Gold: Good Money after Bad Money

By: John Ing | Thu, Oct 2, 2008
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Imagine a game of Monopoly in which one of the players wins, all the buildings, Boardwalk, hotels and railroads. Then in a reality moment the pot becomes $700 billion and that player actually owns all the buildings, railroads and Boardwalk. Messers Bernanke and Paulson have transformed Wall Street's monopoly-like play money of structured securities into dollars by giving Wall Street a $700 billion blank check in the biggest financial bailout in American history. The proposed rescue plan uses taxpayer money to buy Wall Street's toxic assets. The government seems to be the only buyer. Wall Street created these complex instruments by pooling millions of debt (such as mortgages) that were sliced and diced into pieces then resold and even borrowed against. But today they require hundreds of billions of writedowns and cannot be valued because their underlying asset values are unknowable. Yet the Treasury believes that the taxpayer should buy these securities, spending good money after bad money and who is to tell us whether the government is overpaying or not? Someone has escaped with the financial equivalent of a "get out of jail card".

This time the weapons of mass destruction are not in Bagdhad but Wall Street. Not only have they destroyed their creators but they put the biggest dent in the US Treasury, destabilized world markets and put Main Street at risk. The Fed, the lender of last resort has become the garbage collector of last resort taking in hundreds of billions of dollars of dubious assets. And yet to date, the banks have taken $500 billion plus in losses but only managed to raise $300 billion in capital. The financial fix is modelled after the Resolution Trust Corp. (RTC) that cleaned up the S&Ls in the 80s. This new agency will take on the troubled securities, recoup the proceeds when and if those securities were sold, hopefully at a profit but the move is yet another band-aid. It won't keep homeowners in the homes, fix the budget deficit or reduce debt. It's a big step towards hyperinflation.

The cost to the taxpayer increases, but it is just a matter of time before the taxpayer wakes up to the fact that all this spending has been going on without authorization. In a leadership vacuum today there is a lack of trust between financial institutions. There is a lack of trust with its leaders, particularly after Ben Bernanke, the US Federal Reserve Chairman, and Hank Paulson, Treasury Secretary have spent more money in one year than all their predecessors. It is no wonder that gold last month jumped $90 in one day in reaction to the meltdown, and is up 20 percent since Lehman's failure.

Debt on Debt Won't Work

Washington's rescue plan will not work. It is ill conceived. It gives too much power to the Treasury. It helps the bankers but not the taxpayer. It won't restore liquidity. It won't even give them ownership stakes in the very institutions that are to be bailed out. How un-American. Debt on debt will not work. The plan will not fix broken financial and credit markets and is hundreds of billions short of fixing Wall Street's capital problem. We have been saying for sometime that the core issue is the financial sector's grossly undercapitalized and overleveraged balance sheets.

Moreover, valuing these illiquid securities is difficult and even if the new Agency acquires these distressed assets at market prices, what will happen to the capital hole left when the banks sell these marked-down assets? Paulson's bailout does not address recapitalizing the banks. And who is to say that some of those obligations are not fraudulent securities. Risk remains and it seems the Fed has transferred a good part of the risk to the taxpayer. By taking the troubled mortgage assets off the ailing banks' books, it solves a short term liquidity problem but left unsaid is once rid of the toxic assets, how will the financial institutions account for the losses to reliquefy themselves. And unknown is the ultimate cost to the taxpayer? To be sure if the United States can promise $700 billion to Wall Street, what will they offer the auto industry, and after that suntan parlours?

The Paulson plan does not address other debt-related assets like credit default swaps nor relieves other credit problems like credit cards, car loans, commercial loans, bullet payments and other types of credit. The current finger in the dike strategy is not working and destined to fail because the Federal Reserve cannot nationalize all of Wall Street. Confidence needs to be restored. At the core, the capital markets have created their own monopoly funny money such as $54 trillion of credit default swaps. Credit default swaps allows someone else to assume or insure the risk against debt defaults. The house of cards collapsed when some mortgage holders defaulted and this month, billions of defaulted contacts are to be auctioned in a test of the market's worth. AIG alone had almost half a trillion dollar exposure to these swaps. While $54 trillion is the gross credit exposure and more than five times US GDP, the net risk is in the order of $2.5 trillion which would still swamp institutions' capital. Credit default swaps underpin the health of the financial system, something that the US Treasury cannot do. Sure, housing prices will eventually stop falling and financial markets will calm down, but those massive liabilities will still be left.

