Into the Abyss

Alf Field
8 Jan, 2008

Some years ago Gordon Brown, then UK Minister of Finance, was asked at a dinner party why he had allowed the UK to sell 60% of the country's gold reserves from 1999 to 2002. According to someone who was present, the reply was along the following lines: "We stared into the abyss and were concerned that a sharply rising gold price would alert the world to the crisis that the world was facing. That is why we sold our gold".

Whether this is fact, myth or urban legend is not important. What is fact is that a sharply rising gold price does alert people to a major crisis. With gold pushing to new all time highs above $850, we can conclude that the world is facing a crisis of major proportions and that we have been catapulted into the abyss that Gordon Brown feared.

The world is dealing with a Sub-Prime crisis, an Evaporation of Credit crisis, a Banking Solvency crisis, a US Dollar crisis and an International Monetary crisis. These roll into one to produce the "Mother of All Crises", the "Perfect Storm" crisis.

This crisis will not go away. It is destined to escalate. Investors and businessmen need to have a clear understanding of the constituent causes of this crisis and ensure that they develop strategies for the financial survival of their investments and businesses.

It is important to differentiate between the symptoms (which are the items that catch the media headlines) and the underlying disease that needs to be diagnosed and cured.

In this article four sections are covered:

1. THE SYMPTOMS
2. THE DISEASE
3. THE CURE
4. INVESTMENT STRATEGY

THE SYMPTOMS

These are some of the symptoms. The list is not exhaustive but it is not necessary to delve too deeply as the various symptoms are well covered by the news media.

1. Sub-prime problems: The sub-prime problems in the USA, Europe and elsewhere stem from excessive liquidity creation; leading to demand for investment vehicles exceeding supply; leading to creation of new, esoteric products and fraudulent acquisition of business. Losses from the sub-prime area started a chain reaction.

2. Credit Default Swaps (Stop Loss Insurance on credit/financial instruments): CDSs have grown from $10 Trillion to $46 Trillion (notional value) in the 2 years to June 2007, having mushroomed from $22 Trillion in December 2006, a gain of $24 Trillion in just 6 months. Purveyors and acquirers of suspect AAA paper were attempting to cover their backs by purchasing loss insurance. Major losses will emerge from the CDS area, related to both direct losses and losses occurring as counter-parties in derivative transactions fail to meet their obligations.

3. Government Sponsored Enterprises (GSEs) such as Fannie Mae and Freddie Mac face potential bankruptcy as they carry over $4 Trillion of Credit Default derivatives on their books with a capital base of only 1.5% of the liability. The GSE capital base is being eroded by mortgage losses that are escalating daily.

4. The Commercial Paper market has dried up. Banks face solvency problems as their capital and reserves are reduced by losses and they attempt to fund ongoing activities.

5. FASB 157 accounting standards regulation: This came into force on 15 November 2007 and requires financial institutions to disclose their assets as either Level 1 (valuations determined conclusively from quoted market prices); Level 2 (valuations determined indirectly from market prices or other verifiable sources); Level 3 (valuations basically thumb sucks by the banks ­ with no verifiable methodology to substantiate the valuations).

6. The importance of these new accounting standards is that auditors will have to certify whether assets are Level 1, 2 or 3. This puts an onerous obligation on the auditors who must be aware that they may be sued by shareholders if assets are incorrectly categorised. The shadow of Enron looms large. From the end of December 2007, bank and financial company reports will carry this designation of assets. Level 3 assets will be highly suspect.

7. If a bank reveals $150 Billion in Level 3 assets after already writing off, say, $10 billion in sub-prime losses, there will be an expectation that a large portion of the $150 billion will also end up as losses. If the bank's capital and reserves amount to say $30 billion, the situation becomes perilous for the bank's solvency. Banks may be relying on Credit Default Swaps to cover losses in Level 3 assets but it is becoming increasingly unlikely that insurers will be able to meet their CDS obligations in full, if at all.

