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September 14, 2007

Gold: The Collapse of the Vanities
by John Ing

Today, there are parallels with the corrections following the Russian debt default in 1998, the collapse of the Long Term Capital Management hedge fund, the Latin American crisis of the 1980s or the collapse of the junk bond market. The current credit crunch gives us a sense of déjà vu. The collapse, driven by an increase in defaults helped propel a wider squeeze in the credit markets. Investors cannot tell the extent of the losses so they have shunned all assets.

Gold has been a successful safe haven in the past. We believe gold will be today's safe haven as we expect the world's central banks to resolve the biggest crisis in the global financial system with their customary policy of bailouts and money printing.

Ironically, while there is a crisis of confidence in the credit markets, the world is awash in liquidity due to the gargantuan current account surpluses of China and other Asian countries as well as the Middle East. The problem however, is not the supply of surpluses, but the imbalance between the short term and long term obligations of the world's biggest debtor, the United States. The US current account deficit widened in 2006 to $811 billion, the largest ever, or 6.2 percent of gross domestic product. The Americans need to attract about $2.1 billion a day just to fund this gap.

As long as there is a dirth of confidence, central banks have been trying to stabilize the global financial system by injecting huge amounts of liquidity into the markets. However to date, they have only addressed the symptoms of the underlying crisis. The situation will become even worse. Today, central banks continue to boost money supply but the monetary aggregates were already growing at double digit levels leaving little room to manoeuvre. What is likely then is a dramatic reduction in interest rates which will serve as a short term palliative but this will not correct the imbalances.

The expected reduction in interest rates will undermine the US dollar which dropped to another record low against the euro and a 15 year low against other currencies. We have been down this road before.

Up until August 15, 1971, foreigners could swap the dollar for gold at $35 an ounce. At the time, the federal budgetary deficit worsened to $20 billion. Fearing a run on the bank, President Nixon closed the gold window as more and more foreigners sought to redeem their dollars for gold. While the gold supply was fixed, the dollar supply was not. By closing the gold window, Nixon propped up the dollar but this was temporary. The US dollar fell until the Paris Accord and gold hit $850 in 1980. The twin deficits today are over $1 trillion.

Until recently, Americans had the luxury of being able to borrow in their own currency, so there were few restrictions on monetary and fiscal policy. However, foreigners now control the bulk of US debt and the US can no longer risk loosing the confidence of its lenders. To date, risk premiums in London are at nine year highs. So far central bankers around the world are acting as the lender of last resort providing liquidity to an illiquid financial system. This time, bloated with dollars, America's foreign creditor's are shunning the dollar. The latest report from the Federal Reserve shows that central bank holdings of US treasuries fell $7 billion in the week to August 31st after a drop of $25.2 billion in the previous week. We believe this "made in America" credit crunch will spark a reassessment by those dollar holders, such as China laden with $1.3 trillion of reserves, invested mostly in US securities.

The origins of the debt crisis lies with the evolution of America's financial markets using financial engineering and leverage to finance the credit expansion. And the banks, the Fed's supplicant no longer trust the financial system. In the interbank market, the rate for lending between banks is at the highest level since 2001. The banks have borrowed billions from the central bank window but are hoarding that liquidity in order to buff their balance sheets and rebuild Tier I capital. Every bank has become an adversary in a "go it alone" policy and there is a lack of trust among themselves. If they cannot trust each other, who then can trust the banks?

A cut in the Fed Fund rate is simply heroin for credit junkies.

A cut in rates will not solve the problem. This crisis was caused by excess liquidity and a deterioration of credit standards. A drop in rates will do little to change the situation. It will not resuscitate an overhoused America, it will not make investors less cautious nor reflate the asset price bubbles. Credit markets have simply repriced risk.

Complicating the credit squeeze is the US savings glut. The US current account has absorbed almost two thirds of the world's global surplus. The US has been living beyond its means becoming the world's biggest spender and debtor. The Americans have run up huge budget and current account deficits and at the same time, fund wars in Iraq and Afghanistan. In the quest for yield, investors loaded up with US dollars moving away from government bonds placing a big bet (now misplaced) on US credit. For a time, the cost was minimal because real interest rates had been low and modest. The savings glut also applies to the US households. Household spending has grown faster than incomes due to the expenditure of housing and related activities. In 2006, household spending gap represented 4% of GDP or almost half of US GDP.

Like a game of musical of chairs, when the music stops, someone is left without a chair. The subprime crisis has turned a liquidity flood into a liquidity drought. While liquidity appears to be extinguished, the liabilities are still in place. Financial institutions created a Frankenstein with the change from simply lending money and taking fees to securitizing and selling trillions of loans in every market from Iowa to Germany. Credit risk was replaced by the "slicing and dicing" of risk, enabling the banks to act as principals, spreading that risk among various financial institutions. The subprime mortgage debacle revealed that estimated values were just that. When the values of the loans fell suddenly, the underlying securities also disappeared. Securitization allowed a vast array of long term liabilities once parked away with collateral to be resold along side more traditional forms of short term assets. Wall Street created an illusion that risk was somehow disseminated among the masses. Private equity too used piles of this debt to launch ever bigger buyouts. And, awash in liquidity and very sophisticated algorithms, investment bankers found willing hedge funds around the world seeking higher yielding assets. Risk was piled upon risk.