The second problem is the prospect of hyperinflation as a result of the fiat money and debts created to bail out Wall Street and revive the American economy. The problem is that as long as America continues to consume more than they produce, spend more than they earn, another bailout is not going to work.

The Need for Capital

The financial engineers that helped create Wall Street's mess have been retired. First, Bear Stearns. Then Fannie and Freddie. Then Lehman, Merrill, AIG and Wamu. Wall Street's house of cards has crumbled. When one fell, the chain reaction began. Besides like the car industry, with over 8,000 financial institutions including the few investments banks, regional banks, thrifts and savings and loans, there was too much capacity on Wall Street, like its car industry.

Paulson's bailout will leave the banks with a huge capital hole. There is simply not enough core capital to support more write-offs from risky toxic assets. And as asset prices fall, the leverage ratio actually goes up, not down. Wall Street's business model of 30:1 leverage (total assets of 30 times the value of shareholders' equity) is over. At Merrill Lynch, the leverage ratio was 28:1, up from 15:1 in 2003. Lehman's leverage ratio at one time was 35 times and they managed to shrink that to 24 times which was too little and too late. Today, Goldman Sach's is at 28 times and Morgan Stanley was at 33 times at the end of June. Even GE has some $60 billion of equity supporting $700 billion of assets for a strained ratio of 12:1. Wall Street's financial model is broken and while steps have been taken to reduce leverage, needed is more capital. However, to recapitalize, equity must be raised either through profits or outside investment. Of course some debts will never be repaid and turned into equity. At the heart of the crisis, no one including Paulson's plan is ready to recapitalize Wall Street. Warren Buffett's $5 billion investment in Goldman Sachs is a small start but he can't save them all.

And who is to say that the $700 billion bailout which is roughly equal to their US current account deficit is not just a down payment? The costs continue to mount. The Fed has already made $600 billion available for the bailouts of Bear Stearns, American International Group (AIG), Fannie Mae, Freddie Mac and now the money market funds. The cost to the taxpayer of the $700 billion bailout is estimated at somewhere between $500 billion and $1 trillion. But in taking over Fannie and Freddie, the government added $5 trillion to its nearly $10 trillion of indebtedness and is now the new landlord of 80 percent of new mortgages. As a result the legal ceiling on the federal debt needed to be raised to a record $11.3 trillion from the current $10.6 trillion and up significantly from $8.18 trillion in Bush's first term. America is to pay a heavy price to save Wall Street.

America is Deeply Indebted

Of concern is that these skyrocketing deficits threaten to outstrip the US government's tax base. America has borrowed to pay for its deficits and used the printing press to save Wall Street. As a percentage of GDP, household indebtedness grew from 50 percent of GDP in 1986 to 100 percent in 2007. The financial sector's indebtedness rose from 21 percent of GDP in 1986 to 116 percent last year. To be sure, with the Federal budgetary deficit estimated at $430 billion or three percent of gross domestic product next year, Mr. Paulson's rescue plan could easily double earlier estimates to a whopping $1 trillion or six to seven percent of GDP. All this matters because they owe so much. That is more than a $700 billion problem.

While the US government has very deep pockets, private debt stands at $4.4 trillion or 32 percent of GDP. Add in the government's obligations from mortgage giants Fannie and Freddie and the debt to GDP ratio increases to 70 percent. Then there is the rising price tag of the $700 billion bailout and the costs mount in exponential fashion raising the risks that the debt will be monetized with yet more fiat money. One of these days, those same rating agencies that downgraded Japan in the nineties, will wake up. Perhaps, when America's debt to GDP ratio soars past 100 percent next year. America's AAA rating is no longer a sure thing.

Of course, the US always has the power to tax but the bailouts of Wall Street will weaken the long-run competitiveness of the US economy and its future tax base for generations. Indeed, the Federal Reserve has had to tap the Treasury for additional funds. Even the FDIC with only $45 billion left after closing 13 banking institutions including backstopping Wachovia's sell out, requires additional funding. The FDIC seized Wamu and sold the thrift's banking asset in its biggest failure yet. While the rating agencies may think differently, the credit default swaps for the United States have deteriorated following Wall Street's financial meltdown with the insurance premiums on five year government debt increasing to a record. Thus the world's biggest economy is now riskier than Austria, Sweden and even the province of Quebec.

