The High-Yield Collapse Is Here

Another day, another SEC 'inquiry'... Bad news for Santander... $5.3 billion lost in one day... The high-yield collapse is here... P.J. O'Rourke: The man who is sure to lose in November's election...

It turns out Valeant Pharmaceuticals (VRX) wasn't the only company that failed to file its annual 10-K financial report with the U.S. Securities and Exchange Commission ("SEC") yesterday...

Regular Digest readers are familiar with subprime auto lender Santander Consumer USA (SC). The company is a current short-sale recommendation in the Stansberry's Investment Advisory portfolio... and Porter and his team have been all over the problems with this company from the start.

(Porter even "unlocked" the September issue of Stansberry's Investment Advisory so every Digest reader could access it. Click here if you missed it.)

Last month, Santander reported that it wouldn't meet the standard February 29 deadline for filing the report, but that it would be able to file by the March 15 extension.

Late last night, the company said it missed that deadline, too...

Like Valeant, Santander says the delay is a result of an SEC inquiry. In this case, the SEC had questions about a recent change in how Santander Consumer calculates "credit-loss provisions," or how much money it sets aside for losses.

As Porter and his team explained, credit losses for Santander and other subprime lenders have been rising quickly.

This isn't surprising... The company has been ramping up its lending to subprime and "deep subprime" borrowers.

Even a child can understand that lending money to a bunch of folks with terrible credit means you're less likely to get all your money back. Higher losses naturally require higher loss provisions.

But Santander apparently didn't agree. Last fall, rather than pulling back on subprime lending, or accepting higher provisions as a cost of risky business, the company decided to simply change the way it calculates those provisions.

Of course, it didn't admit to this... It said the changes would help "adjust for seasonality" and reduce "fluctuation" from quarter to quarter.

But we couldn't help but notice the change reduced the company's credit-loss provisions by $134 million in the third quarter of the year, and helped it report a 17% increase in earnings.

It appears the SEC couldn't help but notice, either...

The company says it is now changing these calculations again, and is "working diligently to file the Form 10-K as soon as practicable," according to its statement last night.

Unfortunately, it's unlikely to make much difference in the long run. Stansberry's Investment Advisory senior analyst Mike DiBiase shared his thoughts on the news in a private e-mail today...

We're not surprised that the SEC is looking into Santander's loan loss reserves. Back in September, we recommended shorting shares of Santander because we thought its reserves were woefully inadequate.

We saw several unsustainable trends. Santander had been steadily extending the length of its loans – up to 84 months, even for used cars. And it was lending to borrowers with lower and lower credit scores, many of which were "deep-subprime" borrowers.

We didn't think extending $30,000, 84-month loans to borrowers with credit scores below 540 to buy used cars was a good idea when its operating margins were already less than 3%...

As Porter and his team explained in the September issue of Stansberry's Investment Advisory...

We think loan loss could increase 100%-150% in the 2014 and 2015 vintage of subprime auto loans – and it could even be worse.

If that happens, the industry will be facing loan losses equal to 20% or even 25% of its total outstanding loans. That will be catastrophic for companies like Santander and GM Financial. Even in the best of times, they exist on very small operating margins...

If the size of the loan losses grows by just 30%, it will erase all of their profits.

Shares of Santander Consumer fell nearly 8% today on the news, sending shares to a new 52-week low. Stansberry's Investment Advisory subscribers are up 58% on their short position so far.

Speaking of Valeant, news service Reuters reports hedge funds lost a mind-boggling $5.3 billion in yesterday's decline.

As we explained yesterday, billionaire investors like Pershing Square Holdings' Bill Ackman, ValueAct Holdings' Jeffrey Ubben, and Paulson & Company's John Paulson were among the biggest holders of Valeant stock... and the biggest losers of yesterday's 50%-plus decline.

But Ackman's losses in particular could be even bigger than originally estimated...

That's because Ackman doesn't simply own 21 million shares of Valeant stock (at an average cost basis of around $190). He also reportedly has a sizable position in Valeant options.

According to Bloomberg View columnist Matt Levine, those options had a value of negative $274 million following yesterday's plunge. Altogether, Ackman's original $4.1 billion stock-and-option investment in Valeant was worth just $450 million as of yesterday's market close. This represents a decline of nearly 90%... and a massive loss of more than $3.6 billion.

While most funds won't have losses of that size, it's possible many other smaller funds made similarly concentrated bets. We don't know how many of these funds could be sitting on devastating losses right now... and more important, what the fallout from those losses could be.

