You're Welcome, You Moron

Part II of my warnings about the credit cycle... Consumers have never held more debt... What causes subprime lending to boom (and then bust)... A critical update about Capital One Financial... You're welcome, you moron...

Printing money won't work forever...

As you'll hopefully remember, last week, I (Porter) again warned about the coming credit default cycle.

I speculated on a number of problems – falling commodity prices, soaring debt loads tied to tractors and oil rigs – that could be the "tipping point."

That's the moment when suddenly, for no real apparent reason, the market starts paying more attention to rising defaults and less attention to the incredible results at a small number of companies (Amazon, Google, and Facebook).

And this week... I promised to delve deeper into what I perceive as the big hidden problem in our economy and our financial system.

Like I told you last week, we all know that printing money to pay our bills isn't going to lead to wealth or real prosperity. But it sure does feel good in the short term. So why can't it work for long? And what will cause it to collapse?

A handful of crucial financial reports that came out last week...

Before we dive into the "deep end" of economic theory... we need to look at one of these. Because nothing, in my view, was more important than the Capital One Financial (COF) results.

Capital One is a major source of consumer credit in the American economy for subprime borrowers – both in credit cards (revolving credit) and auto loans. As I'll explain below, these two channels of credit have been severely inflated over the past five or so years. I'm certain that the losses on these loans will far exceed Capital One's modeling and projections.

But for now, just know this: Total write-offs on the company's domestic card lending now exceed 5% of the loans outstanding. That 5% mark is a threshold that indicates the credit cycle has turned. (The same threshold, by the way, is often used in judging conditions in the corporate-bond market.)

As a result, the company has increased its reserves against losses by 30%, to almost $2 billion.

That's a huge increase to the company's expected losses. And mark my words, those loss reserves will continue to grow. I believe that over the next three years losses at Capital One's credit-card business will exceed 25% of its lending balances, implying losses five times bigger than the current loss reserves.

Again, I'll explain below why I'm so concerned about this loan portfolio... and the hidden factor that Capital One isn't modeling.

OK... you're just going to have to stick with me here for a minute.

For most of you, what I'm about to explain isn't going to make any sense. I'm sorry about that. There's no simple or easy way to explain this concept. So just read this two or three times and think about it a while... We can talk about it more later.

Here's the idea...

Our modern financial system is fantastically elastic. The crucial monetary reserves that undergird the system can be expanded at will. That has put an end to "runs on the bank." And through various economic levers (manipulating interest rates, tax policy, government spending, etc.), the risks of a runaway inflation can be managed.

These policies along with tremendous gains to productivity through technologies have produced a world with low levels of inflation and very, very high levels of debt.

But there's a glitch... something the clever mandarins who designed this system forgot (or never understood).

Our financial system isn't merely a tool for measuring credits and debits with money.

It's also the most important information channel in our economy. Money conveys critical information to entrepreneurs and consumers via prices. We learn about shortages from rising prices. We learn about gluts from falling prices. And every day, hundreds of millions of consumers, producers, investors, and bankers are using prices to make judgments about what they should do next with their money.

Trouble is, when the monetary system is being manipulated – when it's being inflated and controlled by the world's central banks – those prices we are all relying on become warped. As a result, more and more "noise" enters the channel – false information... prices that aren't real... prices that don't accurately reflect supply and demand... or risk.

Those of you familiar with the mathematician Claude Shannon's work will appreciate how important communications are to outcomes.

For those of you who haven't studied computer science, Shannon was an absurdly brilliant man whose innovations led to big breakthroughs in building better communications systems and computers. And I'm not going to try and explain his entire famous mathematical theory of communication in today's Digest. It's Friday. And I was told there would be no math.

But to summarize... if you want to transmit a lot of data in any communication channel, you need to reduce the amount of noise in the channel. Noise is anything in the channel that doesn't convey new or accurate information. The more noise, the less efficient the communication channel.

What does "noise" look like in our financial system? Consider subprime lending...

Subprime lending is an absurd idea. It's the process whereby someone who isn't creditworthy is extended a loan at a price (an interest rate) that's insanely high. For example, buying a $10,000 used car using a 72-month loan that's charging an annual interest rate of 20%.

Most of the time in our economy, very little of this lending goes on for good reason: These are terrible loans. They have huge default rates. (Duh, the borrowers aren't creditworthy.) And the loans themselves are too expensive to be financed.

