Gear Today, Gone Tomorrow

"Gear Today, Gone Tomorrow" is an old saying in the market place, referring to the propensity for over-leveraged entities to implode. The continuing crisis in the global banking and credit markets has caused the clock to tick past midnight. What was "Today" has become "Yesterday" and what was "Tomorrow" is now "Today".

In April 2005 I published an article entitled "The Seven D's of the Developing Disaster". The article suggested that most of the major problems facing the USA and the rest of the world commenced with the letter "D". The first six D's were the problem areas and the seventh "D", "Devolution", is what investors will do when a financial crisis erupts. The following are the problem areas:

1. DEFICITS (US Current account and Federal Budget deficits.)
2. DOLLAR (US) - a greatly over-valued currency requiring correction.
3. DEVALUATIONS (COMPETITIVE) - by countries such as Japan that keep creating their local currencies in huge quantities in order to prevent their local currencies from appreciating against the US Dollar;
4. DEBT - of all descriptions, that has been growing exponentially;
5. DEMOGRAPHICS - refers to the Baby Boomer generation that are now starting to retire and expect to receive pension and social security benefits from the Government. The Government unfunded liabilities for these benefits are estimated to be between $40 Trillion and $80 Trillion.
6. DERIVATIVES - potentially the biggest problem; the BIS estimated a notional value of $410 Trillion of outstanding derivatives at 31 December 2006. The current figure will certainly be much bigger.

Two additional problems have since emerged, also starting with D's:

DWELLINGS - the problems in the housing and sub-prime credit markets in the USA.

DESTRUCTION - the ongoing wars in Iraq and Afghanistan which are ringing up increasing costs with no end in sight.

The thesis is that when a financial crisis hits the system as a result of problems in one or more (or all) of the above categories, to the point where the system itself is threatened with collapse, then the Fed will "throw money at the problem" using the electronic liquidity creator available to authorities today. Governments would also bail out sectors that were suffering excessive financial pain and threatening bankruptcy.

The resulting massive creation of new liquidity would destroy or vastly reduce the purchasing power of currencies as we know them today. The situation that might eventually emerge could be described as: "Hyper-Stagflation". The financial and banking crisis would lead investors to:

7. DEVOLUTION

This was described in "The Seven D's of the Developing Disaster" in the following terms:

Dictionary definitions of the word DEVOLUTION include the following:

1. A passing down or descent through successive stages of time or a process.
2. Transference, as of rights or qualities, to a successor.
3. Delegation of authority or duties to a subordinate or substitute.
4. A transfer of powers from a central government to local units.

"It is the first definition that is applicable here. Imagine an inverted pyramid of various investment asset classes where the least secure (and most prolific assets) are in the very wide top layers. The inverted pyramid then narrows down through layers of increasingly more secure asset classes to the small point at the base which consists of the most secure (and least prolific) assets. This is an idea propagated years ago by John Exter.

The theory is that in times of financial crisis investors will cause their investments to devolve downwards (hence DEVOLUTION) through the different asset class layers in the inverted pyramid as they search for greater security. DEVOLUTION is thus a movement by investors out of riskier, speculative asset classes into more secure ones. This is what can be expected in the months and years ahead as the creation of electronic US Dollar credits gathers momentum and faith is lost in the US Dollar.

The assets in the most secure category at the tip of the inverted pyramid are gold and silver bullion, assets that have performed the function of protecting wealth throughout the ages. In the layer above the precious metals lie the companies that mine and hold large deposits of gold and silver. The least secure assets in the envisioned environment, which form the broad layers at the top of the inverted investment pyramid, will be the electronic US Dollar credits and assets or loans that are repayable in US dollars."

There is ample evidence that investors are already moving their capital down through the inverted pyramid. Initially the move has been out of the "toxic waste" and lesser quality bonds at the top of the pyramid into bonds with more security, especially Government Bonds and Treasury Bills. Those who feel uncomfortable holding long dated Government paper have been moving into 90-Day US Treasury Bills.

Data updated to 31 August 2007.

What can only be described as a panic surge over the past 3 weeks drove the US Treasury Bill rate down to 3%, and it was around 4% on Friday 31 August, 2007. The 10 Year US Treasury Bond yield also dropped, from 4.85 to 4.50, during the last 3 weeks of August. The extent to which the Treasury Bond and Treasury Bill rates are below the Fed Funds Target Rate is indicative of the level of concern behind the credit market's façade. This is evidence that investors are moving assets down the inverted pyramid and that the process of seeking ever more secure asset classes for investments is underway.

One must assume that there is a lot more bad news to come, news that the greater body of investors is not yet aware of, but which is of sufficient concern to people close to the banking and credit markets that they are scurrying for cover and moving into secure Treasury assets. It took a massive amount of money to move the T Bond and T Bill rates down to the extent that they fell over the past few weeks, funds presumably coming from sophisticated investors.

There is likely to be a lot more bad news to come from the real estate sector. Increasing numbers of mortgages are to be reset at higher rates over the coming 12 months, almost certainly leading to escalating foreclosures and lower home prices. It is a self-feeding downward spiral that reduces personal balance sheets and removes the method of using homes as ATM's to obtain cash to fund consumption spending.