And what about attracting more offshore investment from foreigners and the huge sovereign wealth funds? After all, America's spending has been bankrolled by foreigners for decades with over $9 trillion of dollar denominated securities piled up in foreign vaults. Nearly half of the outstanding Treasuries are held by foreigners. China holds over $519 billion in US Treasury bills with Japan at almost $600 billion. The Chinese have hinted they have too many dollars already and many Asian institutions are now below water on many of their investments in Wall Street. There is growing concern that central banks are also dumping securities in the wake of Wall Street's meltdown amid fears that the US will spend its way out of the financial crisis. Of concern is that the Treasury department reported in July that investors pulled a net $93 billion out of the US which compares to a positive investment of almost $45 billion in June. To be sure, with recent headlines, there will be an even bigger but quiet exodus.

No Nation Is Too Big To Fail

The dollar is the world's currency. But for almost thirty years, too many cheap dollars have been created to finance everything from wars to tax cuts to new homes to Hummers and now a $700 billion Wall Street bailout. A lower dollar then is in the offing making it easier for the government to repay its debts. However, no nation, even the United States, can borrow forever without facing up to economic consequences. No nation is too big to fail.

There is fear and panic today. So there should be. Main Street is only finding out that Wall Street's woes have debased their trust and currency. Wall Street's nightmare is a meltdown. The biggest bank has fallen. The biggest insurer needed an $85 billion loan. By taking on Fannie and Freddie, it makes the government owner of over half of the mortgages in the US. Stellar names like Lehman have folded. Merrill Lynch pursued a shotgun marriage. It goes on. Contagion spreads and there is financial panic in Hong Kong. Britain's biggest mortgage lender is taken over by Lloyds Banks. It goes on. Belgium's Fortis too was in need of a bailout.

And, Wall Street is to be given $700 billion to avoid yet another meltdown? What is going on?. We believe it's all about debt. Subprime debt, credit card debt, LBO debt, mortgage debt and national debt have undermined confidence. Money was too easy. Money has been cheapened. Money is not money. The responsibility for this lies with the president, the Federal Reserve, the US Treasury, the SEC and the once big investment banks. Today there is no trust in the value of money and no confidence in its institutions or central bank.

The Solution: A New Asset-Backed Security

We believe that the banks saddled with questionable securities would more readily bite the bullet and write them off if they could replace those securities with capital. We suggest the creation of a new "asset-backed" security, but this time backed by a real asset, gold. In essence, good money would drive out bad money. The losses reported would be steep but those securities would eventually be repaid as liquidity returned to the market giving everybody time to raise capital. Needed today is the injection of confidence into this liquidity black hole and gold is an asset that has stood the test of time.

We believe the next best alternative to Paulson's $700 bailout is to create a super-agency or sovereign wealth fund with this asset backed security. Today, the fiscal integrity of the United States has been dented by the serial bailouts. Needed is funding in a transparent way to deleverage and recapitalize the financial sector, preferably without taxpayer help and scare tactics. Needed is a way to fund it with not more paper promises, but instead mobilize the Fed's vast gold reserves. This sovereign wealth fund would give loans to companies, governments and purchase preferred stock or even equity as well as beef up its ailing industries. And because the new fund would have the backing of the United States, its debt would be considered AAA backed by both the balance sheet of America and US gold holdings. The new fund could issue new equity when needed and its dividends would even be attractive to other sovereign wealth funds. Why not?

The United States is the world's largest holder of gold at 261 million ounces or 8,133 tonnes representing 77.3 percent of their reserves. Germany's Bundesbank is the second largest holder has said they would not sell any more gold as they see other assets deteriorate. The European banks have also reduced their sales of gold to the lowest in a decade. China only has some 1 percent of its reserves in gold and given the growing importance of gold, we expect China and others with huge dollar denominated reserves to diversify their holdings with gold purchases. We believe a gold backed piece of paper would give credibility and reward those institutions which got their financial houses in order. The gold-backed security would yield a nominal rate since the return would be inflation protected.

