Junk Debt & Auto Loans Reminiscent of Subprime in ’07

“…the problems in the subprime market seems likely to be contained.”

Ben Bernanke March 28, 2007

“Bear Stearns is fine.”

Jim Cramer Tuesday March 11, 2008

(Four days before its insolvency)

“…the likelihood of a severe financial panic has diminished…”

Janet Yellen April 29, 2008

(Global Financial Crisis was well underway.)

In late November 2006 The Wolf first noticed the bankruptcy of a subprime mortgage lender. A quick internet search, led to the discovery of the Mortgage Lender Implode-O-Meter website, where they tracked the housing collapse in real time. Only three months later, there were at least two publicly traded subprime lenders that had declared bankruptcy (New Century Financial being one The Wolf was short.). It was painfully obvious to the Implode-O-Meter, and The Wolf, that the problems in subprime would eventually impact all housing, and then the larger economy, and it most certainly would not be “contained” (Despite Bernanke’s delusional claims.). Today,  The Wolf sees the junk bond bubble in the same vein as subprime housing defaults in November 2006, and the outcome should be quite similar.

The reason for the interest in the subprime lenders back in ’06, was the thought that the homebuilders were a decent short opportunity. The thinking at the time was:  If a slowdown in credit growth, and house prices, eventually led the US into recession, it might be a bad one because of extraordinarily high consumer debt at the time. In fact, it was almost easy to see how problems in subprime would lead us to our current Zero Interest Rate Policy (ZIRP) that remains six years after the crisis, if you just connected the dots.

Like we pointed out in our homebuilders article, those stocks actually topped in the summer of 2005, along with house prices in some of the bubble markets (CA, FL, AZ & NV). By the time the subprime lenders were failing in late ’06/early ’07, it was amazing to see the S&P 500 continue to hit new highs, even as the Fed raised interest rates. A month or two after the S&P finally topped in October ’07, entire industries were already in bear markets or worse (over 150 subprime auto lenders had imploded). In other words, the S&P 500 was whistling past the graveyard of the larger economy.

We see something similar today, except instead of entire industries, it’s entire countries – just take a look at the chart of an ETF for France (EWQ), Spain (EWP) or even the FTSE (ITF) in London. With the S&P at all-time highs, the EWQ is down 15% from the wave (B) high, and nowhere near the ’07 one.

French Stocks Not Even Close to All-time Highs & Breaking Down
French Stocks Not Even Close to All-time Highs & Breaking Down

And now we’re starting to see some troubling news out of junk bond land and subprime auto lenders.

In a recent Forbes article, Martin Fridson, CFA® estimated that there’s going to be nearly $1.6 trillion in defaults in the next few years. Now, nobody really knows how many bonds will default or when. But, the housing bubble sprouted from the Federal Reserve’s holding the Fed Funds rate at 1% for a year. What bubbles have sprouted now that rates have been 0% for six years? We’re guessing there’s a ton of businesses that wouldn’t have received funding had investors not been financially repressed, and forced to “reach for yield” by buying junk bonds. This “reach for yield” has basically forced desperate savers out of safe instruments and into risky ones.

But, we’re now starting to see some actual risk show up in assets like junk bonds. Notice that while the S&P 500 is at new highs (chart on the left), the junk bond ETF (JNK) isn’t anywhere close. Also, notice that the JNK is actually back down to levels last seen in late 2011. And, at the top of the chart in red is the relative strength line for JNK versus the S&P 500; notice the dramatic underperformance since 2011. We think this bearish divergence is important.

 

S&P 500 at Highs, JNK Breaking Down
S&P 500 at Highs, JNK Breaking Down

The market is starting to differentiate between stronger and weaker balance sheet companies, and when those weaker companies aren’t able to roll their debt over because interest rates for dodgy companies have gone up, it’s going to be a bloodbath for all of those investors who “reached” for yield. The same point is made with the chart below, which is of even dodgier debt than JNK. It shows the yield spread for CCC rated debt above Treasuries. This summer they hit an all-time low (investors were the most bullish on CCC debt ever). Much money has flowed to these risky companies whose default rates are around 50% over a full cycle. Keep in mind that all of these risky companies employ people, buy products and have been part of the current economic “expansion.” Once they fail, they’ll be part of the contraction too. Investors have very little yield to compensate them for default risk, and these bonds are terribly illiquid. When investors all rush for the door at the same time CCCs will get hammered, with follow on effects just like subprime defaults in ’06 had follow on effects.

BofAML High Yield CCC Option-Adjusted Spread to Treasuries
BofAML High Yield CCC Option-Adjusted Spread to Treasuries

And, the latest news comes out of a little known corner of the lending market – subprime auto loans. Specifically, Santander Consumer (SC) (which has a cozy relationship with Chrysler, to loan money to its customers with less than stellar credit) has announced that loss rates on “recent vintage” loans have increased. That’s a fancy way of saying that someone who just took a high interest rate loan isn’t going to pay it back. Take a look at a chart of SC, which came public in January 2014, and notice the stair-step lower. The Wolf would be shocked if this company survives the next recession.

Santander Consumer Thrives on Weak Borrowers
Santander Consumer Thrives on Weak Borrowers

What’s an investor to do?

Rather than engage in a strategy of passively holding assets that have tremendous risk, like junk bonds, or stocks for that matter, Trader Skillset believes that investors would be better off developing a skill set that includes some basic technical analysis, incorporating Elliott waves. By allowing us to help you do that, you’ll no longer be concerned about being blindsided by the next bear market, and you can instead keep your eyes on the charts to help forecast, and trade, the next big market moves.

The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.

About The Wolf

Twenty years is a long time to be involved in the trading business. Through many battles in every asset class known to man, knowledge has been gained; and, this project is a way to share that knowledge.
The Wolf is a big fan of repeatable market work, or the creation of a “process.”

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