Editor’s Note: Over the past several days, we’ve featured longtime PBRG friend and founder of Stansberry Research Porter Stansberry… who’s warned that an impending credit collapse is setting up what he’s calling the ultimate “Big Trade.” In today’s special edition, Porter explains why shopping malls are on his “big short” list. (This essay was originally published November 15, 2016, in Stansberry Digest).
Edited by J. Reeves | November 15, 2016 | Delray Beach, Fla.
‘You can’t fix stupid’
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From Porter Stansberry, founder, Stansberry Research: In today’s Digest… a look behind the curtain…
We finalized our "Dirty Thirty" list of companies that are most likely to default on their debts over the next three years. To make the list easier to follow, we’ve broken down the 30 different companies into several segments, including autos, malls, oil companies, master limited partnerships, and subprime lenders.
If you were an early subscriber and you saw our beta version, you’ll notice a few changes to the names we’ve selected for our final list. We’ve focused on firms that have significant "near term" debt maturities.
In total, our final Dirty Thirty list includes publicly traded companies with more than $130 billion in debt repayments due over the next 36 months.
Here are a few highlights…
Been to a mall lately?
Oh man, are these firms in trouble.
The most unusual aspect of commercial real estate (like malls, shopping centers, and office buildings) is that, most of the time, mortgages on these properties aren’t paid down like residential mortgages are. Instead, the owners typically pay interest on the loan and then refinance when it comes due. (That’s called "rolling" the note.) But what happens to properties with big vacancies that can’t generate enough income to safely support a new loan?
Well, then there’s a big problem.
You’ll recall that the key default threshold in "junk" bonds is 5%. Once defaults reach that level, the losses associated with the bad loans cause lenders to draw in their credit. They get more conservative and demand higher interest rates and other safeguards that significantly restrict access to more credit. Well, the same thing happens in virtually every other segment of the credit market, including commercial real estate.
This morning’s Wall Street Journal featured an article warning about the big problems developing in commercial real estate, especially for shopping centers. Overall, the default rate on commercial real estate loans that have been packaged into securities (about $400 billion of debt) has now breached the critical 5% threshold. The default rate on these securities is 5.6%. That means, going forward, it’s going to be a lot harder for commercial real estate firms to move risky mortgages off their books.
Research firm Morningstar now predicts that 40% of commercial-mortgage-backed securities loans maturing next year won’t be paid off.
If that’s anywhere close to accurate, the entire market for commercial real estate lending will be virtually shut down, making it almost impossible to "roll" even relatively safe mortgages forward. This is a huge risk to real estate companies.
And there’s more bad news…
Under the Dodd-Frank regulatory overhaul, a series of new rules will go into effect on Christmas Eve. These new rules require issuers of commercial mortgage-backed securities to retain 5% of the securities they package and sell. That means these firms’ balance sheets will take on even more stress, as they won’t be able to sell all of their loans. Tad Philipp, director of commercial real estate research at ratings agency Moody’s, told the Wall Street Journal, "You couldn’t have planned worse timing."
Finance is often poetic…
Let me tell you the best part about this bad news. Most of the commercial real estate loans that are going bad are loans that were made in 2006 and 2007 and then packaged into securities.
If you recall, that’s the same period when corporate borrowing broke the $1 trillion annual threshold for the first time and saw a huge increase in low-quality residential mortgage underwriting. These residential mortgage securities going bad in 2008 and 2009 created the housing bust and led to speculators making billions in The Big Short. So… if you didn’t make any money from our speculations (we shorted Lehman Brothers, Fannie and Freddie, and General Motors), you have one more shot at the brass ring. Ironic, isn’t it?
Don’t believe any of this?
Well, just drive around to the shopping centers near your house. Do you know what you’re going to find? There’s a good chance you’ll see images like the ones on a growing number of "dead mall" photo websites (like this one).
If this doesn’t strike you as alarming… if it doesn’t occur to you that loans on vacant malls can’t be "rolled" forward… if hearing that 40% of commercial real estate securities underwritten in the troubled years of 2006 and 2007 are going to default doesn’t strike you as a significant financial problem…
Well, I’m not saying that any of our subscribers are stupid. But the words of comedian Ron White come to mind. He brilliantly observed that "you can’t fix stupid." If you don’t think the dramatic collapse in retail traffic to suburban shopping locations is going to cause a gigantic financial problem… well… just remember the words of Ron White.
Let me get into the details of what this problem looks like at the individual-company level…
Look at the six mall companies on our Dirty Thirty list. You can see, over the next three years, $15.5 billion of (mostly) mall debt will have to be refinanced.
Can you think of any investor who would want to put up $15 billion in capital to control America’s worst malls and shopping centers? Meanwhile, we know for certain that the commercial real estate lending machine will be broken, thanks to soaring defaults from 2006 and 2007 vintage loans.
Can any trade be more foolproof than this?
I doubt it.
Let’s take the weakest player in the mall space. I’m talking about a major mall operator that can’t afford its existing interest expenses.
No, I’m not kidding. One company on our list has an equity value of almost $3 billion. Meanwhile, it can’t generate enough cash to cover its interest expense, assuming it’s going to spend anything to maintain its buildings. If you factor in the costs of merely maintaining its buildings, this company is only generating 30% of what it needs to pay interest. It is drowning in debt.
