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July 17, 2009

Is The IMF Becoming A Bad Bank?
by Daniel Aaronson and Lee Markowitz

Brazil's, Russia's, India's and China's (BRIC) intention to buy IMF issued bonds raises several questions. The publicly announced plan states that the BRIC countries will buy the first-ever IMF issued bonds, which will be denominated in Special Drawing Rights (SDR). The plan's objective, as suggested by the IMF, is to increase the IMF's funds in order to allow it to lend greater amounts of capital to countries during times of distress while also giving the BRIC countries a greater voice within the IMF. Another aspect of the IMF bond issuance is the BRIC's possible intent to use the IMF as a bad bank to hold toxic assets that financial markets cannot absorb, specifically, US Treasury Bonds.

First some background on the IMF as per the IMF's website:

The Special Drawing Right (SDR) was created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system. Today, the SDR has only limited use as a reserve asset, and its main function is to serve as the unit of account of the IMF and some other international organizations. The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members.

Additionally, after adjusting the IMF's gold holdings to current market value (the IMF's balance sheet records its gold at historical cost), the IMF has assets of SDR 283 billion, liabilities of SDR 219 billion and equity of SDR 64 billion. The IMF's gold accounts for roughly 25% of its assets. Although it has leverage of just 4.4x, it is questionable how much leverage the IMF should possess given that it does not have taxing authority.

Below is the current composition of an SDR.

The countries buying the IMF bonds are reportedly doing so by exchanging Treasuries for the new IMF bonds. Capital is fungible, meaning any country could sell Treasuries for US Dollars and use those Dollars to buy IMF bonds. However, the direct exchange of Treasuries for IMF bonds raises a red flag because it signals that the IMF bond exchange is as much of an opportunity for each country to reduce its Treasury holdings as it is a way to help fund the IMF. The transaction is paradoxical because it forces the IMF to increase its Dollar holdings, which is in stark contrast to the member countries attempt to reduce their Dollar holdings. This plan is eerily similar to when US financial executives pushed the US government to buy toxic subprime assets in order to clean the financial industry's balance sheet.

Following the initial IMF bond issuance it is unlikely that the BRIC countries will be content with the limited diversification out of Dollars that the transaction provides. Subsequent to the completion of the bond exchange the BRIC portfolios will have shifted from owning US Treasuries (that they do not want) to a mixture of mostly Treasuries along with a small amount of illiquid, low yielding IMF bonds that are still 41% backed by Dollars. Although the BRIC countries will have somewhat reduced their exposure to the Dollar, each country will still be stuck with massive Dollar holdings. This scheme is not a solution but likely just the start of something much larger than this otherwise insignificant IMF bond offering. Furthermore, doubts about the strength of the IMF will intensify as it becomes a bigger and bigger holder of Dollar-based assets with deteriorating liquidity.

Congress' recent approval to allow the IMF to sell some of its gold also supports our view that countries around the world are pushing the IMF to become a bad bank. Not to belabor our views on gold, but of all the assets on the IMF's balance sheet, only gold has been exchangeable for food, goods and services for 5,000 years - not its currency holdings, or its bond holdings. There are two reasonable explanations for why the US is allowing the IMF to sell its gold. The first, tempering gold price appreciation, which indirectly supports Treasury prices through lowered inflation expectations. And second, to directly support Treasury prices by enabling the IMF to use the proceeds to buy more US Treasuries. Again, we foresee a bad bank analogy, whereby the IMF takes the bad assets (US Treasuries) from countries with too much leverage in exchange for good assets (IMF bonds).

There are other interesting points raised by the exchange of IMF bonds. Although the IMF could arguably better serve the world if it had greater funds to lend to countries in need, those funds should be raised through equity injections rather than by the IMF issuing debt. Eventually, the BRIC countries are likely to make equity injections rather than lending money to the IMF, but the US is not ready to allow that to happen. Today, the United States has a 16.77% voting interest; and any change in quotas must be approved by an 85% majority. If the BRIC countries were to make equity injections, this percentage would obviously become diluted. Therefore, it seems likely that, behind closed doors, the United States is telling the BRIC countries to diversify their holdings with new IMF issued bonds, and tempting them with possible future discussions about greater voting rights within the IMF.

The BRIC countries do not need to lend funds to the IMF to gain a greater voice within the global financial community - they already have everyone's full attention. Instead, we are speculating that these nations, all large holders of Dollars and Treasuries, cannot possibly sell out of those positions and are becoming increasingly nervous about what they own. As a result, the IMF bond plan is a mechanism that allows these countries to reduce their Dollar holdings. Today, the initial bond sale may seem like a good idea for all parties involved, however, these countries still remain too exposed to the US and will need to do future exchanges with the IMF, or will eventually be forced to sell their holdings into the capital markets. When the IMF is too full to accept more "bad assets", the inevitable open-market selling will inflict great losses on the IMF and thus, undermine the strength of the very bonds it issues - a logical outcome for a bad bank.

Daniel Aaronson
Lee Markowitz CFA
Continental Capital Advisors, LLC

Continental Capital Advisors, LLC was formed to offset the destruction of wealth caused by the global devaluation of currencies by central banks. The name Continental Capital symbolizes the 1775 US Currency, "the Continental", which was backed by nothing and quickly became devalued.

Disclaimer: The above is a matter of opinion and is not intended as investment advice. Comments within the text should not be construed as specific recommendations to buy or sell securities. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Certain statements included herein may constitute "forward-looking statements" with the meaning of certain securities legislative measures. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the above mentioned companies, and / or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Any action taken as a result of reading this is solely the responsibility of the reader.

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