A Big Warning Sign for the 'Zombies'

Early signs of the next credit crisis... Oh the irony... Some mortgage lenders are already going broke... The reasons why... We owe more than we make... A big warning sign for the 'zombies'... The relief is finished – volatility is back...

This smells like the start of the next 'credit crisis'...

Some mortgage lenders – the worst of them – are beginning to go broke. According to a report from financial news service Bloomberg on Friday...

The U.S. mortgage industry is seeing its first lenders go out of business after a sudden spike in lending rates, and the wave of failures that's coming could be the worst since the housing bubble burst about 15 years ago.

Uh-oh.

It's true. In June, one of the first dominoes fell...

Mortgage lender First Guaranty – which originated $10.6 billion in mortgage loans in 2021 – filed for bankruptcy, after saying it laid off 80% of its employees and stopped making new loans.

(Yes, the irony of a company named First Guaranty being a Last Guaranty is not lost on us.)

The company is owned by the fixed-income giant Pacific Investment Management, best known as Pimco. It said in its bankruptcy filing that it has $473 million in debts. Most of that is owed to banks that provided funding for its residential mortgages, including Flagstar Bank and Customers Bank.

First Guaranty dealt in "non-qualified mortgages," or non-QMs. Non-QMs go to borrowers with erratic income, and they're different from the "qualified" mortgages that came into federal law after the financial crisis... and that have stricter eligibility requirements.

In July, another non-QM company, Sprout Mortgage, suddenly laid off hundreds of employees and closed its doors... The company is now being sued – by employees for three weeks of pay and other firms for defaulting on millions of dollars of home loan purchases.

The reasons why are as old as paper currency...

Too much borrowing... Too much risk-taking... Not enough cash... These lenders are the opposite of the steady cash-generators our research team likes to recommend owning.

First Guaranty, which had about 600 employees before the layoffs, lost "only" $23 million in the first four months of 2022. But coupled with the company's unrealized losses, that was apparently enough to kill it. And it happened only as the tip of the "higher interest rate" iceberg first started to emerge from the economic ocean...

We've spoken at length about the Federal Reserve's influence on the housing market and mortgage loans. The Fed's interest rates track closely with the central bank's benchmark lending rates in the banking system and on through the U.S. economy.

When the central bank indicated it would start hiking its benchmark interest rates late in 2021, you might remember that mortgage rates started to rise quickly. By June, just three months after the Fed started raising rates, a 30-year fixed mortgage hit close to 6%...

Mortgage demand cratered to a 20-year low that same month.

This is by design from the Fed, which is seeking to lower inflation however it can... That means by slowing demand in the economy, and it can do that most directly by influencing the costs of loans. (In real estate, this also means making homes unaffordable for many people and indirectly causing rents – and inflation – to rise in the process, too.)

Mortgage rates have cooled slightly lately. But First Guaranty's CEO blamed the Chapter 11 filing on two factors: a combination of plummeting demand for new loans and a "dramatic collapse" in refinancing... and the fact that First Guaranty couldn't get enough financing to keep operating.

The company said its existing mortgages are serviced by third parties, meaning the bankruptcy filing won't disrupt them. But it laid off close to 500 employees and has left its lenders on the hook for hundreds of millions of dollars.

A dramatic change in interest rates has a clear effect...

The Fed's benchmark lending rate has gone from near 0% to close to 2.5% in eight months (and rates could keep going higher, more on that discussion below). The central bank is having an impact...

As Keith Lind, the CEO of non-QM lender Acra Lending, told the industry publication HousingWire...

These aren't bad loans, just bad prices.

Lenders with thin or negative margins haven't been able to withstand higher rates...

The reactions came quickly. A few weeks after First Guaranty filed for bankruptcy, word leaked that one of the lenders it burned would now be asking 16 loan originators for larger funding advances.

As John Toohig, the head of whole loan trading at investment bank Raymond James, told HousingWire...

We need to see rates kind of stabilize, flatten for a minute, just to kind of be able to work out the problems.

He added that the "hope" is that at some point next year, the Fed will have eased up on its monetary-tightening policy to fight inflation and rates might head lower.

The good news, at least so far, is that we're not talking about big-name banks like JPMorgan Chase, Morgan Stanley, or Bank of America, like we did in the financial crisis 15 years ago...

Since the financial crisis, the biggest banks have dramatically downsized or even eliminated their mortgage businesses, and independent lenders have stepped in to fill the void.

Hence the non-QM designations and the rise of independent lenders like the ones we've mentioned today... These now-bankrupt mortgage lenders are relatively small, though when you add them up, they make up a significant chunk of the mortgage business.

For example, two-thirds of the top 20 mortgage refinancing companies were non-banks last year, according to LendingPatterns.com. That's roughly twice as many as 2004.

And these companies don't have the luxury of a government backstop to bail them out when things go wrong. As Bloomberg shared in its report...

