Wednesday, November 25, 2015

A Massive Wave of Defaults

Debt comes in many forms, including high-quality US Treasury debt, high-grade corporate debt and junk bonds. Debt is also issued by both US companies and foreign companies. Some of the foreign corporate debt is issued in local currencies and some in dollars. In discussing debt defaults, it’s necessary to keep all of these distinctions in mind.

The US companies sitting on hoards of cash, such as Apple, IBM and Google, are not the ones I’m concerned about; they will be fine. The defaults will be coming from three other sources.

The first wave of defaults will be from junk bonds issued by energy exploration and drilling companies, especially frackers. These bonds were issued with expectations of continued high energy prices. With oil prices at $60 per barrel or below, many of these bonds will default.

The second wave will be from structured products and special purpose vehicles used to finance auto loans. We are already seeing an increase in subprime auto loan defaults. That will get worse.

The third wave will come from foreign companies that issued US dollar debt but cannot get easy access to US dollars from their central banks or cannot afford the interest costs now that the US dollar is much stronger than when the debt was issued.

The combined total of all three waves — energy junk bonds, auto loans and foreign corporations — is in excess of $10 trillion, more than 10 times larger than the subprime mortgages outstanding before the last crisis, in 2007.

Not all of these loans will default, but even a 10% default rate would result in over $1 trillion of losses for investors, not counting any derivative side bets on the same debt. This debt will not default right away and not all at once, but look for a tsunami of bad debts beginning in late 2015 and into early 2016.


Jim Rickards