Alex Weber, President of the German Bundesbank and a member of the Governing Council of the European Central Bank, in a speech to Central Bankers at the Jackson Hole meeting last weekend, said that the only difference between a classic banking crisis and the turmoil under way in the markets is that the institutions most affected at the moment are conduit and investment vehicles raising funds in the commercial bond markets, rather than regulated banks. Most of the conduits, however, are owned by banks.

When someone of Mr Weber's stature admits publicly that there is a crisis, we can surely believe that there is a crisis and that it is probably more serious than anyone is currently admitting. Possibly this is because no one knows where the losses will settle. We should expect a string of unhappy announcements and bankruptcies to emerge over the coming weeks and months.

There is potential for considerable debt liquidation and de-leveraging in the credit markets in the months ahead. There is a possibility that the crisis may become severe enough to threaten a collapse of the existing financial system. If that happens, the choice will be to: (i) allow the credit contraction to continue and accept a decade long depression, or: (ii) pump in massive amounts of liquidity and bail out the institutions that could bring down the entire edifice if they collapse.

Past history suggests that politicians will probably (almost certainly?) choose option (ii) and massively inject liquidity into the system, bailing out major banks and players on the way. The only problem is that on this occasion the amount of new liquidity that will be created will dwarf existing money supplies in countries around the world. This in turn will massively ignite the inflationary fires and those investors who have sought "security" in Treasury Bonds and Bills will start to fear the erosion of purchasing power of their capital.

The next phase in the cycle will be a search for asset classes that can maintain their purchasing power. The search for "stores of value", (generally real tangible assets that are not someone else's liability), will then commence. This desire for "stores of value" will cause those investors seeking greater security to move even further down the inverted pyramid, eventually reaching gold and silver at the lower point of the triangle.

Just above gold and silver (and their mining shares) in the inverted pyramid are the other precious metals, such as platinum, and the base metals group. As an example of the scarcity of metals relative to the anticipated new liquidity injections, copper has an annual world production of 18m tonnes or 40 billion lbs. At the current price of around $3.40 per lb, the proceeds of all the copper mined throughout the world in one year would amount to less than $140 billion.

In just a couple of days in the middle of August, Central Banks around the world injected a total variously estimated to be between $300 and $500 billion of new liquidity into the credit markets. Taking the lower figure of $300 billion, the new liquidity injected in just a couple of days would have been sufficient to buy the world's entire annual copper production for TWO years! That is how scarce copper is relative to the inflow of liquidity that we have just witnessed. As this financial crisis develops, the liquidity injections will become massively larger than anything seen to date.

There seems to be an ETF for just about everything these days, but I cannot find an ETF for copper. If anyone knows about a copper or base metals ETF, please email the details to me.

Virtually all the copper produced these days is consumed by industry. Copper stocks at the LME amount to 140,000 tonnes, just 3 days of consumption at current rates. Any purchases of copper for "store of value" investment purposes will probably push the copper price much higher. Increased input costs as the inflation surges will also add upward pressure to the copper price.

The small quantity of available copper stocks means that only a limited amount of investment capital can be funnelled into copper for "store of value" purposes. This makes copper a less than ideal "store of value" medium. Most other metals, including silver, are in the same boat due to strong industrial demand and low above-ground stock levels.

Gold is a different animal. Virtually all the gold ever mined is still available in some form or another. The large chunk of the UK's gold reserves that Gordon Brown sold some years ago at $255 went to someone. The ex-UK gold (less a little that is around necks and fingers) is probably still available to the market at a price. The same applies to other Central Bank sales. The gold that has been sold in recent years did not just "vaporise". It is still held by someone. Some or all of that gold may emerge in the marketplace at much higher gold prices.

Thus while silver and copper may have larger percentage price increases than gold as a result of "store of value" buying, gold will still be the prime target for large investors looking to put very big sums of money into a "store of value" investment. That is why gold is at the point of the inverted pyramid, being the most secure investment asset.

Hedge Funds: Geared Monsters

To fully appreciate the problems that could emerge in Derivatives, it is necessary to examine how Hedge Funds operate. This is not an easy thing to determine as most Hedge Funds are very secretive about their investment processes. Some Hedge fund managers will not allow their management companies to float on the stock exchange because this would require them to disclose their modus operandi. The managers claim proprietary knowledge that they do not wish to reveal to competitors. The other side of the coin is that they do not show investors what risks they are being exposed to.

We can construct a hypothetical Hedge Fund to see what kind of animal it is. We will assume a very simple structure, but it explains the system. Hedge Fund managers typically charge an administration fee of 2% per annum of investor's capital plus an incentive fee of 20% of profits realised.

Assume that our hypothetical manager raises $1,000 million from investors, promising a superior return. The manager invests the capital in, say, Australian Government Bonds at 6% return. After deducting the 2% admin fee, profits would amount to 4%, of which the manager is entitled to 20%. That leaves a grand 3.2% for the investors. Obviously that model will not excite investors. So the return must be "juiced up" by using leverage.