Normally, subprime lending is a tough business. Getting 20% a year on the loan sounds good, but if your cost to finance the loan is 8% or so, your gross spread is now down to only 12%. You can count on default rates of 20%-30%, creating losses of up to 10% of the loans.

So now your gross margin is just 2%. It's not easy to run a business where so much can go wrong on such a small gross margin.

And that's why, for most of the last 5,000 years of recorded history, subprime lending has played a tiny role in our economy. Lending money to deadbeat borrowers isn't a good idea for either the lender or the borrower.

But... everything changes when the funding costs of subprime loans decrease.

If instead of paying 8% for capital, subprime lending companies can get Wall Street's backing, then their funding costs can be as low as 2% – thanks to the Federal Reserve's manipulation of interest rates.

When the Fed pushed interest rates to record lows following the 2002 recession, Wall Street moved into subprime mortgages in a huge way. By 2006, almost 40% of the mortgages being underwritten weren't prime. You know what happened next...

But it's not all Wall Street's fault. And it's not all the subprime borrowers' fault, either. Both parties were enticed into making a bad financial decision because of the "noise" in the primary financial information channel: The price of money wasn't accurate.

When the price of money is artificially lowered, subprime lending booms. It will happen every single time, because those interest rates create a huge spread between the cost of money and the price a subprime borrower can be charged to borrow it.

I'm convinced the zero-percent interest-rate policies (and even negative interest rates) we've seen in all the world's major economies have created the biggest subprime bubble ever in the U.S. consumer sector.

As result, Capital One's loss provisions are going to turn out to be woefully inadequate. We're in the midst of a huge subprime collapse. Only this time, the problem isn't in mortgages... It's in credit cards, autos, and student loans.

Here's a fun fact...

Loans for education and cars contributed to 90% of the growth in consumer debt since 2012. By 2015, roughly 25% of car loans were made to subprime borrowers.

But why should the banks care? These auto loans are securitized, just like the bad mortgages were. In the last five full years, $455 billion in auto loans were securitized. Remember, one out of every three cars that are traded in for a new car have negative equity (meaning the unpaid portion of the old loan is "rolled" into a new loan). And the durations of auto loans have been extended. (The average auto loan is now 68 months)... Given those facts, it's a safe bet that something like half (or more) of these securitized auto loans have zero equity.

You might recall a major factor in the mortgage crisis of 2008 was that most subprime mortgage holders (and even a lot of prime mortgage holders) had zero equity in their homes. Walking away from those mortgages was a rational (if not ethical) financial decision.

Today, with used-car prices plummeting... how many subprime borrowers are going to keep paying 20% a year to drive a car with zero equity?

And then there's the elephant in the room...

Student loans. Today, a record number of Americans has a student loan (42 million of them). This debt is virtually impossible to extinguish in bankruptcy. It's not going away. And the total debt outstanding has doubled in the last 10 years to $1.3 trillion. That's bigger than auto loans. Bigger than credit cards.

And the problems in student lending are nightmarish. Currently, 8 million people, who collectively owe $137 billion, are seriously delinquent. That means they're more than 360 days late. That's 19% of all borrowers. Another 3 million (owing $88 billion) are at least a month behind on their payments and likely to default. So more than 25% of all student loans are essentially in default.

That's bad enough. But it doesn't tell the whole story.

People have all different kinds of ways to defer paying these loans. So if you include all the loans that aren't being serviced, you find that more than 40% of these loans aren't being serviced and are likely to default.

And here's the "good" news... It's not just "kids" who borrow for college. About 3.5 million adults have borrowed $77 billion on behalf of their children.

We've never seen figures like these before in the U.S. economy.

Currently, U.S. consumer debt, not including mortgages, equals 20% of gross domestic product (GDP) – an all-time high amount. The culprit is ballooning auto loans and soaring student loans. We already know that a shocking number of these loans aren't being serviced and will not be repaid.

The bad car loans will be repo'd and sold. (That's why used car prices are plummeting right now.) But how will the student loans be cleared? Nobody knows.

These problems tell me that economic growth is going to be a lot weaker than most people expect.

Likewise, the amount of subprime borrowing and the size of these consumer-loan balances as a percentage of GDP tell me that the recovery rate on these loans is going to be terrible.

The three largest subprime auto lenders are: Santander Consumer USA (SC), Capital One, and General Motors (GM).

