The Next AIG-Style Meltdown Began 24 Hours Ago

Yesterday a stock called “Glencore” had a very bad day and dropped 29%.

You may know the name. You may not.

I’d wager that by the end of this year, everyone will know the name Glencore. Just like they know the names “AIG,” “Lehman Brothers,” and “Bear Stearns.”

You see, what happened yesterday with Glencore is an eerie, picture-perfect replay of what happened in the AIG meltdown of 2008. And what happens next is going to rock the entire market.

I don’t tell you this to scare you, though it is scary. This is a major “market event.” I think it will get a Wikipedia page of its own (or several) when the dust settles. But we know from history that it always pays to get on the leading edge of a crisis and get your money “sure.” I’m here to show you how to do that and be in a good position to harness the upside from this event too.

Right now the Glencore event is still playing out, as I’ll show you (though the direction is clear to those of us who run in the credit markets). But one thing’s certain. It is going to have a near-immediate, hard-hitting effect on all the risk assets out there – just like AIG’s collapse did in 2008.

Feel free to forward this message to your family, neighbors, broker, money manager…

We all have to move quickly on this one…

If you haven’t heard of it, Glencore PLC (GLEN.L) is a European commodities and mining powerhouse. Its London-listed shares have collapsed by more than 80% from a 52-week high of 345.69 pence to open at 97p yesterday, as investors have lost confidence in the company. But yesterday it fell another 29% to 68p. Even more ominously, the credit markets are now questioning whether the company will be able to survive the carnage in major commodities markets that are battering the company’s earnings and threatening its investment grade credit rating.

Investors are fleeing Glencore’s bonds as well. Its €1.25 billion of notes due March 2021 have fallen to 78 while its €750 million of bonds due March 2025 have dropped to 67, both record lows.

It’s rebounding today, but that won’t last.

Investors can’t flee Glencore exposure fast enough.

Here’s What’s Wrong with Glencore

Glencore is facing a number of big problems.

First, its earnings are plunging on the back of lower commodity prices. Sales have plunged from $240 billion in 2013 to an estimated $162 billion this year. Net income has followed from $4.3 billion in 2013 to an estimated $1.47 billion this year. That might still sound like a lot of money, but not when you are carrying over $45 billion of debt ($30 billion net of cash) like Glencore is. The company’s interest bill will be about $1.25 billion this year. It simply has no further margin of error if commodity prices fall any further, which they are likely to do. (See page 18 of my Super Crash Report.)

The company is fatally vulnerable to a weakening global economy and what that means for commodity prices – every 10% drop in copper lowers EBITDA (cash flow) by $1.2 billion. Glencore is facing a toxic mix of too much debt and plunging commodity prices, and there is no way out unless commodities stage a miracle rally – which isn’t going to happen.

But there’s an even bigger problem facing the company.

Glencore carries $19 billion of derivatives on its books. If Glencore loses its investment grade rating – which is a virtual certainty – it is going to be required to post additional cash collateral for these contracts. And the company doesn’t have enough cash to do that.

If this scenario sounds familiar, that’s because it’s very similar to what happened to insurance giant AIG in 2008 at the height of the financial crisis. AIG had written hundreds of billions of credit default swaps on subprime mortgage deals. When it lost its investment grade rating and was required to post additional cash collateral for these contracts, it was unable to do so and had to be bailed out by the U.S. government.

Before that happened, the price of credit insurance on AIG blew out.

And that’s exactly what’s happening to Glencore now.

What Happens Next: A Hefty Chance of Default for the World’s Largest Commodity Trader

For healthy companies, credit insurance is priced in terms of an annual payment that generally ranges between 100 basis points for investment-grade companies to several hundred basis points for junk-rated companies. Credit insurance for companies considered to be in financial trouble also includes an upfront payment that can range from 100 basis points to several hundred basis points.

And this is where things are getting interesting – in a bad way. Because for the first time since during the financial crisis in 2009, sellers of credit insurance on Glencore are requiring an upfront payment in addition to the annual insurance premium. That is a very bad sign. Based on the latest data available, it costs 875 basis points a year including the upfront payment to buy insurance on Glencore, which equates to a 54% chance that the world’s largest commodities trading firm is going to default.

To put that in perspective, 875 basis points is where a B- rated company trades – which is six levels below investment grade.

