Proof that the auto-loan market is in huge trouble... A look at one of our short-sell recommendations... Another company to watch... Reader feedback: Why we don't have a newsletter covering investment-grade bonds...
There's only one thing I (Porter) want to show you and talk about in today's Friday Digest. It's the single-best data point I've seen that demonstrates how completely out of control the world's credit markets have become...
From this morning's Wall Street Journal:
Over the six months through September, more than $110 billion of auto loans have been originated to borrowers with credit scores below 660, the bottom cutoff for having a credit score generally considered "good," according to a report Thursday from the Federal Reserve Bank of New York. Of that sum, about $70 billion went to borrowers with credit scores below 620, scores that are considered "bad."
The amount of super-low-quality auto lending is now surpassing the totals of dubious lending that peaked in 2006. Total auto lending in the U.S. is now more than $1 trillion – the all-time highest amount of debt tied to cars in the U.S.
Newsletter publishers like to say the "sky is falling" all the time about every small problem we face. But this isn't a small problem. The comptroller of U.S. currency is issuing a warning to anyone who will listen. He says this situation with auto loans reminds him "of what happened in mortgage-backed securities in the run-up to the crisis" of 2008.
Why would anyone make these loans? Well, subprime lending is incredibly profitable when the cost of capital is cheap. By lowering finance companies' cost of capital to almost nothing, the Federal Reserve spawned a huge wave of subprime lending.
These firms pay 2%-3% for capital and can lend it for more than 20% annually to folks who can't get financing any other way. That's a huge "spread," which, with a little bit of leverage, can generate outrageously high returns on equity.
The problem is that eventually the loans will go bad and the resulting losses will inevitably wipe out these businesses. It's just a matter of time. So... where are we in this cycle? Let's take a look...
I've been warning about this growing problem and its inevitable consequences since March 2014. And I've been updating our work in this area ever since.
In our Investment Advisory publication, we recently recommended shorting one of the largest subprime-auto-finance companies in the U.S., Santander Consumer USA (SC). If you haven't read that issue, I urge you to read it carefully. (I've "unlocked" the issue for you to read here.)
As my subscribers know, one of the architects of the last big credit bust – who we call the "Dark Angel of Bad Debt" – has joined the company as a "nonexecutive chairwoman." While it's not clear what responsibilities that title entails, Santander Consumer USA's stock has fallen from around $25 to around $17 a share since she joined the firm. The falling share price is a sign investors are worried that the auto loans this firm owns and has been selling to investors around the world could end up going bad, costing billions in losses.
They're right to be worried. Charge-offs in the company's $36 billion portfolio of auto loans (all subprime) that were originated in 2014 have risen to 26%. So is the company moving toward making better loans? Nope. Loans to borrowers with FICO scores less than 540 have increased to 46% of the portfolio so far in 2015.
The auto lenders all say "it's different this time" because cars can be quickly and easily repossessed and sold through auction. So far, the total amount of car-loan delinquencies remains low (around 3%). And so far, the average prices of used cars sold at auction remains high (see the indispensable Manheim Used Vehicle Value Index chart below).But just like with mortgages, the people who are judging the market for cars are completely missing how much low-quality lending is responsible for this kind of sudden growth and how it can warp the market. Demand for cars is being vastly inflated right now by the outrageous, almost unthinkable amount of subprime lending. And trust me, that won't last. It never, ever does.
Another stock to watch is America's Car-Mart (CRMT), a big used-car dealer that specializes in subprime auto lending.
The company now has 146 locations in the U.S. It describes its business model as "integrated auto sales," which is a nice way of saying it only sells cars to people who are willing to pay outrageous interest rates.
Yesterday, the company disclosed that almost every possible measure of the credit quality of its portfolio was in a significant decline: Net charge-offs are now 8% of receivables (up from 7%) and provision for credit losses now equals 32% of sales (up from 26%). What is management doing about the rapidly deteriorating ability of its clients to afford the company's absurdly high interest rates? Buying back stock, of course – most recently, 89,658 shares. Brilliant plan, boys...
Finally, I would also warn you to stay away from Capital One Financial (COF) and General Motors (GM), since both are big players in the world of subprime auto finance.
But the real problem isn't these companies or their incredibly fragile business models. The real problem is that the amount of subprime lending in the auto industry suggests that we're approaching a huge day of reckoning.
Today, subprime lending makes up nearly 40% of all auto loans. These loans will go bad. When they do, the industry will be completely devastated – every bit as bad as when the mortgage bubble popped. The size of the auto-lending business (more than $1 trillion in loans) means that when this happens (and it certainly will happen), the resulting damage will hurt the entire financial sector and our economy.
As I've been saying... the coming default cycle is going to be massive. Millions of people will be wiped out. But it doesn't have to be a tragedy for you. As loans go bad, billions and billions of assets will simply swap owners. Don't think of it as a depression. Think of it as a tremendous, legal transfer of wealth... and make sure you're on the right side of that deal. To learn how – and to learn more about our brand-new distressed-debt newsletter – click here.