Unlike banks, independent lenders often don't have emergency programs they can tap for financing when times get tough, nor do they have stable deposit funding. They depend on credit lines that tend to be short-term and depend on mortgage prices. So when they're stuck with bad assets, they face margin calls and potentially go under.

The situation is less dire for lenders that work with government-backed companies like Fannie Mae and Freddie Mac. But that doesn't mean big banks are immune to the consequences of a higher-interest-rate world, either.

Debt is debt, of course... It's all connected, as if you were playing a financial-asset version of the Six Degrees of Kevin Bacon.

Consider the ratio of U.S. debt to gross domestic product ("GDP"), which measured 123% at the end of 2021. We owe more than we make. The only year this figure was more pronounced was 2020.

A big warning sign for the 'zombies'...

These mortgage-lender bankruptcies are a big warning sign for the economy and what could unfold on a larger scale if borrowing costs throughout the economy continue to go higher...

For one thing, bad, overleveraged businesses – such as "zombie companies," as our colleague Mike DiBiase calls them, which can't even afford to pay the interest on their debt – will go bankrupt. As Mike shared in a Q&A with us in May...

Nearly one out of every four companies is a zombie. That's the most by a long shot. It's higher than before the last financial crisis and higher than the previous peak of 17%, set back in 2001.

These companies are living on borrowed time. They're dependent on creditors who are willing to lend them more money when their debt comes due. They might be banking on their businesses turning around as they burn through their cash... or they might have plans to sell assets... or issue shares of stock to pay down debt.

The next recession is going to bury many of them. Zombies are already choking on today's higher interest rates and inflation. An economic downturn will be the final nail in the coffin.

Higher rates and more expensive borrowing make business harder. It's as simple as that. And this scenario can kill off garbage companies the quickest... which is what we're just starting to see.

Just today, "meme stock" favorite AMC Entertainment (AMC) emerged as another example of this scenario, with its shares falling 30% – after a 25% loss last week – mainly because its rival Regal Cinemas said it's considering filing for bankruptcy.

It's like fear by association and for good reason. AMC has more than $10 billion in long-term debt.

At the same time, the next credit crisis will also be an opportunity for savvy investors...

That's because in a crisis often there's too much fear in the market... which makes for great buying opportunities if you have the cash to deploy...

When large numbers of companies go bankrupt, no one wants to own their stocks, of course, but many investors also flee from owning any corporate bonds anymore – that is, the debt of companies in general – good or bad ones.

But, as Mike points out, this is exactly when you should be buying corporate bonds.

Many bonds – those considered distressed debt, meaning the market is concerned they won't be repaid amid the "credit crisis" – trade at a steep discount. And they are safer than stocks... and offer a set return.

Unlike when you invest in stocks, companies are legally required to pay back your principal when a corporate bond matures and all of your interest on time. As Mike explained to us...

When you buy a bond, you know exactly when and how much you'll be paid. You know exactly what your return is going to be on the investment as soon as you buy it. That's the complete opposite of what folks are used to. With a stock, you don't know what your return is going to be until you sell it.

So you make money as long as you find a company that avoids bankruptcy during the period you hold the bond. Mike and our colleague Bill McGilton do the research on bonds worth buying in our Stansberry's Credit Opportunities newsletter.

You can learn much more here.

This is all related to today's market sell-off...

U.S. stocks had their worst one-day performance since June. The benchmark S&P 500 Index was down 2.1% and the tech-heavy Nasdaq Composite Index was down 2.5%... and the CBOE Volatility Index ("VIX") popped by 16%, a signal of increasing uneasiness in the markets.

Following a down day on Friday, too, the S&P 500 is now off roughly 3.5% over the past two trading days, while the Nasdaq is off about 4.5%.

We've been anticipating that the rally in stocks since mid-June would cool off, and that appears to be exactly what we're seeing now. As our Ten Stock Trader editor Greg Diamond wrote this morning, from a technical perspective...

The setup for a completion of this summer relief rally is in progress, if not already complete.

As far as we see it, the major catalyst for the sentiment shift is a few key events for the markets that lay ahead this week... As Stansberry NewsWire editor C. Scott Garliss shared this morning, another round of inflation data is coming out later this week.

One is the U.S. Bureau of Economic Analysis' release of July Personal Consumption Expenditures ("PCE") data, which is the number the Fed is referring to when it talks about its 2% inflation target. It comes out on Friday.

That same day – and more notably – Federal Reserve Chair Jerome Powell is set to speak in the morning from the central bank's annual confab in Jackson Hole, Wyoming. Wall Street will be looking for any clues into what the Fed is thinking about its rate-hike plans.

We haven't heard anything from the central bank other than plans to raise rates as long as inflation is higher than 2%. But as we've discussed lately, speculation about the central bank easing up on rate increases has partly fueled the recent stock market rally.