Why did subprime consumer lending boom?

Because central banks caused the price of money to become far too cheap. Likewise, central banks' buying of equities (which I described last week) is causing investors to become dangerously overconfident. It is leading far, far too much capital to accumulate in the largest stocks.

Just imagine what's going to happen when those two trends – wildly overdone subprime lending and wildly inflated stock prices – collide.

Oy vey.

New 52-week highs (as of 4/27/17): Tencent Holdings (0700.HK), Automatic Data Processing (ADP), American Financial (AFG), Aflac (AFL), AMETEK (AME), CommScope (COMM), Ctrip.com International (CTRP), Digital Realty Trust (DLR), Facebook (FB), Alphabet (GOOGL), PureFunds ISE Mobile Payments Fund (IPAY), JD.com (JD), Nuveen Preferred Securities Income Fund (JPS), KraneShares CSI China Internet Fund (KWEB), 3M (MMM), Microsoft (MSFT), AllianzGI Equity & Convertible Income Fund (NIE), Annaly Capital Management (NLY), ProShares Ultra Technology Fund (ROM), Sanofi (SNY), and Two Harbors Investment (TWO).

In the mailbag... occasionally, our dear subscribers can be confused about who recommended what or why. And we understand: We publish a lot of material. It's virtually impossible to keep up. On the other hand, if you're going to call someone "scum," you might want to at least check your facts first.

Whether you write to praise us... or to call us "scum"... we promise to read every note you send. Send yours here: feedback@stansberryresearch.com.

"Porter remember BTU? That turns into BTUUQ – lost everything THANKS. where is that debacle in your newsletter, you think it fair to just tell about your winnings? Scum." – Paid-up subscriber "Moneyshot"

Porter comment: No, I don't ever remember recommending Peabody Coal. Are you sure that was me? Doesn't seem like the kind of business I'd ever recommend. I prefer companies with valuable brands, strong operating margins, and something I call "capital efficiency." That's a description for a business that's able to grow without using more and more additional capital – like Hershey (HSY).

In any case, I'm sorry for your losses. Take a free trial offer to TradeStops.com. It's a great way to help you understand and manage the risks you're taking in your portfolio. In my opinion, it's a lifesaver for individual investors. If you try it, you'll greatly reduce (essentially eliminate) all your catastrophic losses.

"That's too bad Porter that you won't even fess up to BTU. Yes you did an entire page and a half about how old the company was and the cash on hand, ratio vs this and that etc, etc. But the one thing I remember most because all coal plants were in decline was you saying this company would survive and not seek bankruptcy. I so want to go to my office and find that newsletter and prove to you it most certainly was you. I probably won't get that chance, upon reflection I'm pretty sure I threw all your material out." – Paid-up subscriber "Moneyshot"

Porter comment: Just remember. I tried to be nice...

Look a**hole, not only have I never recommended Peabody Coal, it's the complete opposite of the kinds of businesses I do recommend. Furthermore, if you knew anything about Stansberry Research at all, you'd know we constantly stress the importance of risk management. So even if I did recommend a business that bad (and I didn't), you shouldn't have lost more than 1% or 2% of your portfolio.

That's why I was referring you to TradeStops. Its technology can actually take complete losers, like yourself, and turn you into decent investors. You just need to do three things:

1. Actually read our newsletters,
2. Follow reasonable position-sizing guidelines, and
3. Use stop losses.

Since you've obviously done none of these, I really can't help you.

But one thing is certain: I had nothing to do with your losses. Not only have I never recommended Peabody Coal, if you read my June 2012 newsletter ("It Can Always Get Worse") you'll discover that at least four years before most coal companies went bankrupt, we warned that the entire sector was probably going to go bankrupt.

In the section titled "Our Best Energy Short Idea: King Coal," we warned investors that:

"King" coal's dominant position as the fuel for electricity generation has never been more threatened... Coal has historically held on to its market position in the U.S. because it is incredibly abundant and, as a result, cheap... These are exactly the advantages natural gas is taking away.

We recommended selling short Consol Energy in that newsletter. And while we were stopped out of that position for a loss a few months later… Consol Energy – like Peabody Energy, and virtually every other major coal miner – went bankrupt in 2016.

You're welcome, you moron.

Regards,

Porter Stansberry
Baltimore, Maryland
April 28, 2017