The Worst Default Wave in History

The worst default wave in history... Recovery rates are plunging... Earnings season is here... A 'perfect storm' for banks... The $147 billion question... A notice for Stansberry Gold Investor subscribers...

"The coming default wave is shaping up to be among the most painful..."

No, that isn't a quote from one of Porter's repeated warnings about the credit markets... though you would be forgiven for thinking so.

Instead, it's one of a handful of recent financial-news headlines echoing what Porter has been predicting for months. The mainstream media could finally be taking notice of these problems...

For example, the Bloomberg Business article quoted above highlighted research showing that losses in the bond market are likely to be much higher compared with previous credit-default cycles. This is because U.S. companies have taken on so much more debt compared to their assets this time around. From the article (emphasis added)...

In bad times, corporate bond investors on average lose about 70 cents on the dollar when a borrower goes bust. In this cycle, that figure could be closer to the mid-80s, Bank of America strategists said. Those losses would be the worst in decades, according to UBS Group AG's analysis of data from Moody's Investors Service.

At least part of the pain that investors will experience in this downturn was deferred from the last credit crunch, which for corporate issuers was relatively short-lived. During the financial crisis, the Federal Reserve was quick to cut rates, and investors began diving back into junk bonds quickly, said Alan Holtz, a managing director in the turnaround and restructuring practice at AlixPartners, a consulting firm that focuses on companies in distress. Many companies were able to refinance debt instead of defaulting.

"A lot of the troubled companies that had become overleveraged were able to find more temporary solutions in the last credit cycle," Holtz said. "Those Band-Aids are no longer available now, and a lot of companies are going to have to face distress," he said.

Hmm... Where have we heard that before?

The article also noted "recovery rates" – the percentage of principal that investors recover when a bond defaults – are already falling. Two years ago, they averaged approximately 44 cents on the dollar. Today, they sit at just 29 cents on the dollar... meaning investors are losing more than 70% of principal on average.

The UBS Group says that the long-term average recovery rate across the entire credit cycle is around 40 cents on the dollar. This falls to around 30 cents on the dollar when "times get bad."

In other words, recovery rates are already worse than they usually get during downturns... and this default cycle is just getting started.

UBS says the lowest recovery rate on record was around 22 cents on the dollar in 2001. We wouldn't be surprised to see a new record before this cycle is over.

A recent piece in the Financial Times was even gloomier, noting that the problems in the credit markets are "different" this time around. From the article (emphasis added)...

What is different this time is, at least in part, the unintended consequence of actions taken in response to the last crisis. Years of extraordinary monetary policy have encouraged corporations to borrow colossal amounts of debt, often for dubious purposes.

There are problems in the credit markets, the most obvious being energy and mining. What is more, zombie companies from the previous cycle that were bailed out by easy credit are due for their comeuppance. While it is impossible to predict the exact timing, based on the indicators we track, it seems default rates have begun their inexorable climb.

According to the article, this means the "old bets" – like buying distressed bond funds or indiscriminately scooping up defaulted bonds – are unlikely to work this time around. More from the piece...

Simply put, the old playbook of buying defaulted bonds at 35 cents because, on average, they tend to recover 50 cents, may be obsolete. In the coming cycle, nimbleness will be critical to success...

Investors in distressed debt funds the past few years are doubtless familiar with the major disappointments in shipping, power, retail, and, worst of all, the oil and gas sector (in which we saw virtually zero recoveries for many 2015 vintage defaults). For whatever reason – excess monetary stimulus, zombie companies, unsustainable profit margins, or other factors – there is something different happening this time.

In other words, if you're looking to profit from bonds during this default cycle, you'll have to be extremely selective. This means buying only the right distressed bonds – those that are unlikely to actually default – at the right price. (This should sound familiar to regular Digest readers... It's exactly what Porter and his team have been recommending for the past several months in Stansberry's Credit Opportunities.)

Even the U.S. government's Securities and Exchange Commission ("SEC") is getting in on the act...

Speaking at a conference late last month, SEC Chair Mary Jo White warned mutual-fund managers about the dangers of "harder to sell investments" like distressed bonds. She pointed to the collapse of the Third Avenue Focused Credit Fund last fall as an example of what can happen when mutual funds load up on these positions that can't be easily liquidated.