I wish I could tell you the whole story of how this happened. It’s the single most outrageous thing I’ve ever seen done in capitalism. It was the biggest farce in the history of retail.
As everyone should know, this company isn’t going to make it. Over the next three years, it must repay $2 billion in debt, including $300 million next year. Meanwhile… its traffic, revenue, and gross margins continue to fall, year after year.
There’s no way this company will avoid bankruptcy. But its stock is still worth $3 billion.
That makes no sense. And as soon as this company runs into a significant debt maturity, a lot more people are going to realize these facts. Overnight, the share price will collapse by 50% or more. If you’re holding puts here, you’ll make 10-20 times your money.
So… let me ask you: Do you think it’s safe to own this stock? Or do you think it’s safer to own puts?
Malls are just one of the opportunities we have…
The auto segment is even more debt-inflated. In fact, one auto company (out of four) on the Dirty Thirty list could default at any time. Currently, this company is only earning 50% of what it needs to pay the interest on its existing debts. (I’m not kidding.)
Normally, you’d expect to see a credit this weak paying huge interest rates… And you’d expect there to be little equity value left. Remember, if this company defaults, the value of its equity would drop to zero almost immediately. But… such a huge bubble has formed in corporate lending that this company, which is on the verge of default, is still only paying about 8% a year on its bonds and has more than $10 billion in equity value! These numbers make no sense.
All you need to know is this: Over the next three years, this company must repay or refinance $1.1 billion in debt… but it can’t even afford the interest on its existing debt.
Given that the company can’t generate enough operating earnings to cover its current interest obligations, we think it’s highly unlikely that this company will avoid a default.
It’s inconceivable that this company will be able to survive. A debt restructuring/equity wipeout is, in my view, a certainty in the next 36 months.
And that means anyone who owns a long-term put on this company has a great chance to make 10-20 times his money. This is a fantastic opportunity to speculate for huge gains, or to simply put a small amount of money aside to hedge your other investments.
Again, I’ll ask you: Given these facts, do you think it’s safer to own this stock or safer to own a put? The put may go down in price for several months. And the stock may go up in price, even for several more months. But eventually… the nonsense hype of enthusiastic equity investors will crash up against the shore of economic reality. And on that day, you’re going to be glad you owned the puts, not the shares.
As a whole, the four auto companies on The Dirty Thirty list will show you, in stark terms, what a mess the U.S. auto industry remains to be. The worst three of the four firms have lost over $24 billion in cash over the past decade. These four firms have amassed huge debts totaling $169 billion. Altogether, the companies in this segment will have to repay (or find a way to refinance) over $40 billion in debt over the next three years.
As you’ll see when you learn more about these companies, there is no way that’s going to happen. Investors won’t keep plowing money into firms that can’t earn their cost of capital and can’t afford to pay the interest on their loans… and keep losing money quarter after quarter.
I could go on for a long, long time…
I’ve just covered a few of the ideas that are on our Dirty Thirty list.
These are the 30 biggest corporate deadbeats in America. We’ve done all of the research you need to fully understand exactly why and when these firms will default on their debts. Many of them can’t afford their current interest payments. Virtually all of them have inflated asset values and will have to be written down, tripping debt covenants.
All of them have significant near-term maturities that will cause equity investors to fear debt downgrades and stock "re-ratings" – which is a polite way of saying these stocks are all poised to fall out of bed once creditors are asked to roll their debts. (By the way, Trump’s soaring-interest-rate environment isn’t going to help any of these firms refinance… and it might make it impossible for more than a few.)
Here are some eye-opening numbers…
These are from the current Dirty Thirty list – as I mentioned, we tweaked it a bit (as we will do from time to time).
The Dirty Thirty is a list of American corporations that have a little less than $500 billion worth of equity value but hold $716 billion worth of debt (and preferred equity). Collectively, they’ve lost $77 billion in free cash flow over the last 10 years – meaning, they’ve borrowed heavily over the last decade to finance their operations.
Their incredibly weak financial position is further proven by their interest coverage. After including spending on capital expenditures, many of these companies cannot afford the current interest on their debts. (For the accountants among us: On average, their earnings before interest and taxes is only 80% of their 12-month trailing interest expense.)
And yet, over the next three years, these firms must find a way to repay or refinance more than $130 billion in debt.
We’ve shown you how U.S. corporations went on an unprecedented debt binge over the last decade…
Between 2010 and 2015, American corporations both borrowed more than ever before (more than $1 trillion annually and nearly $1.5 trillion in 2014 and 2015). We’ve shown you how this huge volume of debt was also the lowest quality (the highest percentage of junk bonds). And with the Dirty Thirty, you can see exactly how "Obama’s Legacy" will play out inside individual companies and various sectors of our economy.
To my knowledge, no research firm in America has done more work in this crucial area than us. And I’m certain that never before have individual investors been offered this kind of detailed, comprehensive research on dozens of companies facing debt defaults. You don’t have to invest millions of dollars in a specialty distressed-debt hedge fund to learn more about these trades. All you have to do is listen to our FREE webinar tomorrow night at 8 p.m. Eastern time.
Horse, meet water.