The Coming Storm

David Chapman
March 8, 2004

"The coming storm" is the title of an article in the Economist (February 21, 2004). The article was noteworthy and important because the Economist is not noted for being alarmist. Not that this article came off as being overtly alarmist written as it was in the Economist's usual calm, well researched, analytical manner. So just what was it that caught their attention?

Well it is that bastion of conservatism known as the banks. Contrary to popular opinion, banks are often anything but the sober thoughtful deposit gatherers, loan givers and money managers that they love to portray. But retail banking is just the most obvious public face of your friendly bank. Behind the scenes often unbeknownst to the general public are the capital markets, investment banking and corporate finance divisions financing the global corporate world and involved in a wide array of trading activities. And it is here that they often make huge gambles that can also result in spectacular failures.

As the Economist article points out one of them was the gamble that after Russia defaulted in 1998 it resulted in not only the markets going "berserk" but in the collapse of Long Term Capital Management (LTCM), a very large hedge fund that had to be bailed out by its bankers at the behest of the Federal Reserve. Bank losses were huge and LTCM disappeared but evidence later emerged that this was so huge it almost brought down the banking system if the Federal Reserve hadn't stepped up cutting interest rates rapidly and flooding the system with money to provide liquidity to prevent the meltdown. The resulting massive liquidity injections were then eventually one of the reasons behind the stock market bubble of the late 1990's.

In pointing this out the Economist went on to relate how once again the banks are making huge bets in the market and that their risk management models underestimate the potential of big shocks when everyone is trying to get out of the market all at once. So just what are banks doing?

Well for one thing they have huge investments in hedge funds. The very name hedge funds is a misnomer as many of them are anything but. Hedge funds make their huge returns by taking big bets in the market using at times enormous leverage. And banks themselves do the same things with depositor's money in their trading and lending activities. This works well when markets are going up and the policies of the Federal Reserve and the world's central banks are in alignment encouraging the markets so that their huge bets are almost "lay-ups".

This phenomena was best illustrated with the Yen and Gold carry trades of the mid to late nineties whereby they were able to borrow funds cheaply (in Yen and through gold leases) knowing that the monetary authorities were determined to maintain low rates in the case of Japan and that the central banks were seeking a return on their vast gold holdings. The resulting funds were then re-invested elsewhere from US Treasury bonds to emerging market debt and the stock market, wherever considerable higher returns could be had. Of course when things go wrong in a big way as they did in 1998 they couldn't get out fast enough to prevent a blow-up and their risk management models proved to be useless.

Banks themselves are notorious at building up huge positions in the latest hot market only to discover that when conditions change, often quickly, they wind up with huge losses. Think back to the early 1980's and the collapse of the third world debt, the oil price collapse in the mid-eighties, the real estate debacle in the early nineties and more recently the internet, technology and telecommunications collapse. With exceptionally low interest rates banks have been increasing their bets in a wide array of areas including junk bonds, derivatives and structured products and of course the above mentioned investment in hedge funds. Oddly enough many of the biggest hedge funds are run by former bank and investment dealer traders who left their companies to set up their own hedge funds.

Take derivatives for example. In the past year alone (third quarter 2002 to third quarter 2003 the period for which the latest data is available) US banks derivatives positions have increased by 26% to $67 trillion. Assets on the other hand are only up 11% to just over $6 trillion. But of the derivatives fully half of them are with one financial institution J.P. Morgan Chase Bank (JPM-NYSE). We remember when we were astounded that their derivative positions totalled $23 trillion.

We are not sure what to make of the last reported position for JPM of $34 trillion up 29% in the reporting period. Of this the largest positions are in interest rate swaps. Of course we don't know what is on the other side or the effect of netting agreements (according to numbers some 80%+ of derivative contracts) on the positions that may lower the risk. Of course it is when whatever is on the other side defaults then the trouble begins especially if as it was in 1998 big enough.

But the point is, if something went amiss, losses could be enormous. Large write offs were seen as a result of derivatives and loans in the 1998 collapse and again in 2002 as a result of the internet, technology, telecommunications collapse. But banks are in the business because the returns are huge and their gamble is that nothing untoward will happen to cause huge losses or certainly nothing large enough that would seriously impair their capital. And of course as long as the monetary authorities set the proper conditions (which they invariably do) their gambles are almost assured.

But with each round of financial disasters that seem to imperil the system every so many years the markets and the economy become more susceptible to shocks. And each time it takes increasing amounts of new debt and money to bail the system out. But in the "what me worry" world of banks, corporations and consumers they know that while some will get hurt they know that the Federal Reserve will ride to their rescue. So it is okay for the consumer to spend more than he earns, to save nothing, to watch debt grow well past 100% of income even as real wages are falling.

And the corporations and banks encourage this as well with their own risk taking recognizing that maybe something might happen to cause a temporary blip in their earnings but that at the end of the day once again the Federal Reserve will ride to their rescue and lower interest rates and flood the system with liquidity ensuring that they will survive the bumps so that they may go on to the next round. Even Alan Greenspan has expressed recent concern about financial institutions such as Fannie Mae and Freddie Mac (describe by some as hedge funds in disguise) or the growing unsustainable debts being accumulated by the current White House administration all as if they have no concern about the future.

Of course the question begs what if it outside the realm of their risk management models something happened that was beyond their control that even the Federal Reserve couldn't properly respond to. With interest rates already at record lows coupled with ongoing liquidity injections for almost any reason over the past number of years and enormous debt loads already in place here is very little room to manoeuvre if another major crisis hit.

So where could a crisis come from? The Economist mused on some even if they did not get too specific. What if there were serious dollar crises that caused interest rates to spike or a huge spike in oil prices (flashpoints might come in Venezuela where there are ongoing rumblings against a President that the US would love to remove or Saudi Arabia where there has been considerable unrest in the past year including a few terrorist bombings directed at foreigners and indirectly at the Royal House of Saud) or an emerging market getting into trouble (Argentina for example who we understand may be prepared to default the IMF).

We also add our musing of what of another terrorist attack on US soil or a major US political assassination. On the latter we are reminded of the 20 year cycle of Presidents elected in years ending in zero who have a history of either death in office or assassination. Of the 8 Presidents since 1840 (Bush jr. is the 9th) in years ending in zero 4 were assassinated with only the last one Ronald Reagan surviving an assassination attempt. While this thought might seem "out of it" cycles do have an odd way of repeating themselves so it should not be instantly dismissed.

So if the "coming storm" as outlined by the Economist isn't enough they followed it up the very next week with "A phoney recovery" (The Economist February 28, 2004) outlining how the current US recovery is anything but. The job numbers released today are confirming that something is clearly amiss in the so called recovery. We should be paying attention. After all, the Economist is supposed to be a conservative, sober, well researched, analytical magazine. They are certainly not alarmist analysts predicting a financial Armageddon with the only safe haven being gold.

Note: In our last article on "Poor man's gold" we forgot to mention another excellent silver analyst in TedButler whose web site can be found at www.butlerresearch.com. Worth checking out.

David Chapman
March 8, 2004
email david@davidchapman.com
www.davidchapman.com

David Chapman is a director of the Millennium Bullion Fund.