8. Derivative contracts outstanding world-wide recently exceeded $600 Trillion in notional value. Interest Rate Swaps account for the largest proportion of outstanding derivative instruments, approaching $500 Trillion in notional value. Counter party failure is a major risk in this area. Counter parties who fail for other reasons (e.g. sub-prime or credit default problems) may bring down this shaky house of cards.

Governments and central bankers will not stand by idly while the financial markets burn. Interest rates will be rapidly reduced and any major institution that threatens to collapse the financial system will be bailed out. It is unthinkable that Fannie Mae and Freddie Mac will be allowed to go under. Nor will any major bank be allowed to go belly-up. There is discussion about nationalising Northern Rock in the UK, thus shifting the burden directly onto the tax payers.

Governments have the ability to create as much new liquidity as is required to avoid a systemic melt-down and they will use this ability to attempt to avert, or at best, delay or ameliorate the major systemic crisis that the world is facing. The outlook is for a flood of new world wide money creation as far as the eye can see.

THE DISEASE

The disease stems from a malfunctioning and dysfunctional international monetary system in which governments can create new local money at will without restriction. This has been the case since 1971 when the Bretton Woods system collapsed and all currencies floated against one another. August 1971 was when President Nixon decreed that the USA would cease exchanging gold at $35 per ounce for gold tendered by foreign central banks.

Since 1971 the world has embarked upon a binge of undisciplined credit and debt creation. It is the first time that this has happened on a world-wide scale and the unpalatable consequences of this orgy are revealed in the symptoms section above.

It is a boring subject, but it is worth spending some time trying to understand the sequence of events that has brought the world to this massive crisis.

Once gold was removed as the disciplining factor in the monetary system, a new reserve asset had to emerge. The US Dollar, presumably because of the size of the US economy, became the de facto international reserve asset. What evolved became known as the US Dollar Standard.

The principal flaw in the US Dollar Standard is that it has no mechanism to prevent or correct large and persistent trade imbalances between countries. Consequently, the deterioration in the US current account deficit has gone unchecked. It recently reached the level of $2 Billion per day. This excess of imports over exports is settled by exporting newly created US Dollars.

When foreign companies sell goods in the USA they take their dollar earnings home. When these proceeds are converted into their own currencies it puts upward pressure on those currencies. The central banks of those countries intervene to prevent their currencies from appreciating so as to preserve their trade advantage. They intervene by creating local money and using this to buy the dollars entering their countries. In this way, the exporters are able to keep their export earnings in their domestic currency while the central banks accumulate large foreign exchange reserves.

Countries with trade surpluses with the USA experienced economic bubbles, Japan in the 1980s, the Asian countries in the 1990s, and China today. As the central banks of the United States' trading partners reinvested their dollar surpluses back into US dollar assets, the USA itself (aided and abetted by lax credit and monetary conditions in the USA), experienced a series of bubbles, such as the stock market bubble in 1999/2000 and the real estate bubble from 2002/2005.

The US current account deficit has destabilized the global economy. It has also brought the US Dollar to the point where other countries recognise that the US Dollar is grossly over-valued and that the US Dollar Standard as the basis of the international monetary system has passed its "Use By" date.

Before the breakdown of the Bretton Woods international monetary system, international trade balanced. Under the Gold Standard, or the quasi gold standard Bretton Woods system, large and persistent trade deficits could not be sustained. The US would have had to pay for its deficits out of its limited supply of gold reserves.

The willingness of the USA's trading partners to accept payment in dollars instead of gold meant there was effectively no limit to how large the US trade deficits could become. This vendor financing arrangement allowed much more rapid economic growth around the world than would have been possible otherwise. The greater the US current account deficit became, the more the US trading partners benefited.

The magic of the Fractional Reserve Banking System and the fertile imagination of hedge funds, investment bankers and other speculators in creating new derivative investment products with levels of leverage unimaginable even a decade ago, have created a most unstable world-wide financial and economic structure that is in the process of collapse.

The disease can be diagnosed as unsound money, plus an unsound international monetary system, combined with undisciplined politicians and central bankers who have spawned a system that is awash with vast quantities of newly created liquidity and lax morals.