She also announced a new rule proposal that would require mutual funds to hold much larger cash positions to weather investor redemptions. The rule would also make funds disclose exactly how long it would take to sell every security they own.

The Wall Street Journal reported that these remarks were noteworthy because the SEC rarely singles out the problems of individual firms like Third Avenue. The move suggests even the SEC is extremely concerned more problems could be coming.

Speaking of potential problems, first-quarter-earnings season is officially underway...

Aluminum producer Alcoa (AA) was the first to report results after market close last night. The company said its first-quarter earnings fell 92%, and it lowered its outlook for the rest of the year.

Of course, Alcoa has been hit hard by the decline in commodities prices, but expectations aren't much better for the broad market...

Wall Street expects that total S&P 500 earnings per share ("EPS") will decline 7.5%-8.5% on a year-over-year basis.

This would be double the 4.2% decline in EPS in the fourth quarter of 2015 that coincided with the market's big decline this year. It would also mark the first time since 2009 that S&P 500 earnings declined for three quarters in a row.

But even those figures may be too rosy...

S&P Investment Advisory Services Chair Mike Thompson says that companies are relying more and more on "financial engineering" to inflate their earnings. As Thompson explained in an interview with financial-news network CNBC yesterday...

Where are profits coming from? It's amazing, but honestly a lot of what you do see in terms of the profit growth you do have now is engineering [such as stock buybacks and global labor arbitrage].

These are the levers companies have to work with. They're taking advantage of the fact that there are a lot of opportunities to just continue to engineer their earnings.

Unfortunately, even financial engineering hasn't been enough for the banks...

Per news service Reuters, it has been the worst start to the year for banks since the financial crisis. Wall Street analysts are forecasting an average 20% decline in earnings among the six biggest U.S. banks. Some – including renowned investment bank Goldman Sachs – are expected to report the worst earnings in more than a decade.

Banks are suffering from a "perfect storm" of sorts... Years of low (and now negative) interest rates have made it harder and harder to generate revenue, while new regulations have dramatically increased costs. As Goldman Sachs lead bank analyst Richard Ramsden noted to Reuters...

What's concerning people is they're saying, "Is this going to spill over into other quarters?" If you do have a significant decline in revenues, there is a limit to how much you can cut costs to keep things in equilibrium.

Many banks are also exposed to large potential losses in the energy sector... and those losses could actually be far larger than almost anyone originally believed.

The Wall Street Journal reports the 10 largest U.S. banks could be on the hook for an additional $147 billion in so-called "unfunded" loans. These are loans that have already been promised to energy companies, but haven't been used... yet. And the vast majority of those loans were made by the four largest U.S. banks: JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo.

But that figure only includes the loans that have been disclosed... The Journal notes smaller U.S. banks and large international banks have made billions more of these same unfunded loans.

So far this year, a small number of energy companies announced tapping more than $3 billion of these unfunded loans. But banks don't have to disclose these loans. This means no one really knows how many more have been tapped but not announced... And no one knows how many of these loans will ultimately be tapped in the future. As Barclays analyst Jason Goldberg put it...

With oil at $60, it's not that big of a deal. With oil at $40, it becomes more of a source of concern. Will companies draw down in difficult times?

The longer oil prices stay low, the greater the incentives will be for energy companies to use these loans. Troubled banks could suddenly have a lot more exposure to energy debt... the same toxic debt they're already struggling to deal with.

One final note before we sign off...

Since launching Stansberry Gold Investor on April 6, gold prices have gone straight up. And prices for gold stocks, which are leveraged to the price of gold, have gone even higher.

Early subscribers to the service are already sitting on large gains across the recommended portfolio. But today, many of the stocks we recommended are trading well above their buy-up-to prices.

We sent an e-mail to all Stansberry Gold Investor subscribers yesterday urging everyone to be patient... and we would like to repeat that message in today's Digest. It's unwise to chase these stocks above their maximum buy prices. You're simply taking on too much risk.

