Another 'bubble' could be collapsing... A major development in student loans... The latest from P.J. O'Rourke...
Editor's note: Be sure to read to the bottom of today's Digest for the latest installment from contributing editor P.J. O'Rourke...
As we discussed yesterday, we could now be seeing the first signs that Porter's prediction is coming true...
In short, the latest data suggest the three biggest credit "bubbles" in the U.S. – in high-yield corporate bonds, subprime auto lending, and student loans – are starting to collapse... and the "period of vast credit default" Porter warned about could be about to begin.
The problems started in the oil and gas patch, but a recent report confirmed credit stress has already spread from the energy sector to other debt markets.
According to credit-ratings agency Standard & Poor's, 99 global companies have defaulted so far this year. This is the second-most defaults in more than a decade (trailing only 2009).
Think about that for a second...
Only 2009 – in the midst of the worst financial crisis in a generation, where global markets fell 50% or more – saw more defaults than we've already seen this year. And this is with most developed economies in "recovery"... and global markets near all-time highs.
Clearly, something is "amiss" in corporate debt markets. As one asset manager told the Financial Times...
The heart of the storm has been in commodities, but it hasn't been limited to just that. It feels like every week there's another company in the headlines. You hope it's isolated, but you don't know.
But problems aren't just isolated to the bond market alone...
On Friday, Porter highlighted some of the first signs of credit stress in subprime auto loans.
As he explained, America's biggest subprime auto lenders are reporting that the credit quality of their "portfolios" is rapidly declining. At the same time, lending to super-low-quality or "deep subprime" borrowers continues to grow.
In other words, just like we saw at the beginning of the housing crisis, lenders continue to give money to "customers" with worse and worse credit... even while more and more of their existing borrowers have already stopped paying.
Today, we have the first signs of serious trouble in the student-loan market as well...
In a report last week, ratings agency Fitch quietly announced that it is proposing changes to the way it rates some securities – called asset-backed securities, or "ABSs" – backed by government-guaranteed student loans from the Federal Family Education Loan Program ("FFELP").
These particular securities are known as student-loan asset-backed securities, or "SLABSs" for short.
A detailed explanation of ABSs is beyond the scope of today's Digest. But in simple terms, they're investments like bonds... only instead of being backed by a company, they're backed by a "pool" of underlying assets.
In theory, this reduces risk... For example, if you personally lent money to a single student, and he or she couldn't pay you back, your investment would be in trouble. But if you lent a little money to hundreds of students, your risk would be spread out. If any single borrower – or even a handful of borrowers – couldn't pay you back, you'd still get most of your money back.
It's the same idea with ABSs... Lenders bundle up a bunch of assets and divide the "risk" up among many investors.
In theory, this makes buying ABSs safer than buying the underlying asset directly. But that's not always the case...
As we saw during the housing crisis, mortgage-backed securities ("MBSs") – a type of ABS backed by residential mortgages – "blew up" when unexpectedly large numbers of homeowners stopped paying their mortgages.
These securities simply didn't account for the risk that housing prices could fall... or that huge numbers of homeowners would go into foreclosure.
Today, a similar crisis is brewing in student loans...
Just like in the run-up to the housing crisis, the government has done everything it can to encourage folks to take on absurd levels of debt... all in the name of making college "affordable."
As Porter and his team explained in the October issue of Stansberry's Investment Advisory, the government has not only made it easier to borrow... it has also made it much easier to defer repayment (or avoid it all together)...
The government passed various measures – primarily from 2007-2013 – to ease the borrowers' burden, including:
• Allowing students to put off payments if they attend graduate school.
• Capping the exorbitant "Contingency Fee" plan.
• Holding servicers accountable for how they treated customers.
• Implementing "Income-Based Repayment" ("IBR") and "Pay as You Earn" plans, which cap payments at a percentage of disposable income... or allow borrowers at a certain income level to cease payments altogether. Often, any balances not repaid after 20 years will be forgiven.
• Allowing graduate students to essentially borrow unlimited amounts under various federal programs (in contrast to capped undergraduate loans).
• Creating a "not-for-profit loophole," which forgives the entire outstanding balance after 10 years for any graduate student who becomes a teacher, public defender, or works at a not-for-profit organization.
As always... the government's best intentions simply gave borrowers license to act recklessly. It shifted the "moral hazard" from the lenders to the borrowers.