As Daryl Jones, director of research at Hedgeye Risk Management, noted to Reuters this morning, "For smaller funds, and not that we wish this on anyone, this has the potential to be an event that puts them out of business."

Following yesterday's massive decline, Valeant shares bounced this morning – up around 3% as of midday trading. But risk remains high.

We know that saying Valeant could default on $30 billion of high-yield debt may not mean much to you. But it's important to understand just how serious this could be.

As we mentioned yesterday, Valeant's debt makes up more than 1% of the most widely owned high-yield bond funds and exchange-traded funds ("ETFs"). A default will cause investors to pull out their money... which will cause the funds to sell other bonds to meet those redemptions... which will then cause yields to rise across the high-yield market.

Valeant debt is also a big part of the collateralized debt market. According to Jim Grant, editor of the legendary Grant's Interest Rate Observer newsletter, Valeant loans are the most widely held debt in collateralized loan obligations ("CLOs") issued in the last several years.

If you're not familiar, these are just one of several types of "securitizations." All this means is a bunch of debt – in this case, business loans – is packaged up, split up into pieces, and sold to investors.

In theory, because each investor gets a tiny piece of many different loans, risk is reduced. The securities are also ranked in tiers (or "tranches") based on the quality of the underlying debt, again reducing risk in theory.

We say "in theory," because it was this same model – particularly securitized mortgage loans – that blew up and caused the last crisis. If Valeant defaults, we could see a similar scenario where investors suddenly discover these CLOs are far riskier than they were led to believe.

To put these risks in perspective, remember that the collapse in high-yield bonds last year was triggered by defaults in the oil and gas sector.

These defaults totaled less than $18 billion. Valeant alone would be nearly twice that big... and thanks to the CLO market, these debts are likely held by far more investors. Again, there's simply no way to know what the fallout could be.

This is the risk of "contagion" we've been warning about for months. It's what Porter has devoted Friday Digest after Friday Digest trying to explain. But Valeant isn't the only concern... it's just one of countless "dominoes" that are ready to fall.

Another $13 billion in energy debt has already defaulted this year... not including Peabody Energy (BTU), that warned of bankruptcy this morning. Ratings agency Fitch says it expects at least another $63 billion in defaults this year.

The bottom line is clear: Porter's prediction of a high-yield collapse is no longer a prediction... it's already here.

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New 52-week highs (as of 3/15/16): Johnson & Johnson (JNJ), Public Storage (PSA), Sysco (SYY), and AT&T (T).

In today's mailbag, more feedback on Porter's Friday Digests. Let us know what you think at feedback@stansberryresearch.com.

"Porter, as usual, thank you for another great Friday Digest packed with knowledge in your attempt to teach us what you would want to know if the roles were reversed. I especially appreciated your note [at the bottom of the March 4 Digest] regarding your mom. I had the pleasure of meeting her in New Orleans along with you [and the rest of your family]. My interaction with them really was the critical event that got me to spend the money to become a Stansberry Alliance member. After speaking with everyone (your mom & dad the most), it confirmed what I already knew about you.

"I became an Alliance member in late 2014. I couldn't be happier with my investment in you and your business. You have continued to add value to my membership. I can't really say thank you enough, so I've decided the best way is to continue to support you and your businesses (proud OneBlade 0023 & collector's edition BlackBlade 0015 owner), and offer as much feedback as I can so you can be reminded what a difference you're making. Thank you, Porter. I look forward to seeing you again in September [at this year's Alliance conference]." – Paid-up subscriber Jesse Haro

Regards,

Justin Brill
Baltimore, Maryland
March 16, 2016

P.S. Time is running out. You have just 10 more days to claim your free OneBlade razor. Learn more here.

The Man Who Is Sure to Lose in November

By P.J. O'Rourke

Now that the results of "Semi-Super Tuesday" primary elections are in, we're beginning to know how this election will turn out.

Somebody is going to lose the presidential race in a big way. He isn't a candidate. He isn't even alive. But America is going to be a lot worse off without him.

The loser will be Adam Smith (1723-1790), the man who founded the discipline of economics, discovered the way economies work, showed how free enterprise creates wealth, and wrote The Wealth of Nations.

Donald Trump and Hillary Clinton have not read the book.

Trump is a demagogic "moneybags" with a rich kid's disdain for economics. Clinton is a famously grasping old wirepuller of a political hack who knows nothing about economics and couldn't care less, except when the billfold contents of her own designer handbag are involved.

