Thursday, November 3, 2011

Credit Default Swaps

Sometimes readers need a pictorial explanation in order to fully grasp an important concept. In this case, we would like to help you understand what is really happening in the sovereign debt markets. This picture is an effective representation of the circumstances that several multinational banks are facing. This particular structure was a neighbor of MF Global until Monday.


Most of the New York banks, especially the primary dealers, are levered at a rate of more than 20:1 with respect to their base capital. This means that a $5,000,000,000 capital loss can completely wipe out a $100,000,000,000 balance sheet.

Traditionally, sovereign debt is treated as a very stable asset on the balance sheet. Maximum borrowing privileges are typically extended to these assets. Recently, riskier credits have been appealing due to their marginally higher coupons. When risk was questioned, Ivy League executives lashed out accusing heretics for failing to understand the difference between gross and net exposure to risk.

Lets say that back in 2010 a firm bought $500,000,000 worth of 10-year Greek debt that carried a coupon of 10%. This was seen as a smart trade because if readers remember the Greeks estimated that $80-100 billion would solve their temporary issues. Think back to the events occurring in the spring of 2010.


The purchasing institution will seek to protect this asset using a derivative product called a Credit Default Swap. This is an insurance policy that is designed to pay the purchaser in the event that the issuing nation defaults on its obligation to perform as promised. MF Global had significant exposure to Greek, Italian and Spanish credits on its books. Late last week, holders of Greek bonds received a 50% reduction in the value of their investment as a condition of further assistance. The International Swaps & Derivatives Association determined that this was a voluntary event and therefore did not constitute a failure to perform by the Greek government. What is confusing for us is that the event did not seem voluntary?

Immediately following the decision, banks holding Greek debt instruments would legally have to make adjustments on their balance sheets reflecting the new valuation. In reference to our example above, a firm holding $500,000,000 in Greek debt would be required to take a $250,000,000 loss. This was a death blow for MF Global. Margin calls forced the firm to file for Chapter 11 protection late Sunday night.

The Italian government is facing problems far larger than Greece. Italian debt has eclipsed 120% of GDP and Italian GDP is six times that of Greece. More firms will be affected by the ongoing events in Europe. The problem is simple: these nations are over-leveraged and there is no possible way to proceed without a direct devaluation of their debt.

When you hear a firm discussing Net exposure, keep asking questions. We are interested in Gross exposure. If credit default swaps are not going to pay out on the debt devaluation, gross exposure is what matters. The gross exposure to European credit could wipe out several large institutions. Some would assume that this incident would be isolated, affecting only the holders of the paper who should have known better. Don't be surprised when your money market account is inaccessible.

We continue to seek shelter in an asset that is not the liability of any other party, especially a power hungry, underfunded, and over-extended government.

Monday, October 31, 2011

What's in Your Wallet?

If you have not heeded our warnings to flee the the following asset classes you deserve what is coming to you:
  • Savings accounts
  • Certificates of deposit
  • Cash (Beyond a reasonable stash)
  • Government bonds
  • Municipal bonds
  • Currency markets
In 1944 world economic leaders met in Bretton Woods New Hampshire to structure the post war monetary system.  Upon the conclusion of World War II the United States possessed 22,000 tonnes of gold.  This put the US in an incredible position of strength.
In liberal classrooms students are taught that fairness and equality are to govern society.  In real life, strength, power and force determine direction and more importantly who gets to drive.

The dollar would now be the denominator currency with respect to settlement of world trade.  At any time, $35 could be exchanged for one ounce of US gold.  This would allow other currencies and commodities to trade off of this standard.  Pseudo-intellectual know-it-alls call this a "Gold standard" but they are once again wrong.  This is an exchange standard.

By the late 1960's the US was committed to the great society and to a complex military effort in southeast Asia.  Many veterans are unwilling to study what was really happening in Vietnam but sometimes the truth hurts.  This effort was not winnable and financiers funded the opposition.  There was tremendous wealth to be made from the US spending required to continue fighting.  US politicians were determined to please voters receiving new domestic entitlements while at the same time defending positions in the Asian jungle.  Some money would need to be printed in order to prevail on both fronts.

Merchant bankers were delighted to assist the political class in this effort.  Freshly printed dollars were then quietly taken back to the gold window and exchanged for bullion.  This continued until the US was left with 8,200 tonnes of gold.  Richard Milhous Nixon announced that as of August 15, 1971 the exchange window would be closed.  He was also kind enough to explain to an unaware populace that the speculators had caused this problem.

Now the currency was floating freely with no formal denominator.  The problem with this structure is that leaders never met to discuss this arrangement.  The US positioned itself inside the Saudi government in order to create what we call the "Petro dollar."  This was an effective strategy for many years.  Oil trades would be required to settle in dollars.  The Saudi's could control OPEC and we could control our chosen puppet leaders.  What many readers do not know or accept is that the US Treasury has significant operations within Saudi Arabia.  This presence was required because we forced the Saudi's to funnel their petro dollars though the treasury auction system.

In an effort to keep your attention, we will fast forward to the present.  Governments are facing the reality that they have leveraged their societies to unrealistic levels.  There is simply no way of cutting back sufficiently without destroying growth.  At the same time, there is no way to grow out of the hole.  Like a band-aid applied to a severed artery, politicians seeking job security have chosen to print additional currency in "moderation."  While this allows them to avoid pain they are using the citizens as human shields.

Countries must maintain a weakening currency in order to prevent their economies from seizing up entirely.  Japan has tremendous issues in this realm and was sustained by a weak yen for nearly two decades.  Now that other developed nations are rushing to devalue their currencies, the yen has strengthened making Japanese exporters drastically less competitive.  The Japanese government has established a fund to help companies that are suffering under the burden of a stronger yen.

Last night the Bank of Japan intervened in the currency market in order to weaken the yen:
Take special note of the time that this occurred.  Now notice the corresponding impact on the gold price in dollar terms:
When we specifically point out that this gold chart is in dollar terms we are trying to illustrate that the Bank of Japan acting to weaken the yen strengthens the dollar.  For new readers, currencies are only trading against one another in the form of a cross trade.  If you are long yen you must be short dollars, euros, francs or any currency of your choice.

This concept is critical to understand because the currency market is one massive pile of worthless paper.  When paper is rising or falling in value against other paper you must zoom out and see the entirety of the market.  In this case, would acquisition of a tree farm not be the proper course of action for a savvy investor?
 
These and other actions are occurring with increasing frequency.  Central planners are responding like junkies to the problems created by years of manipulation.  The problem with synthetic addiction is that increasingly large quantities of substances must be ingested in order to maintain or even achieve a high.  In the beginning the drug serves the user but in the end the user serves the drug.  We can only picture the offices of central planners beginning to look like this:
So what is the solution?  We urge readers to consider The Art of War by Sun Tzu.  Chose the battles you wish to fight as each one requires energy.  This is one where we urge you to consider abstinence if possible.  Purchasing precious metals and hard assets using soon to be worthless paper currency is our recommended strategy.

Talk it over with your stock broker but please force him to comment on the world's debt load.  Force him to answer the question of how the debt will be repaid.  If he admits that they will likely devalue the currency to accomplish this insist that he outline an investment strategy that considers this fact.