Not surprisingly, many folks have overextended themselves and borrowed far more money than they can reasonably afford to repay. And these measures only make it more certain that a huge amount of this debt will never be paid back.
Just as we saw with MBSs, this could be terrible news for the SLABS market as well. More from Porter and his team...
As with the mortgage-backed-security model and the auto-loan-backed-security model, this ABS creates a win-win situation for the originator and investor – as long as the underlying loans are being paid on time.
But they aren't being paid on time. Programs like IBR and debt forgiveness have made the timing of these payments questionable. When [a student loan borrower] defaults, the principal and accrued interest may be paid in full by the government... but it will be years past due at that point.
In other words, even though these FFELP loans are "guaranteed" by the government – meaning the government has promised to pay these loans off if the borrower can't – it will likely take years for these claims to be paid, if they're actually paid at all.
In the meantime, the SLABSs are required to pay interest to investors. A delay in payment would constitute a default, regardless of whether or not the underlying loan is eventually paid off by the government.
As the Stansberry's Investment Advisory team explained last month, this means many SLABSs that are currently rated "investment-grade" are likely far riskier than they appear, and the ratings agencies are catching on to these risks...
In April, both Fitch and Moody's placed tens of billions of dollars' worth of ABSs on "credit watch"... Moody's was "a little surprised" to learn that around 10% of the FFELP ABSs were made up of borrowers either making no payments at all or only paying interest.
According to Structured Finance, an industry publication, when Moody's notified investors of these findings, the investors were "shocked." This was a huge development that has essentially frozen the entire student loan ABS market.
Since then, the SLABS market has not improved... and if the latest news is any indication, it could soon get much worse.
As we mentioned earlier, Fitch announced last week that it's considering making changes to the way it rates these SLABSs.
According to Structured Finance, Fitch said it could downgrade as many as 45% of the SLABSs it rates. Worse, it said some downgrades could be as "steep" as five notches... and estimates that 10%-15% of SLABSs currently rated "AAA" could be slashed to "junk."
This could have several important consequences...
First, it would be devastating for SLABSs originators – companies that own the underlying FFELP student loans, and "originate," or sell, the SLABSs to investors. And as Porter and his team explained, one company in particular tops the list: Navient (NAVI).
The company was created when the government-backed Student Loan Marketing Association – better known as "Sallie Mae" – split up. Sallie Mae's banking and private student loan business became SLM Corp., while the government loan business went to Navient.
Navient owns close to 50% of all outstanding FFELP loans.
But because of a change in federal law in 2010, Navient's portion of the business is no longer allowed to originate FFELP loans like Sallie Mae once was. Instead, it can only service those loans... meaning it collects a small fee for processing the loan payments.
Loan servicing is a low-margin business, so Navient has relied on SLABS origination to operate its business. More from the October issue of Stansberry's Investment Advisory...
ABSs are one of Navient's key sources of liquidity. Navient funds nearly 75% of its business with ABSs...
As a simple example, let's say Navient pools $1 billion in FFELP loans yielding 2.5% on average... and uses those loans as collateral for a new "security" that will pay 1.25%. The security is then sold off to investors.
Navient receives a lump sum from investors and can use that money as it sees fit. So Navient is happy because it receives a chunk of cash up front, which it generally uses to buy more student loans. Furthermore, Navient enjoys a 1.25% "rate spread"... as it collects 2.5% from its borrowers and pays only 1.25% to its ABS investors. (The spread is generally wider for loans not guaranteed by the federal government.) The investors are happy because they hold a security paying 1.25% in a 0% interest rate world.
But as we saw earlier, the market for SLABSs has been frozen. And credit downgrades will only make the situation worse. And without SLABSs, the company can't grow its business.
The stock has fallen nearly 45% over the past year, and downgrades will likely send it even lower. As the Stansberry's Investment Advisory team put it, we believe Navient "is on a long, slow slide to zero."
But the risks of downgrades extend beyond this company...
For every SLABS Navient sold, some "investor" bought...
We don't know exactly who owns these securities, but we bet we're going to find out soon.
The vast majority is likely owned by large institutional investors – like mutual and pension funds – who could see their AAA-rated securities turn to "junk" overnight, and be forced to sell.
As Porter has warned, these problems are massive and contagious... and they're likely to spread to other markets in ways no one expects. Folks who are unprepared could be wiped out... but you don't have to be one of them. To find out how you can prepare– and to learn more about our brand-new distressed-debt newsletter – click here.