And the worst thing about the two of them is the one thing on which they agree. They oppose each other about everything except one crucial economic issue: Both candidates are against free trade.

One of Trump's few well-defined policy positions (besides anti-immigrant nativism) is his promise to "bring manufacturing jobs back home where they belong" and "take back those jobs China is stealing."

Clinton has more policy positions than you can shake a stick at. But the populist blather of socialist nitwit Bernie Sanders has forced her to shake that stick at her own previous pro-free trade agenda. She has now turned against the Trans-Pacific Partnership, which she helped negotiate, and the North American Free Trade Agreement (NAFTA), which she helped her husband push through Congress.

Abolishing free trade won't make America better, it will just make America more expensive. Almost everything we buy will cost more. And foreign economies will be destroyed.

We'll be broke. They'll be poor. How is this a recipe for more jobs with better pay?

The Wealth of Nations is 1,000 pages long, but Smith's point can be summed up in one sentence: Wealth is created by the pursuit of self-interest, division of labor, and freedom of trade.

Any interference – domestic or international – with these economic fundamentals destroys wealth creation. Trump and Clinton promise to interfere with all three.

"Mercantilist" is the economic term for Trump and Clinton.

Mercantilism is the idea that a country gets rich by exporting more goods and services than it imports.

That would be true if a country were a lemonade stand. Or if money were a good or a service instead of a measure of the ever-changing value of goods and services.

Under mercantilism, government erects trade barriers to keep a country's citizens from getting the things they want from overseas. And government creates trade incentives to get a country's citizens to send the things they make to foreigners. The result is a trade surplus. The country accumulates a bunch of money.

Never mind that when people go to buy goods and services with the money, they find the goods and services have all been exported and the money is worthless.

Mercantilism was the dominant economic policy in the 17th century, when world leaders were (as they are becoming again) completely ignorant about economics.

The main reason Smith wrote The Wealth of Nations was to show that mercantilism is stupid.

Mercantilism confuses money with wealth.

As Smith put it, "Goods can serve many other purposes besides purchasing money, but money can serve no other purpose besides purchasing goods."

Book IV, Chapter I of The Wealth of Nations includes a wonderful passage about the nature of money. I quote it in slightly abridged form...

After the discovery of America, the first inquiry of the Spaniards used to be whether there was any gold or silver to be found in the neighborhood.

Likewise, Friar Carpino, a monk sent as ambassador from the king of France to the court of Genghis Khan, said that the Tartars frequently asked him if there were many sheep and cows in France.

The object of the two questions was the same. The Spanish and the Tartars both wanted to know if a country was rich enough to be worth conquering.

Among the Tartars cattle are the instruments of commerce and the measure of value. Wealth therefore consists of cattle as far as the Tartars are concerned. And wealth consists of silver and gold as far as the Spanish are concerned.

Of the two, the Tartar notion, perhaps, is nearest to the truth.

I don't expect either presidential candidate to read The Wealth of Nations. It has too many long words for Trump. And it contains such excellent arguments for economic liberty that perusing it might cause Clinton to collapse and wither away, leaving nothing but an empty pantsuit on the campaign stump.

However, maybe some small part of the meaning of what Smith had to say about free trade can be gotten across to the candidates in the form of a parable:

The Parable of Japan in the 1980s

Thirty years ago, American politicians, policy makers, and pundits were alarmed about America's trade deficit with Japan.

The Japanese kept giving us radios, TVs, stereos, and cars. In return, we kept giving them little green pieces of paper.

The Japanese were mercantilists. They refused to buy anything American-made except Michael Jackson audio cassettes. We didn't even make the valuable part – the cassette. This left the Japanese with a huge accumulation of little green pieces of paper.

According to mercantilist theory, this made Japan a rich and powerful nation.

Japan thought it was such a rich and powerful nation that, instead of buying things from America, the Japanese decided to buy America itself using their little green pieces of paper.

They bought office complexes, golf courses, and hotels. They bought Rockefeller Center. They bought Pebble Beach.

The Japanese bid up the price of American real estate until the bubble did what bubbles do.

By the 1990s, America had all the radios, TVs, stereos, and cars... and it had all the office complexes, golf courses, and hotels, too. America had Rockefeller Center. America had Pebble Beach. And America had all the little green pieces of paper.

Meanwhile, the Japanese had stuck their economy in a place where the Rising Sun never shines.

Regards,

P.J. O'Rourke