In France, the government issued "Giscards" in 1973 named after President Giscard D'Estaing. The issue carried a seven percent coupon rate and the redemption value was indexed to one kilogram of gold. The issue, however was linked to the price of gold and not backed by France's gold so upon redemption, the issue actually cost the government more because the bonds increased in value by 700 percent over ten years. Other gold securities included the gold warrants issued by Echo Bay Mines, a gold producer, which was backed by gold at a price of $595 per ounce. We expect a gold backed issue would be oversubscribed providing needed integrity, transparency and liquidity. Indeed were the Treasury to issue these securities, liquidity and trust would instantly return to the wholesale markets.

Indeed, the Americans already have an institution with its roots in gold. The Treasury has tapped the Exchange Stabilization Fund for $50 billion to buy illiquid mortgage assets to help the money markets. The Americans are already utilizing, at least indirectly their gold since the Fund was set up with gold backing. The Fund was originally created by the Gold Reserve Act to stabilize the US dollar during the Depression but has been used lately for other purposes like helping out the Mexico peso in 1995. The Fund with the approval of the president can use its money to "deal in gold, foreign exchange, and other instruments of credit and securities". We believe that the Fund, can go a long way to using the gold reserves. Otherwise based on the Japanese experience, it could take at least a decade to recover from this financial crisis.

Amid the talk of market reform, policymakers blame the sell-off on the short sellers and they have become the new scapegoats. It seems that the short sellers are the newest messenger to blame for Wall Street's troubles. Much of the problem surfaced when the SEC abolished the "uptick rule". It allows short selling only when the last tick in a stock's price was positive. By introducing new rules and still avoiding re-establishing the "uptick rule" this year, the SEC has not solved the problem. In our opinion, short sellers are the new vigilantes and in fact properly done, they should be allowed to make money like everybody else. Short sellers provide liquidity in an illiquid market and have a necessary role. The SEC should re-establish the old rules that disallowed naked shorts. That should change. One must borrow or own shares to sell. Don't shoot the messenger.

So What to Do?

Commodities have become a hard asset class in their own right led by gold. Oil, natural gas and other commodities including gold have collapsed hurt by collateral damage from the meltdown. It is a purchase opportunity. As the old expression goes, when they raid the brothel they not only take all the good girls but also the piano player. This time they have taken the piano too. Market psychology has changed and there are fears that the contagion will lead to a global economic slump. The consensus is that we are heading into a serious recession (although Wall Street may think it's a depression). We believe that consensus is wrong. The bond market should be celebrating such news but it too is down.

There are two realities. The first is that the current collapse in commodities and resource stocks is attributable to more technical factors such as the unravelling of many of the hedge funds who are facing heavy redemptions. In recent years, commodity volatility attracted new players such as the big commodity funds, pension funds and hedge funds. Many of the portfolio managers benefited from the old adage, a rising tide lifts all boats. However, when the swamp drained, only the ugly frogs remain. Everyone rushed to the exits at the same time. Some fund managers have even taken to reducing their fees in order to keep investors from fleeing. So far over 176 funds in the United States went out of business and that is expected to increase before year end, since July and August were disastrous for fund managers. The big hedge funds were big sellers of not only commodities but also resource stocks. Many hedge funds' business model was based on using leverage and when they found out that credit was no longer freely available, the hedge funds imploded. The reality is that hedge funds cannot make money during these difficult times, because leverage works both ways. In London, RAB Capital, once one of the major players in commodities and in junior resource stocks has reduced fees to keep investors. Ospraie Management announced a closing of its flagship Ospraie Fund having fallen almost 43 percent this year owing to the collapse in commodities and resource stocks in Australia. SemGroup LLC's bankruptcy hurt the oil market since it had hedged 21 million barrels of oil.

Gold Is a Hedge Against The Financial Woes

Gold is an alternative. Gold is a barometer of financial stress and provides both safety and soundness. Gold's price rise is telling us the truth, not of gold but about the greenback. If debt can't be reduced, the dollar will fall further. That is an important message to all central banks. Debt on debt will not work. Gold's time is now.

The second reality is the fear that emerging economies which are dependent on the western economies will also slowdown. However, China's domestic economy continues to grow at not only at a healthy rate but in fact exports have become less and less a factor. China's major export market is not even the United States but Japan. We believe that the emerging economies will continue to grow and thereby underpin the positive move in commodities.

The financial meltdown was fuelled by excess credit. In its wake, there has been just too much liquidity, which will eventually underpin higher commodity prices. We believe that investors will again invest in resources as "hard assets". We recommend an overweighted position as a hedge against inflation, further dollar weakness and continued stress on Wall Street.