New 52-week highs (as of 11/23/15): American Financial (AFG), Lancashire Holdings (LRE.L), McDonald's (MCD), Prestige Brands Holdings (PBH), Public Storage (PSA), Sinclair Broadcast (SBGI), Constellation Brands (STZ), and Valero Energy (VLO).
In the mailbag, Porter answers yet another question about bond investing. Send your questions to feedback@stansberryresearch.com.
"Hello Porter, I've read all of your bonds Digest series and thank you for them. It is a really valuable knowledge. I've discussed the issue with my financial mentor and he much agreed on your words that this strategy can be much better than buying stocks, though he warned that it is not as easy as it seems. The main thing he noticed is that if your distressed bond go bankrupt you need to go to court to confirm your rights as a creditor. You said nothing about it in your letters. Can you please comment? Thank you." – Paid-up subscriber Philip
Porter comment: First and foremost, you don't want the bonds you buy to default. If they default, you should carefully consider selling, rather than waiting for a recovery. Often enough, the recovery amounts aren't nearly as large as investors expect.
Having said that, your mentor isn't wrong – unless you're buying these bonds on a scale I don't understand. In the event of a bankruptcy, the largest holders of the bonds – typically insurance companies or pension funds – will head the creditor's committee and work with the bankruptcy judge to adjudicate a settlement.
The main principle of bankruptcy law is that each class of creditor is treated equally, so there's no reason to hire a lawyer – you'll get the same recovery as everyone else holding the same bonds. I say principle because lately, strange things have happened in bankruptcy court – most notably, the government completely defrauding the bondholders of General Motors and Chrysler in order to give tens of billions of dollars to unionized workers. Welcome to Amerika.
Regards,
Justin Brill
Baltimore, Maryland
November 24, 2015
How I Learned About Economics by Watching People
Try to Kill Each Other
By P.J. O'Rourke
Stansberry Research newsletter readers understand economics. That's why they read Stansberry newsletters. Many readers took Econ in college (and had to unlearn what they were taught). Some were students at a tougher school, the Academy of Experience. Others learned from the hardest-grading professor of all, the personal-investment balance sheet.
I followed a different route. I was a foreign correspondent for 20 years, first for Rolling Stone, then for the Atlantic Monthly.
I filed stories from 40-some countries, none of them the nice ones. I reported on wars, revolutions, coups, riots, civil disturbances, persecutions, oppressions, and other human unpleasantness. My job as a journalist was, basically, to watch people trying to kill each other.
I didn't realize it at the time, but watching people try to kill each other teaches a lot of important economic lessons.
Lesson 1: The Power of the Economic Impulse
The first time I went to a war zone was in 1984 during the Lebanese Civil War.
I flew to Beirut. Just stepping off the airplane showed me how the country was tearing itself apart.
The airport windows were shattered. The fronds were blown off the palm trees in the parking lot. The surrounding streets were pitch dark; all the lamp posts had been run over by tanks. The taxi I got into looked like it had been used by Steve McQueen for a POW breakout attempt in The Great Escape.
Getting into the city from the airport meant negotiating a dozen checkpoints controlled by different militias from Lebanon's various warring factions. At each checkpoint militiamen would brandish their weapons and shout at me, "Bassboat!" "Passboot!" "Pisspot!" What they wanted was my passport, the one English word that every militiaman knew and none could say.
I finally got to the Commodore Hotel, the unofficial HQ of the foreign press in Lebanon. The bell clerk, attempting humor, asked, "Would you like a room on the car-bomb side of the hotel or the mortar-shell side?" I had to empty the mini bar to get to sleep.
The Lebanese Civil War lasted from 1975 until 1990. It started as a conflict between the Christian Lebanese, who were the majority of the politicians, and the Muslim Lebanese, who were the majority of the population.
In 1975 and 1976, Beirut – "The Paris of the Middle East" – with its cafes, nightclubs, luxury hotels, and beachfront corniche, was reduced to rubble. Thousands of people died. The country's government collapsed. And – the Mideast being the Mideast – things got worse after that.
The Sunni Muslim Lebanese began fighting the Shi'a Muslim Lebanese. The Islamic fundamentalist Lebanese began fighting the Islamic secularist Lebanese. The Palestinian refugees living in Lebanon began fighting the Druze, a Lebanese sect that's an offshoot of Islam. Then Syria invaded one end of Lebanon, and Israel invaded another.
