What the Refco Mess Teaches Us: The Meaning of the Term Counter Party Risk

By: Bruce Culver | Mon, Oct 24, 2005
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As you probably already know if you follow the Markets at all, Refco, one of the world's largest financial institutions has filed for bankruptcy. The financial implications of this are enormous and although they appear to be short-term negative for precious metals, I believe long-term they will likely be very positive. In case you haven't been following the news, here's a synopsis from a recent Reuter's report.

NEW YORK, Oct 18 (Reuters) - Refco Inc. filed the fourth-largest U.S. bankruptcy and agreed to sell its core futures trading business to an investor group for $768 million to salvage some parts of the damaged commodities and futures brokerage.

The developments followed a week in which customers pulled assets out of the New York-based firm as Chief Executive Phillip Bennett was charged with securities fraud. He is accused of hiding $430 million he owed the company.

Before its recent troubles, Refco was one of the biggest market makers for commodities and financial futures, allowing funds and companies to trade contracts on commodities, bonds and currencies.

Many of the ramifications of this event for the financial markets are surely yet to be known. It is likely that it has resulted in some of the recent weakness in the commodities markets, which in the U.S. are largely paper, i.e., derivatives markets. We do know that investors in one major commodity fund, the Rogers International Raw Materials Fund will be unable to redeem their shares for some time as the fund has as much as 63% of its assets frozen in the Refco bankruptcy.

This reminded me of an e-mail conversation I had late last year with Hat Trick Letter writer, Jim Willie, in which I expressed my opinion to him that the use of derivatives to hedge other financial assets was acting to damp the price of gold which traditionally has played that role. He seemed to agree that was one among several factors at play. I believe at that time I also stated my opinion that it might take some melt down at a financial institution, introducing the investing public to the notion of "counter party risk," to launch precious metals into the next phase of their bull market. This Refco debacle may be just the event I was anticipating.

As you may know, many astute market commentators including Richard Russell, Jim Puplava, and Jim Willie are of the opinion that having just come out of a period in the financial cycle where paper assets were gaining in value relative to hard assets, we are just in the beginning of a commodities super cycle where the reverse will be true. According to this view point the huge overhang of debt in the economy will lead to an increasing distrust in paper--often debt based-- assets and a move by holders of such to exchange them for hard assets such as precious metals and other commodities. Note: debt is etymologically related to the word doubt. What we are witnessing here in the early stages of this secular bull market in precious metals is literally the beginning of the loss of faith (doubting) in the myriad of paper promises to pay with which the financial world has been flooded.

Now, the Refco bankruptcy may cause some gut wrenching volatility or perhaps even some weakness in the commodities markets, as they are -- in the U.S., anyway-- largely paper markets and Refco was a major broker to the players in those markets. Nevertheless, it should really bring home to the investing public the meaning of the term counter party risk. It only proves the wisdom of commentators such as Dave Morgan and Jim Puplava who have encouraged investors to forego the futures market and invest directly in the metals themselves along with some mining stocks. As Richard Russell often says gold and silver are the only financial assets which are not another's liability. As this is more and more realized it can only add to the demand for the precious metals in specie.

Don't be at all surprised if some mainstream media, financial paper hucksters try to spin Refco's demise as signaling an end to the commodities bull. Don't believe it. How could this do anything but accelerate the rate at which people recognize the inherent danger in holding cleverly disguised I.O.U.s? I mean the derivatives being spun out in ever greater number by the wizards of modern fiat finance. In my opinion the collapse of Refco is a signal event to a coming credit crunch that will wipe out trillions of dollars of paper wealth, yet cannot touch the value of an ounce of gold or silver. I expect to soon see an accelerating rush to exchange I.O.U s for real, tangible things. And since precious metals are the most liquid of the tangible assets, I would expect them to recover pretty quickly from whatever setback is dealt to them in the futures markets from the Refco meltdown.

Of course, I believe the foregoing analysis is correct, but perhaps one caveat is in order: I believe it is at least possible that the aforementioned credit crunch will come on with such force that the system will be overwhelmed and we will end up with a scenario such as Robert Prechter describes in his book "Conquer the Crash" where gold and silver suffer the same fate as other commodities in a mad rush to get liquid with good old cash, which is after all "legal tender" even if only by government fiat. In that case gold and silver bullion would probably increase in value relative to most things except cash. We could-- though I highly doubt it-- have gold selling for under $250 an ounce, but $250 will be worth much more than it is now. However, in this scenario all but the most elite mining stocks would become worthless. I rather think Bob Hoye's view is correct and that gold and gold mining stocks will perform very well during the coming contraction. Nevertheless, I will keep my portfolio hedged with a pretty good weighting of cash until such time as I see a new upswing in money supply growth.


 

Author: Bruce Culver

Bruce Culver

Bruce Culver is an English teacher, small-time private investor and a gold bug.

His writings are for entertainment and the provocation of thought and should in no way be construed as investment advice.

Copyright © 2005 - 2006 Bruce Culver

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