Using the $1.0 billion of Australian Govt Bonds as security, the manager borrows say $5.0 billion in Japan at 1% and invests the money into more Aussie Bonds at 6%. That is a profit of 5% x 5 = 25% plus the 4% on the original capital = 29% return. That is more like the profit that Hedge Fund investors are looking for! The manager takes home $20 million in admin fees and $58 million in incentive fees (20% of $290m). Not a bad reward.

There are several risks in this hypothetical structure. If the Japanese Yen declines against the US$, the fund makes a currency profit but if the Yen appreciates against the US$, there would be a loss. Solution: buy some cover against the Yen rising against the Dollar. There is also a currency risk in the Aussie dollar/US$ exchange rate. The Aussie rises and the Fund makes a profit but a decline in the A$ could cause losses. Solution: buy some cover against the Aussie dollar declining. These are currency derivatives that would typically be arranged with banks or other counter-parties.

A further risk is that the Aussie Bonds might decline if there is an increase in interest rates. Solution: buy some cover against Aussie interest rates rising. With all these risks covered, albeit at a cost that will reduce the return to investors, the manager can put up the "Gone Fishing" sign and just wait for the money to roll in.

Enter Greed. Some new investments yielding say 8% are offered to the manager. The investments are rated triple A, so the manager exchanges the Aussie Bonds for the new investments, boosting the return to a margin of 7% x 5 = 35% plus 4% = 39%, less the cost of protections purchased.

Things go wrong. The banks become concerned about the quality of the security that they are holding because of turmoil in the credit markets. At the same time 25% of the investors ask for their money back. The manager finds that there is little or no market for the securities that he is holding. In unwinding the transactions the fund takes a bath on both the Yen and Aussie currencies and has a loss on selling the assets. The manager claims against the derivative products that he has purchased in order to recover the fund's losses. The question now is whether the Fund's counter-parties can or will honour their Derivative obligations.

Derivatives are created by private treaty and there is generally no market in these OTC products. There is no Clearing House and there are no financial guarantees. The ability of the loser in these products to meet their commitments depends on the strength of their balance sheets. Invariably the risks are arbitraged from the originating contract maker to many other participants, possibly other Hedge Funds specialising in these products.

Thus one domino falling in the system can trigger an ongoing collapse as the loss is passed around. Derivatives have grown from a notional $50 Trillion 8 years ago to $410 Trillion at 31 December 2006. That figure has probably mushroomed to at least $450 Trillion now, and possibly much more. This is a trembling house of cards and the potential source of major trouble.

It is easy to visualise how these ultra highly geared Hedge Fund vehicles (some are said to operate at 10x1 and even 50x1 gearing), operating across currencies and across interest rate spectrums, can run into serious problems. It will come as no surprise if we hear of many more bankruptcies in the Hedge Fund area. An exodus of investors from Hedge Funds will cause a further serious unwinding of leverage with unknown consequences. It will be "Geared Today, Gone Tomorrow" with a vengeance.

What is most concerning is the level of new liquidity that will be created to bail out banks who have been big lenders to the Hedge Funds. While individual Hedge Funds may be allowed to go to the wall, banking bankruptcies have the potential to bring down the financial system. They can be expected to be bailed out.

If we assume that the bail out is for just 10% of the notional total of Derivatives, that would amount to a huge $45 Trillion. This is a massive injection of new liquidity relative to present world money supply. The destruction of purchasing power of currencies will be equally large and the move down the inverted pyramid into "Stores of Value" will become a stampede.

It is difficult to conceive exactly how big this amount of $45 Trillion is. Even $1 Trillion is a mind boggling sum. If there were $1,000 bank notes in existence, (I think $500 may be the biggest note) it would require 1,000 bank notes to make a million dollars. A pile making up the million dollars would, at a guess, be perhaps 6 inches (15cm) high.

If the pile of $1,000 notes was extended up to $1 Trillion, how high would the pile of bank notes be? The answer is 150 kilometres, or nearly 100 miles. The height would double if $500 notes were used in place of the non-existent $1,000 notes. That is just $1.0 Trillion. Imagine 45 stacks of notes each 100 miles high and you get some concept of what may happen - and that is on the relatively conservative assumption that only 10% of the existing Derivatives are bailed out.

These are potentially very frightening times that we are contemplating. It is appropriate to move assets down the inverted pyramid and to have, at the very least, an insurance position in "Store of Value" assets.

Alf Field

Comments to: [email protected]

Disclosure and Disclaimer Statement: In the interest of full disclosure, the author advises that he is not a disinterested party in that he has personal investments in base metal mining shares including Zinifex and Mincor ment. The author's objective in writing this article is to interest potential investors in this subject to the point where they are encouraged to conduct their own further diligent research. Neither the information nor the opinions expressed should be construed as a solicitation to buy or sell any stock, currency or commodity. Investors are recommended to obtain the advice of a qualified investment advisor before entering into any transactions. The author has neither been paid nor received any other inducement to write this article.