We also believe that the positive supply/demand fundamentals that drive higher commodity prices remain and that the stocks will regain favour. Oil while correcting to $100 a barrel faces tight supplies going into winter. Potash is sold out next year and it goes on. We believe the super-cycle bull market is intact, demand for resources will continue particularly when there is so much liquidity around. While equities have been dumped by speculators and investors, deep pocketed state owned companies have become strategic buyers. Brazil's Vale has been a major opportunistic acquisitor. Indian and Chinese buyers are also buyers of companies which will support higher commodity prices. Russian companies too have branched out abroad.

While gold production has fallen and costs have increased, the supply side is still a major problem gold with South African production off 16 percent in July. Physical gold is actually in short supply and the US Mint has rationed gold coin sales due to depleted inventories and unprecedented demand. Physical demand remains strong particularly during the high holidays in India. Bullion ETFs reached a record 1056 tonnes up 33 percent from a year ago.

We believe that gold and hard assets will protect investors against the deleveraging of Wall Street, the sinking greenback and the coming inflation. Gold's allure today is its store of value in a world of sinking asset values. It is a defence against inflation. Gold is money, when there is a need for money. Gold provides portfolio insurance when there is a need for insurance. Washington's unprecedented bailout of its financial system has created a risk of a sharp rise in American inflation. Gold's rise shows investors are nervous. In March, gold peaked at $1033 an ounce up from $257 an ounce in 2001. That is why investors should worry, not the loss of some of Wall Street's investment bankers. Gold's qualities are the best of both worlds; both liquid, like a currency and an asset, like property. As such, we continue to believe gold will peak at $2,500 an ounce.


The implosion of the market has decimated resource stocks. Junior mining stocks in particular have been hard as some resource funds have been dumping and hitting every bid in sight. Ironically gold bullion has done the reverse since September 11th but the gold stocks have been laggards. It has been a joyless bull market. Gold equities are attractive values down here.. We continue to believe that gold and gold stocks are effective hedges in this hostile financial environment.

We also expect the senior gold producers to do well, particularly since there are so few. The senior producers are liquid and we recommend Barrick Gold Corp., Agnico-Eagle Mines, and Kinross Gold Corp. Eldorado is also recommended because of its expanding production profile. The junior producers and developers were particularly hard hit and there are at least fifty juniors in need of financing. However, we also think that there are some terrific opportunities among some these juniors because frankly it is cheaper to buy ounces on Bay Street instead of spending the money to explore. On a larger scale, Goldcorp's premium acquisition of Gold Eagle mines is a reflection of the need by the majors to boost their ounces. To be sure, with the capital costs of opening a mine in the billions, it is cheaper for the well heeled producers to acquire reserves on Bay Street. Thus we continue to believe that a portfolio approach to the juniors is an effective way to play the gold and continue to recommend Aurizon, High River, US Gold and silver producers MAG Silver and Excellon Resources.


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Analyst Disclosure
Company Name Trading Symbol *Exchange Disclosure code
Barrick Gold ABX T 1
Eldorado ELD T 1
Excellon Resources Inc. EXN T 1,5,8
High River Gold HRG T 1
Kinross K T 1
Mag Silver MAG T 1,8
Disclosure Key: 1=The Analyst, Associate or member of their household owns the securities of the subject issuer. 2=Maison Placements Canada Inc. and/or affiliated companies beneficially own more than 1% of any class of common equity of the issuers. 3=<Employee name> who is an officer or director of Maison Placements Canada Inc. or it's affiliated companies serves as a director or advisory Board Member of the issuer. 4=In the previous 12 months a Maison Analyst received compensation from the subject company. 5=Maison Placements Canada Inc. has managed co-managed or participated in an offering of securities by the issuer in the past 12 months. 6=Maison Placements Canada Inc. has received compensation for investment banking and related services from the issuer in the past 12 months. 7=Maison is making a market in an equity or equity related security of the subject issuer. 8=The analyst has recently paid a visit to review the material operations of the issuer. 9=The analyst has received payment or reimbursement from the issuer regarding a recent visit. T-Toronto; V-TSX Venture; NQ-NASDAQ; NY-New York Stock Exchange



John Ing

Author: John Ing

John R. Ing
Maison Placements Canada
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Toronto, Ont. M5H 3P5
(416) 947-6040

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