New 52-week highs (as of 11/19/15): Aflac (AFL), Chubb (CB), and Travelers (TRV).
In the mailbag, a fantastic question about investment-grade bonds. Send your bond-related questions to feedback@stansberryresearch.com for Porter to answer in a future Digest.
"After learning the price of the service related to distressed bonds, and thinking a little more of what Porter has said about how relatively foolish it is to invest in stocks, I wondered why not start a service along the lines of True Wealth, Retirement Millionaire, or any one of the other lower cost investment newsletters Stansberry Research provides. This new advisory would deal solely in bonds, not the distressed type where huge returns [and larger risk] may be available, but a service dealing in the bonds of stocks rated much higher, and therefore much safer...
"Why not provide a sort of 'introductory' bond advisory that truly provides an investor with the opportunity to gradually become acquainted to a totally different style of investing, and provide it at relatively lower cost as in the investment newsletters? If you have access to virtually every bond of every corporation trading in the market, one would think [or at least I do] you would spot these higher rated opportunities while digging through the mass of other offerings. No axe to grind here. Just wondering why only distressed bonds?" – Paid-up subscriber George E.
Porter comment: Great question, George – one of the two or three best questions we've gotten.
As subscribers to Stansberry's Credit Opportunities know, we do cover high-quality bonds. Our research assigns a rating to every liquid corporate bond that trades in the U.S. and matures within five years. That's thousands of separate bonds. For example, we have Apple bond (CUSIP No. 037833BC3) ranked "10" – our highest rating. S&P ranks it "AA+". It shows up in our screen because, in our opinion, it should be AAA, but it isn't.
This would be a great bond to recommend to investors seeking absolute security. But here's the problem: This bond currently yields less than 0.5%. If you put $1,000 into this bond (which trades at par), you'll get a grand total of $3.90 a year in interest. If you invested $1 million into these bonds, you'd earn just $3,900 a year.
I don't know too many investors who would be satisfied with these anemic returns. These absurdly low interest rates are a function of the Federal Reserve's manipulation of the markets. Investors who require higher-yielding investments have been forced to go way out on the risk spectrum to find reasonable returns.
That's what led to the massive increase in high-yield corporate-bond issuance in 2012, 2013, and 2014, when more than $300 billion in high-yield bonds were issued each year. That was more than double the previous all-time-high annual issuance for three years in a row.
It's this enormous pile of bonds that are beginning to "sour." At some point in the future, that will spark a panic in the credit markets. When that moment arrives, I don't expect the yields on high-quality corporate bonds (like Apple's) to move that much. They will fall a little, because when the mutual funds are forced to sell their bonds (because of redemptions), those will be the only bonds liquid enough to move into the market. Even so, I don't think those bonds will ever be attractive for investors seeking stock-like total returns.
During the last default cycle from 2008 to 2012, our bond analyst Mike Williams recommended 50 different bonds. Ten resulted in losses and 40 resulted in gains – an 80% win rate. On average, these recommendations (both winners and losers) resulted in an annualized return of 19%.
When I say you shouldn't buy stocks, what I mean is that this track record is better than any long-term portfolio performance we've ever produced in stocks – both in terms of win percentage and average returns. The nearest result is the long-term results of Steve Sjuggerud's True Wealth, which have produced average annualized gains of nearly 16%, according to our internal audit, but his win rate was far lower than 80%. Meanwhile, there is no doubt that buying bonds is safer than buying stocks.
So at the right times during the credit cycle, I absolutely believe you can make much more money in discounted corporate bonds, while taking less risk, than you can buying stocks, even during a bull market. However, that's only true if you're willing (and able) to dig into the kind of corporate bonds that have "warts." These securities aren't A-rated... not even close. With these bonds, a default is not rare. Something like 30% of these bonds (maybe more) are likely to default over the next four years.
That's why our research has so much value to investors who understand this segment of the market. There's no need for this kind of research with high-quality bonds, because almost none of them will default, they will always trade close (or at a premium) to par, and there is no way to make a reasonable return on those securities. That's why nobody would want a newsletter that was covering investment-grade bonds. Every report would say exactly the same thing: This bond is perfectly safe, and it yields almost nothing.
In regards to our "expensive" $5,000 price for Stansberry's Credit Opportunities, the simple fact is buying a single bond at par will cost $1,000. Buying a reasonably diversified portfolio of bonds, even if they're trading at a discount, will cost between $15,000 and $25,000. Offering high-quality advice (from a staff that includes two CPAs, an attorney, and two senior market analysts, plus a virtual army of computers and data) on which bonds to purchase should be worth it to anyone with the means to build such a portfolio. That's especially true given the lifetime nature of the offer. You'll be getting this research throughout the entire cycle. Meanwhile, our research costs the same as buying five bonds. I hope if you can use a product like this, you'll give it a try. Learn more about it here.
Regards,
Porter Stansberry
Baltimore, Maryland
November 20, 2015
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