We believe that the subprime crisis is not a "one off" event but the beginning of a significant sea change in the modern-day financial markets.

At long last, the financial system is being marked to market. The virtual cycle of credit evolution has been broken. As this contagion spreads, political pressures on central banks will allow the reliquification of the markets by the slashing of rates and the opening of the liquidity floodgates.

But, here is the rub

Today's investment banks have less than 10 percent of their liabilities backed by the assets. Many of those assets are triple-A rated US treasury bills. Under the Basel Accord for every $100 of AAA securitized assets, a bank need only hold $0.60 of equity, to back up that debt. The theory is AAA assets are among the highest rated and thus the risk of default is virtually nil. However, for every BBB securitized asset, a bank would have to hold almost $5.00 of equity for every $100. The higher the rating, the lower the need for capital.

While much was made of the integrity of our financial system, the subprime mortgage debacle resulted in the rerating of a host of securities, from AAA to BBB in a single day. The credit rating agencies, Moodys, S&P and Fitch now have feet of clay as they too, underestimated their risk models and overestimated balance sheets. Ratings reflect credit risk. The rating agencies in their enthusiasm have rated about 80 percent of debt in banks backed by subprime loans as triple-A, the same rating as virtually risk-free US treasuries. Ironically the two Bear Sterns' hedge funds that went under, actually had less leverage than many of the banks' that extended their loans.

The shock waves from the US subprime collapse also put private equity deals on hold. It has been estimated that the investment banks have yet to finance some $300 billion of leveraged bridge loans in private equity deals which have not yet been completed. In Canada, the biggest deal has yet to close until late this year and there are concerns that the leveraged loan market is now closed to even the biggest. Like the 80s, when the S&L meltdown caused an abrupt halt in financings and a stock market collapse, it took years for the financial markets to recover. The S&L meltdown too had its origins in financial engineering as well as loose regulatory standards. This time, the financial institutions are much bigger but not big enough to fail. The failure of even one investment bank threatens to impact our shaky financial markets.

In Canada, the sub-prime market debacle has caught Canada's commercial paper market in its vortex. Commercial paper at one time was a short term obligation from companies looking to raise cash for their day-to-day needs. However, Bay Street enthusiastically embraced another structured product, asset backed commercial paper (ABCP) or conduits which was a form of a short term obligation with the underlying asset backed by car loans or credit cards, or other obligations. Of course this type of paper carried a higher yield and institutions scrambled for a piece of this estimated $50 billion market. The rating agencies played a key role by giving this paper the highest ratings because the banks were to provide back-up facilities. Fitch, the credit rating agency estimates there are $1.4 trillion of banksponsored conduits in the United States.

Issuers retained these credit agencies and paid for the ratings, not the users. Amazingly, the rating agencies created their own rating system, not dissimilar to Starbucks who created a new word for "small". Triple A does not in fact always mean triple A in the rating business. Indeed, the rating agencies also helped the big investment banks to create the complex asset backed structures, so the participation was hardly arms length. While Wall Street is looking to Fannie Mac and Freddie Mac, to bailout the millions of loans, many overlook that both institutions already have their own financial problems.

Gold: $1000 an ounce

And when the Fed reduces rates, this will certainly reduce the incentive to invest in the United States, removing the last prop to the beleaguered US dollar. Today's credit crisis is just the beginning. Central bank intervention so far has been akin to "pushing on a string" as investors and institutions alike hoard available cash. Defaults are piling up and the liquidity crisis deepens. The market expects the Fed to cut interest rates but as we saw in Japan, interest rate reductions do not always alleviate liquidity. Despite near zero interest rates, Japan suffered an asset deflation for 10 years and real estate is nowhere near peaks. Pundits such as Jim Cramer calling for a drop in the Fed fund rate, do not remember that interest rate reductions and negative interest rates failed to help Japan avoid a decade-long deflation.

The real issue is that the excess liquidity created by the central banks, led by the Americans through a decade of overspending, debt creation and the implosion of numerous arcane financial instruments, is being monetized which will cause an inflationary bubble not seen since the seventies. What is needed then is not a series of interest rate cuts but a change in policy.

Consequently, gold is a good thing to have. In the collapse of the vanities, the massive injection of half a trillion dollars by the central banks will eventually stoke inflation. The inflationary effects of cheap credit from the leverage bubble are only just surfacing. The history of finance makes one point clear, investors always seek the asset that best holds its value. Through thousands of years of history, gold is the best thing to have. Gold is poised to break out to new highs from an 18 month trading range. Gold will surpass the May '06 peak at $730 an ounce, the 1980 high at $850 and record a new high at $1,000. Gold stocks will be another good thing to have. This gold bull run has only just begun.

John R. Ing
Maison Placements Canada
130 Adelaide St. West - Suite 906
Toronto, Ont. M5H 3P5
(416) 947-6040

Disclosures:
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