We believe the prices of gold and gold stocks will be much higher in the future. But nothing goes up in a straight line forever. We're sure that once the current excitement surrounding gold and gold stocks dies down, you'll be able to enter these positions at much better prices.

So be patient. Don't bid these stocks above their buy-up-to prices. If you weren't able to establish positions in certain companies, don't worry. We'll issue new recommendations in the near future.

New 52-week highs (as of 4/11/16): Franco-Nevada (FNV), Market Vectors Junior Gold Miners Fund (GDXJ), Invesco Value Municipal Income Trust (IIM), Kaminak Gold (KAM.V), Nuveen AMT-Free Municipal Income Fund (NEA), Newmont Mining (NEM), NovaGold Resources (NG), New Gold (NGD), Nuveen Premium Income Municipal Fund 2 (NPM), Nuveen Municipal Value Fund (NUV), OceanaGold (OGC.TO), Prestige Brands Holdings (PBH), Seabridge Gold (SA), SEMAFO (SMF.TO), and Wells Fargo – Series W (WFC-PW).

In today's mailbag, praise for P.J. O'Rourke's latest... and two longtime subscribers share their thoughts on Stansberry Research. Send your questions, comments, and even complaints to feedback@stansberryresearch.com.

"PJ hit the nail on the head last night. What a great addition to your Digests." – Paid-up subscriber Steve P.

"P.J. O'Rourke's essay on double taxation hit close to home. Recently when I was ready to build a house, the county government tried to hit me up for a substantial impact fee. 'What impact?' I queried. 'There's already a well, power, septic and a mobile home on the property. And it's just me not a family of ten moving in.' I was told that it was for schools and fire protection. I replied that my property taxes pay for that. This was double taxation! They told me that they would give me $3500 credit when I removed the mobile home. Not good enough I told them. There shouldn't be any impact fee. You think you own the property you paid for but the government has other plans for you and your property." – Paid-up subscriber H.N.

"There is no teaching... only learning. As an Alliance member I'm probably the most educated investor / trader / buyer and seller of financial instruments on the planet. Well, I could be, if I were able to read every single thing that is available to me. I did, for a while, and I still try to, but I don't always. I was excited about the Stansberry Gold Investor letter. I looked at the list and already had a few of those names in my portfolio. One name in particular I looked at a little more closely, and found a great set of options available for an alpha-like trade. I sold a put that gets me in well below the buy-up-to price, then used that premium to buy a call that will be worth a pretty penny if the stock does anything, and I have two years (almost) to be right!

"Thank you for thinking about what you would want me to teach you, if our roles were reversed.

"One other humorous note – my son, who is 9, and often hangs out near me wanting to get me outside with a football, asked me between tosses, 'Why do you get so many emails from Stansberry Digest?' I laughed, and explained that I am a subscriber, and then we started talking about compound interest. He wanted to know 'what is the first stock [he] should buy'. Is there any plan to build a newsletter for kids who want to park some money in a stock and forget about it? I suppose the advice is the same, but if there were something written at / for kids, you'd have a taker." – Paid-up subscriber Alex W.

"There have been a lot of times when I didn't listen and learn from you folks. I finally learned to make good decisions using the vast amount of information available to me right here. Although I can't pull off the cash-flow for some of the prime services, I've received an education that the small amount of money it cost could never have given me anywhere else. Bravo! When I got my hard head out of the way and listened to Porter saying 'There is only learning,' my results started smoothly improving.

"I cut at my stops. And, when Steve S. says he's all in, that's good enough for me. It was a bit nerve wracking with those wide stops, but I hung in there and didn't stop out and now I'm rolling with Steve. I'm also market neutral now and not worried about getting crushed. I'm beating the market handily. It's a great thing to be at 0 or up on a 1% down day in the market. I have no fear of a crash and I actually am looking forward to the huge bargains that will be had. Now, if only my 401k allowed for me to trade...

"Thank you all for giving me such an invaluable and inexpensive investing education. I took my whoppers at first not following my stops, but when I started following them, all of the worry went out of my investing and I'm not afraid to make a strong move. A happy paid-up subscriber!" – Paid-up subscriber Marty S.

Regards,

Justin Brill
Baltimore, Maryland
April 12, 2016