In other words, the market has already decided that Glencore no longer deserves its investment-grade rating. It is not only a matter of time before the credit rating agencies, Moody’s and S&P, catch up. Once that happens, the next problem will be whether Glencore can post enough collateral to keep these derivative contracts in place of whether it will default on its $45 billion of debt and $19 billion of derivatives.

If you check press reports, you will see that “sources close to Glencore” claim that the company has enough liquidity to meet its obligations. But if you go back in time to 2008 and read similar press reports about AIG and Lehman, similar “sources” said the same things about those companies. If they said anything else, it would further spook the markets and it would be game over right now.

If you want to know what’s going on, pay attention to what the markets are saying, not what these so-called “sources” are saying.

Defaulting on $64 billion of debt obligations is bad enough. But the story doesn’t end there.

Because this is where the consequences of the end of the Debt Supercycle come in.

A $155 Billion Mess Has Big Ripple Effects…

Glencore doesn’t exist in the vacuum today, just like AIG didn’t exist in a vacuum in 2008. Glencore is an essential link in a networked global financial system. It is an important counterparty to many of the largest financial institutions in the world, who are in turn counterparties to other financial institutions, who are in turn counterparties in an endless chain of relationships that keep the global markets operating.

And the global counterparty chain is only as strong as its weakest link. In 2008, its weakest link was AIG until the government stepped up and bailed out the insurer. Then the weakest link became Lehman Brothers, and when the government refused to step up and bail out the brokerage firm, all hell broke loose.

Fortunately, Glencore is a lot smaller than Lehman Brothers with a balance sheet of $155 billion compared to Lehman Brothers’ $600 billion in 2008 when it went belly up. But $155 billion is still a big mess to clean up. And Glencore is connected to a lot of other counterparties who will have to scramble if it collapses. A Glencore bankruptcy will be a disaster for markets that are already on the run.

The most important message I am trying to convey right now is that you should monitor the situation since it has the potential to deteriorate quickly and rock the markets. But there are a number of ways to protect yourself and profit too.

Let’s walk through those “ripple effects” of a Glencore failure… and the pockets of opportunity.

1) Commodities Sector in Chaos (Going Down)

As the largest commodity trader in the world, Glencore’s failure would throw the severely depressed commodities sector into chaos. Commodities hedge funds are already reeling from catastrophic losses that would only worsen if Glencore couldn’t meet its obligations. A number of them would likely fail. Wall Street trading desks, who have done nothing but cut risk since the financial crisis and the advent of Dodd-Frank, aren’t going to step up and fill the void created by Glencore’s failure.

A Glencore bankruptcy would send already battered commodity prices into a freefall – creating an opportunity today to short commodities (and catch them on the way back up).

2) Stocks and ETFs to Focus On (Going Down)

You can sell short Glencore shares on the London exchange, although this may be out of reach to many investors. The stock could easily go much lower since the company is going to lose its investment-grade rating, which could trigger a total collapse of its business. (Today may be a good time to move, as the stock has recovered by around 17% to around 80p.)

Glencore’s collapse is putting pressure on other large Asia-Pacific commodity stocks such as Sydney-listed Rio Tinto (NYSE:RIO) and BHP Billiton Ltd. (NYSE:BHP) as well as Singapore-listed Noble Group Ltd. (N21.SI). Expect these stocks to follow Glencore down in the days ahead as the entire commodities complex goes from bad to worse.  These stocks could also be shorted.

You can also short the commodities complex more broadly by selling short ETFs, but there are surprisingly few large commodity ETFs or ETNs. PowerShares DB Commodity Tracking ETF (NYSEArca:DBC) ($2.5 billion) or iShares S&P GSCI Commodity ETF (NYSEArca:GSG) ($750 million) are among the few relatively large broad-based commodity ETFs.

You can also consider shorting specific commodities for which Glencore is a dominant trader, such as copper.

There will also be an opportunity at the height of the chaos for patient investors to buy assets on the cheap. Stay tuned for that.

I know all of this is ugly. But it’s another reality check that will reset markets and create some great investment opportunities. It gets brighter.

I’ll follow up with you every step of the way as it unfolds.

12 Responses to “The Next AIG-Style Meltdown Began 24 Hours Ago”

  1. Seldom and never do I add comments to writings…but here I make the exception. Extraordinary insight and depth in thinking evident here is worth the read. The danger component in these markets makes Michael’s views exceptionally valuable.

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