Folks either don't believe the Fed when it says heading off inflation is priority No. 1, or they don't want to believe it because that means more economic pain ahead... and higher odds for the sort of debt crisis we discussed earlier...

In any case, a more definitive message about the central bank's plans – anything close to something like, "We will keep raising rates until inflation cools more and we won't stop until it does" – could sour any optimism that remains at the end of this week.

Stay tuned, and we'll keep you posted.

Debating the 'Inflation Reduction Act'

Recent guests of our editor-at-large Daniela Cambone have shared their thoughts on the "Inflation Reduction Act" – and talk about if it will actually reduce inflation. Listen to what they have to say...

Click here to watch this video right now. And to catch all of the videos and podcasts from the Stansberry Research team, be sure to visit our Stansberry Investor platform anytime.

New 52-week highs (as of 8/19/22): AutoZone (AZO), CTS (CTS), General Mills (GIS), Hershey (HSY), ShockWave Medical (SWAV), and UnitedHealth (UNH).

In today's mailbag, more notes about financial literacy... plus feedback on Dan Ferris' latest Friday essay... What's on your mind? As always, send your notes to feedback@stansberryresearch.com.

"Loved all the feedback on teaching kids financial literacy. Growing up in a blue collar family of nine, the only financial lesson we learned was 'You want something? Figure out a way to earn it without borrowing from anyone.' A lesson that served us all throughout our lives. Thanks for all the great information." – Paid-up subscriber Kathy D.

"Interesting stories. I basically agree. I am in my ninth decade and glad that I learned the time value of money early. I eschew debt except for a paid off early mortgage with 9% interest. I have a car loan but 0% interest. I figure I can use the capital better elsewhere in the meantime.

"Who is encouraging people to learn/have terrible money managing habits? The people who gain from charging 24% or similar rates on credit cards. This is legal usury among other things. We all pay for the negative consequences.

"I remember an article in Time in about 1958 about a newfangled way to invest. As I remember they featured Massachusetts Investment Trust, a mutual fund. Later I learned about loads and no loads.

"I am encouraging my grandchildren to be aware of their personal finances and yes, this should be a school subject requirement." – Paid-up subscriber John J.

"Team, I appreciate all the great info and perspectives from each and every one of you.

"Dan's comment 'prepare don't predict' has really impacted how we live.

"First, don't fear. Live life and enjoy everything you can. Don't put stuff off.

"Second, money won't buy us out of the pain coming. And it is. When the debt market freezes up and the infamous Fed (they are the villain, Dan not you) can't control anymore that's where being prepared comes in...

"Everyone has their own idea of what that emergency kit and cash/gold stash looks like but we need to have it just like an emergency fund. Trading food and supplies will be critical.

"Fortunately we raised our kids to give, save, and live within their means. They don't have credit card debt and just keep things simple.

"The best story I have about being smart with money is from work.

"I am retired now and worked for a large telecommunications company. The company gave our department a generous auto allowance. The company offered a 401K matching $1 for $1 up to 6% of pay every two weeks.

"When I hired a new employee I made sure they signed up immediately for the 401K. Some didn't which blew my mind.

"I recommended they put their car allowance into the 401k since it was part of their salary, and drive their current car or buy a dependable car for cash or very low payment.

"Well, you can guess. A week later 80% of the time there they were out in the parking lot showing off their leased or $700/month Mercedes, etc.

"I just always said 'nice car.' And thought in 20-30 years that thing will be in a rust pile in a garbage dump vs. the employee having over a million from investing via dollar cost [averaging] into a 401K equity fund.

"That's the lesson I have always shared with my kids. Many of those employees are still working and can't stop financially, and I am retired from that business at 59, can do what I want to do, and most importantly help my family.

"Thanks to all of you for the knowledge you have given me." – Paid-up subscriber Ken W.

"Dan, I've read many of your articles over the years. But this one is my favorite. You were so 'right on' with your calling out culprits and characters, I can't think of a better way to demonstrate the current state of the financial markets.

"I had some great laughs reading it. I've been in commercial real estate over 37 years. You explained the chicanery and hype perfectly.

"Thanks for that highly entertaining and informative piece. It would be great to have it as a leading article in the Wall Street Journal. Keep them coming!" – Paid-up subscriber Brian H.

"Dan, IMHO I think Adam Neumann's Flow venture will go the same way as Jeff Goldblum's Apartments.com TV ads that were so hip in 2019 and then fell off the face of the earth in 2020 when COVID came on the scene, and so will a16z's $350 million." – Flex Alliance Member Kenneth S.

"Wow! That is truly some great insight as to how far from the top we really are. I am happy you don't have the $350 million to toss away, you bring way more value helping your subscribers with this type of intel.

"Just when I think we are nearing a bottom we are not even at the top. Never would have seen this anywhere so thank you so much and keep educating us." – Paid-up subscriber Mark R.

All the best,

Corey McLaughlin
Baltimore, Maryland
August 22, 2022