Juggling Dynamite

Years of reckless lending and borrowing are nearing another predictable end: surging defaults and losses. As Oaktree Capital Management’s co-chair and credit specialist, Howard Marks, has noted: “The worst loans are made at the best of times,” when credit and optimism are plentiful.

While risk-sellers continue to insist that households are in good financial shape (just as they did in 2007), credit card delinquencies (90+ days late on payments) have increased to a near-record 12%, second only to the 13.8% high in 2010.

Consumers tend to pay auto loans first over mortgages since vehicles are often essential for work. It’s ominous, then, that new auto loan delinquencies (90 days or more) in the second quarter matched the rise in 2020 and 2010 before that. The subprime auto-loan delinquency rate, considered a leading economic indicator, leapt 9.3% in August (ABA Banking Journal+1). See, Auto industry is Flashing a Warning Sign on the U.S. economy:

The auto industry is flashing warning lights on the state of the U.S. economy. Automakers’ profits are getting squeezed by tariffs. A subprime auto lender recently collapsed, and some car retailers are warning that consumers are pulling back.

CarMax , the biggest seller of used cars, said Thursday that its sales and profit plunged in the latest quarter. The company’s results, which sent its stock tumbling 20%, is the latest in a series of unsettling developments in an industry under strain from President Trump’s tariffs and carmakers’ recalibration of expensive electrification strategies.

Profits at CarMax’s finance arm also declined, as the performance of loans originated in 2022 and 2023 deteriorated, and the company increased its provision for losses.

At the same time, Tricolor, a subprime auto lender and car dealer owner, abruptly filed for bankruptcy liquidation earlier this month amid government investigations and a bank partner’s allegations of fraud. The Dallas-based company offered auto financing to customers who lacked credit history or a Social Security number and operated 65 dealerships.

First Brands, a major auto-parts supplier behind products such as Fram oil filters and Anco windshield wipers, is preparing to file for bankruptcy protection, with more than $6 billion in outstanding debt.

In epic complacency, lenders and credit investors have been accepting record-low compensation for escalating capital risk. Investment-grade bonds are paying just 74 bps (the lowest since 1998, indicated by the gold line below) and high-yield investors just 275 bps over similar dated treasuries (the least since 2007, shown by the blue line below). See, The Credit Market is Humming and that has Wall Street on Edge:

One concern is that lending to riskier borrowers has been growing for years, first through traditional bonds and loans, then in the form of private credit and the revival of complex asset-backed debt. The longer that credit boom lasts, the more likely it is that defaults will rise. Likewise, the higher the valuations of corporate bonds and loans, the more susceptible they become to selloffs.

The fate of the market could depend on the direction of the economy. Some investors note that the current benign environment could continue if inflation pressures ease and there is no further deterioration in the labor market, allowing the Federal Reserve to boost economic activity by cutting interest rates and relieving pressure on borrowers.

Credit is the foundation of the economy and financial markets. Leaping loan defaults, along with the lowest risk compensation for investors since past bubble peaks, is a foreboding combination for all risk assets.

High-yield analysts at Barclays compared the current situation—with valuations so high and signs of stress emerging—to being in a Star Wars garbage chute with Princess Leia and Han Solo and “the walls compressing on all sides.”

Institutional exposure to equities is at its highest level since November 2007, and American households’ allocation to stocks has surpassed the 2000 tech-bubble highs. Trading volume on U.S. stock exchanges last week reclaimed last April’s record high.

At the same time, as debt prices have soared, the yield reward that investors are receiving from owning corporate bonds is at its lowest since 1998.

The good news is that the majority of risk assets have rebounded from April’s crash and ripped higher year-to-date.

The bad news is that the more they continue, the more brutal the subsequent sell-off is likely to be — that’s the math.

Of course, not everyone is helplessly long risk securities. A few have preserved and increased their fortunes over time by patiently waiting for more durable and rational opportunities to act on. See, Black Swan Manager Sees Huge Rally, Then 1929-Style Crash:

“I’m the crash guy—I remain the crash guy,” says Mark Spitznagel, who earned $1 billion in a single day for his clients during 2015’s “Flash Crash.” A protégé of “Black Swan” author Nassim Nicholas Taleb, his hedge fund, Universa Investments, also scored major gains when Lehman collapsed and when Covid-19 sparked a meltdown.

The alarming part of Spitznagel’s current outlook is that he sees conditions akin to 1929, the year of the Wall Street crash. The silver lining for those hoping the bull-market music will keep playing a while longer: He thinks this is more like the early part of 1929 when stocks added significantly to their Roaring ’20s gains.

In fact, since 1980, the S&P 500 has returned an above-trend 26% annualized in the 12 months preceding the start of each bear market (shown below).

Booming markets tend to attract capital with increasingly wild abandon. The bad news is that subsequent bear markets take back years of capital gains and more. “The markets are perverse,” says Spitznagel. “They exist to screw people.”

Last week, Equifax Canada reported that 286,000 businesses in this country missed a loan payment last quarter.

In the Greater Toronto Area, the number of mortgage lenders repossessing homes and selling them has climbed roughly 60 per cent year over year.

Ninety-day-plus mortgage delinquency rates are climbing in Greater Toronto, Greater Vancouver and Canada generally, according to data from RBC.

Scott Terrio, an insolvency expert, recently told The Globe and Mail that he is talking to homeowners who are “teachers, firefighters, cops. Two years ago, I was doing two to five meetings a day, now I’m doing 10,” said Mr. Terrio.

The debt-fueled housing boom from 2015 to 2022 is costing Canada a fortune. See Debt is Catching Up With Canadians:

It is a personal one for people who dreamed too big and extended themselves too far. They are now reckoning with the consequences of going all in on real estate during the early 2020s boom – crushed credit ratings, legal action, consumer proposals, powers of sale and bankruptcy.

We are seeing the fear of missing out giving way to the fear of losing everything. The Financial Consumer Agency of Canada’s five-year plan to improve financial literacy, which launched in 2021 and cost taxpayers millions over the years, can’t compete with the stickiest financial lessons that hard times will teach.

Canada won top prize at the International Monetary Fund last year for the most household debt as a percentage of GDP in the G7, surpassing with ease the U.S., the United Kingdom and Germany. Italian households carry about a third of the household debt to GDP that Canadians do. In laymen’s terms, Canada is the most vulnerable G7 country to an economic recession and falling housing markets.

The segment below is a worthwhile update on property and mortgage trends in the Greater Toronto Area and beyond.

Toronto home prices have returned to pre-pandemic levels, but financial stress is mounting for homeowners. This video analyzes the surge in power of sale listings, which have risen by 60% year-over-year, and explains the underlying dynamics, from interest rate hikes to rising unemployment. Lenders, particularly individual private lenders, are more frequently initiating power of sales, contributing to a growing inventory of distressed properties. The video also delves into the renewal wall, the impact on the broader market, and the potential for financial contagion. Viewers will learn how to identify these distressed listings and understand the legal process behind power of sale in Canada. With predictions showing the peak of distress occurring around late 2026 or early 2027, this comprehensive analysis offers crucial insights for both buyers and sellers navigating this challenging real estate landscape. Here is a direct video link.