Fund (VOO).

The feedback on Porter's "epic" Friday Digest continues to roll in. Send your notes to feedback@stansberryresearch.com. As always, we can't provide individual investment advice, but we read every e-mail.

"Another epic Porter Friday Digest! Thanks again for the learning, Porter. I feel like a frog in a pot slowly coming to a boil – student loans, mortgage debt and home prices, auto prices, stock prices, state and federal deficits, pension shortfalls – is it starting to feel a little warm around here? I sincerely appreciate you sharing your market insights – even if it isn't a specific stock selection. I think your Friday Digests are much more valuable than a stock pick.

"Speaking of businesses built to last, interesting how so many of Friday's 52-week highs are [Stansberry's Investment Advisory] recommendations (that I gladly hold) – AXP, DIS, HSY, MCD, MKTX, TRV, and WRB. Thanks Again Porter! I hope to see you back in the Friday Digests more regularly." – Paid-up subscriber Matt V.

"I wanted to thank Porter for this latest Digest. It hit home for me as a legacy employee working for a business that was purchased by a private equity group 4 years ago. I have personally seen the trend (on a micro level) that Porter references in his writings and have often scratched my head as management focuses on short-term performance over sustainable long-term business building practices. The short-term group think has intensified over the last 6-12 months which tells me they must be trying to attract buyers as they continually try to bring business forward while hurting long term prospects. Welcome to the new 'capitalism' everyone!" – Paid-up subscriber Andy S.

"Thanks for such a thoughtful and detailed analysis of the nation's financial situation. Very sobering, and completely true. I still intend to ride this runaway train until it jumps the track. I feel like I have a solid exit plan. I hope your other readers do too." – Paid-up subscriber Billy T.

"Porter: Just read the Friday Digest. As a former banker trained in fundamental analysis, I read your litany of unicorns while shaking my head. This will not end well. As I enter retirement, I am combing your publications for tools to survive what WILL come. I encourage all of your editors to be clear and frank with recommendations and all your readers, especially those of us over 60, to be honest with yourselves about how much risk – in $ terms, not % – you can take." – Paid-up subscriber Mark J.

"Hi Porter, great Friday Digest... Also commending you for not accepting rapacious VC money at OneBlade. Happy customers are your best marketing, even if it takes longer than two quarters to double the user base. I tell every friend they should be using OneBlade, not just because it is a better shave, but also because the economics of OneBlade + Feather blades are far superior to commercial shavers and cartridges over time." – Paid-up subscriber Darin W.

"I enjoyed [Friday's] essay by Porter. I am a OneBlade daily user and have been for as long as the product has been available. Yes, the OneBlade is a quality product that has not malfunctioned since I got it over two years ago. It is one of very few products that I use that actually works as advertised. I appreciate the effort that was put in to the development and creation of the OneBlade.

"Nothing else, maybe minus my Apple products, have lasted more than about a year. It is frustrating when I shop for things, quality is missing. Like just about everything. I remodel houses, and quality materials are hard to find; and if I do find them it is usually from Stardust or Habitat for Humanity – two non-profit construction supply companies. They take donations from demo-ed houses. Stuff that was built years and years ago; and it still works! Doors, windows, lumber, you name it.

"I think when the economy finally crashes hopefully new businesses will emerge with quality being the number one priority. Life is so much less stressful when you can buy a quality product that you don't have to worry about breaking down or going obsolete.

"So thanks Porter. For the OneBlade. It's a good model to emulate when somebody wants to start up a business with a product. The more things like this that become, the better the chances of a conscious turnaround in the economy. I think it will be inevitable in the near future. At least I hope so." – Paid-up subscriber John L.

Regards,

Mike DiBiase
Atlanta, Georgia
April 30, 2019