THE CURE

The cure must be the creation of a new international monetary system based on the principles of sound money. Sound money requires the removal of the ability of politicians and central bankers to create new money at will.

This is obviously easier said than done.

It is unthinkable that politicians and central bankers will give up their existing sovereign situations without a major fight. That unfortunately means that the world's economic and financial condition must deteriorate to such dire depths that a point will eventually be reached where a consensus will emerge that something radical must be done about it. One shudders at the thought of the awful economic, financial and social consequences that must occur in order to reach that stage.

Only then will the causes of the problem be assessed objectively.

Once such a consensus is reached and it is finally accepted that monetary discipline must return, then an international gathering of experts might have a chance of thrashing out a new monetary system based on the principles of sound money. What seems likely is that a new world-wide currency will have to be created, a currency that all nations will use. It must be a currency that cannot be created at will by anyone. It will have to be managed and policed by a totally independent and international body. It will also have to be based on something of real value and be freely exchangeable.

It is futile for over 150 countries to each have their own local currency. Globalisation suggests that a single currency used world-wide is now possible. The template is the Euro which replaced a whole raft of different European currencies. Be prepared for the eventual arrival of the "GLOBAL".

INVESTMENT STRATEGY

How does one plan an investment strategy for such an awful outcome?

The first thing is to accept that this is a real crisis of truly major proportions that will require past investment yardsticks to be jettisoned. For example, the present unit of measurement, the US Dollar, will become increasingly less suitable for performing that function as the new money creation and bail-out bandwagon gathers momentum. It is possible that gold may become the de facto new unit of measurement.

In the investment and business areas, anyone who is not aware of the causes and consequences of this major crisis is likely to be crushed by it. It is the single most important investment issue at this time and it transcends all other considerations.

It seems unlikely that the world will enjoy a miracle and be able to avoid the crisis by virtue of some special person appearing on the world stage with the ability to solve the problem. It is more likely that each country will do whatever is perceived to be in its own best interests, and will do whatever is required to prevent a financial or economic collapse in their own countries.

Historically this type of situation has resulted in politicians and central banker's throwing newly created money at the problem areas. There is little reason to think that the current crisis will be any different, except that the quantities of new money that will need to be created to attempt to bail-out all problem situations as they occur will be so huge that people will finally realise that the money has become valueless.

The odds strongly suggest that the world is facing the largest ever transfer of wealth from financial (paper) assets to tangible assets, otherwise known as "store of value" assets. This is the most likely strategy that investors will adopt to cushion themselves in the attempt to survive the disaster that seems certain to lie dead ahead.

Each person will have a different view of what constitutes a suitable tangible "store of value" asset. Different assets will have different propensities for the protection of real wealth, which is why gold may emerge as the de facto unit of measurement.

For example, a blue chip centre city property may cost $850 million today, which means that it has the same value as 1.0 million ounces of gold at the current gold price of around $850. The test of how well that property protects real wealth is whether it can be sold some time in the future for more or less than the equivalent of 1.0m ounces of gold at that time.

In previous articles ("The Seven Ds of the Developing Disaster" and "Gear Today, Gone Tomorrow") mention was made of John Exter's inverted asset pyramid.

Imagine an inverted pyramid consisting of layers of various investment asset classes where the least secure (and most prolific assets) are in the very wide top layers. The inverted pyramid then narrows down through layers of increasingly more secure assets to the small point at the base which consists of the most secure (and least prolific) assets. The theory is that in times of financial crisis investors will cause their investments to devolve downwards through the different asset layers in the inverted pyramid as they search for greater security. This move to assets representing greater security is already happening in the current crisis.

The asset in the most secure category at the tip of the inverted pyramid is gold. Platinum and silver bullion lie directly above gold. Precious metals have performed the function of protecting wealth throughout the ages. In the layer above the precious metals are base metals, uranium and the minor metals. Above them are the companies that mine and hold large deposits of metals. The least secure assets in the envisioned environment, which form the broad layers at the top of the inverted investment pyramid, will be financial and paper money assets.

5 Jan, 2008
Alf Field

321gold Ltd