There's not room here to explain it all. There's not room anywhere to explain it all. But by the time I got to Lebanon, the place was really a mess.
Economics was the last thing on my mind. I was reporting on war and the political, religious, and ethnic issues that led to the fighting. At the time, it didn't occur to me that Lebanon even had an economy.
Of course, Lebanon did have an economy. Otherwise all the Lebanese who weren't dead from the civil war would have been dead from starvation and exposure.
Actually, looking back on it, Lebanon had a remarkable economy. In the midst of murderous chaos, the Lebanese economy continued to function. Considering the circumstances, you could even say it thrived.
True, the war led to runaway inflation, as wars do. The Lebanese pound was worth three to the dollar in 1975. By 1992, $1 bought 2,500 pounds. But this didn't bother the Lebanese. They conducted business in U.S. dollars, British pounds, French francs, or whatever hard currency came to hand. Children selling cigarettes in the street could give you that day's international exchange rate.
Beirut was loud, but not with the din of battle. The city's electrical grid had been destroyed, so every business and home had a portable gasoline generator on the sidewalk with extension cords snaking every which way. The generators were noisy enough to drown out all but the loudest gunfire.
Fuel seemed as plentiful as ammunition. Traffic was heavy, and the driving was erratic. It always is in the Mideast. But more so when the stoplights don't work, the traffic cops are in hiding, and drivers are dodging sniper fire.
Shops were open, including those selling things you wouldn't think would have a wartime market. Few journalists returned from Beirut without an acre of Persian carpets – bought at "special war price."
The Commodore Hotel did a brisk business, especially its bar where the press corps sought treatment for post- (and pre-post-) traumatic stress disorder.
Lebanon produces good wine. Chateau Musar, vintage 1975, was in great demand – in such great demand that an amazing number of bottles of Musar '75 were for sale – so many that the Chateau Musar vineyard must occupy most of Lebanon's land area and 1975 must have lasted for 10 years.
The Muslim militia controlling the neighborhood around the Commodore opposed alcohol and invaded bars and sprayed the wine racks and liquor shelves with machine-gun fire. But I presume some kind of deal was made. The Commodore's bar was invaded once, for form's sake. But no bottles of Musar '75 were machine-gunned, just Coke and Fanta.
And Lebanon's national airline, Middle East Airlines, flew almost without interruption throughout the war. MEA lost one airplane to a bomb in 1976. After that, I presume some kind of deal was made.
Where the money came from for all this economic activity, I don't know. And I'm not even counting that highly capital-intensive economic activity called war. (Though I do know that when I visited Lebanon's fertile agricultural area, the Beqaa Valley, the fields were full as far as the eye could see with lush, tall, green marijuana plants.)
The Lebanese Civil War caused terrible losses. More than 250,000 people were killed or wounded – 10% of the pre-war population. Nearly a million people were displaced. Property damage was incalculable. But one thing the Lebanese did not lose was their economic impulse.
While I was working on my article about the civil war, I went to the southern suburbs of Beirut to interview people about the political, religious, and ethnic issues that led to the fighting. I was stopped at a Hezbollah checkpoint (the same Hezbollah that's still fighting in Syria now).
Hezbollah's checkpoints were manned (I should say "boyed") by 14- and 15-year-olds with AK-47s. They twirled their weapons around, poked them in the dirt, and scratched their ears with the muzzle sights. Gun-safety merit badges must go begging in the Lebanese Boy Scouts.
"Bassboat!" shouted the adolescent at this checkpoint. When he saw my American passport he was furious. He stuck the AK-47's barrel inches from my nose.
I thought about how small the hole is where the bullet comes out, yet what a big difference it would make in my social life.
The teenager spoke some English. He subjected me to a 20-minute tirade about "Great American Satan Devil." I was berated at gunpoint for how America had caused war, famine, injustice, poverty, and Zionism all over the world.
At last, the boy had finished his rant. He lowered his gun and gave me back my passport. Then he said, in a normal tone of voice, "As soon as I am getting my Green Card, I am going to Dearborn, Michigan to study dentist school."
God bless the power of the economic impulse. Today, that kid's probably a wealthy orthodontist living in Bloomfield Hills. And I'll bet he votes Republican.
Regards,
P.J. O'Rourke
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