United
States currency notes carry the motto "In God We
Trust". Well, not anymore, we don't. Put a letter
"l" into the second word and you just may have a
winner.
With the global financial system
basically dysfunctional, the issue for
hard-working Asians is where to put their money. I
would suggest looking at physical commodities such
as gold and oil, if only the prices hadn't already
jumped. The price of gold surged
above
US$700 an ounce on Thursday to its highest level
since May 2006.
How the system
works In a previous article, [1] I
explained how banks typically function as
intermediaries for risk and liquidity across the
system. Over the past few weeks, though, banks
have come up against a wall of their own making,
namely the failure to trust one another in terms
of overnight lending.
Typically, central
banks set a target rate, which is observed by
banks lending to one another in the overnight
window to balance total cash in the system. In
proportion to their deposits, banks must hold
reserves with the central bank, on which a
specific deposit rate - usually 100 basis points
below the target borrowing rate - is paid. When a
bank runs short of such a cash amount, it has to
borrow from another bank to maintain the level of
reserve; such borrowing is priced at the target
rate. Failure to source enough borrowing from
another bank would push the cash-short bank to
borrow from the central bank itself, at a penal
rate that is usually set 100 basis points above
the target rate. This is called the
discount-window rate.
The interbank market
is a different kettle of fish, as this is where
banks borrow from one another for all other
purposes, including funding their overseas assets
(for example, European banks buying
US-dollar-denominated assets will need to borrow
US dollars from one another). Rates at which banks
will borrow from one another determine the London
Inter Bank Offered Rate (LIBOR), which is set
daily in London based on a poll of 16 prime banks.
The theory is that borrowing rates should not
exceed the penal rate mentioned above (ie, target
plus 100 basis points usually) because then banks
could simply approach the central bank for funds.
In the staid world of banking, though,
this borrowing from a central bank therefore
carries a stigma, ie, that the bank is not trusted
by other banks and therefore needs to approach the
central bank for money. Hence many banks would
rather pay over the penal rate in the interbank
market than risk their reputation by approaching
the central bank.
Of course, it is not
just banks that individual depositors can go to.
In many cases, they go to money-market funds,
which offer higher deposit rates than banks do,
and typically provide a form of principal
protection in excess of the cap that is in place
for deposit insurance in many countries. This
normally attracts wealthy people and companies
with excess funds on their balance sheets for any
operational reason. Such money-market funds
typically buy commercial paper.
Commercial
paper (CP) is a slight variation on the theme of
interbank borrowing. The idea is to expand the
pool of potential borrowers in the market, and
this is achieved by issuing short-term notes that
are typically of high quality. With a CP program
in place, borrowers can access the funding market
that will tap both banks and money-market funds.
Asset backed commercial paper (ABCP) refers to CP
programs where some form of collateral, usually of
very high quality, is used to underpin the quality
of the program and thereby provide increased
safety for anyone buying notes issued by the
entity. Typically, ABCPs are used by financial
entities to arbitrage between short-term borrowing
rates and longer-term yields available on such
securities.
Now that we are this far into
the alphabet soup, I might as well add structured
investment vehicles (SIVs) to the mix. These are
specialized financial entities that invest in
higher-risk (but still highly rated) assets, such
as derivatives issued on financial assets such as
mortgages and credit-card debt outstanding. These
securities have a lot of mind-numbing
abbreviations such as RMBS, CMBS, ABS and CDOs,
but in effect, all point to the same thing: a
financial derivative on relatively illiquid
underlying assets.
How it broke
down In the past few weeks, as European
banks started disclosing the level of their
potential losses from buying US subprime assets,
two things broke down. First, the various
money-market funds started facing redemptions once
it turned out they too had exposure to derivatives
written on US subprime assets. They then had to
stop purchasing ABCP and CP in the market, putting
the onus on banks to carry the entire burden.
Banks, of course, were the main sponsors
of SIVs, although some of the largest ones facing
the biggest issues now are actually run by
non-bank financial entities such as brokers and
hedge funds. In any event, once the SIVs could no
longer fund themselves in the CP market, their
game was up - their assets were illiquid because
of the current level of losses in the underlying
securities (borrowers defaulting on their
obligations much more frequently than was
initially assumed, which helps to drive the price
of derivatives down a whole lot faster).
This meant that many bank-sponsored SIVs
had to be absorbed by their sponsors, which in
turn caused the banks to record both investment
losses and stretch their capital. Under the rules
of global banking, having assets ranging from
loans to derivatives attracts various degrees of
capital requirement to ensure that banks have
enough of their own equity at stake in investments
rather than only risking the money from depositors
or other banks that help to fund their own book.
When risky assets are purchased wholesale, no one
knows for sure how valuable these assets are and
therefore how much loss the banks have to take.
In this environment, banks stopped
trusting one another. LIBOR has jumped well past
the circuit-breakers such as penal overnight
borrowing that exist, because of this lack of
trust. Even as the US Federal Reserve cut its
discount rate to just 50 basis points over the
target rate, banks found it difficult to convince
one another of their stability and solvency.
That lack of confidence among banks has
put paid to any central-bank efforts to hike
rates, as required by looking at rising global
economic growth and inflationary pressures.
Instead, the Federal Reserve has signaled a
willingness to cut rates this month, and the
European Central Bank, which pre-announced a hike
for September just last month, had to backtrack
hastily this week and keep rates on hold. Even all
of that flip-flopping has not helped in the
interbank market, because LIBOR remains stubbornly
high.
What to do When trust
breaks down across banks, investors have no option
but to walk away from financial assets. This has
already happened, as gold prices surged above $700
an ounce, and oil prices hit a new high for the
year (US$77 a barrel). The preference for
commodities is bothersome for central banks, as
high input prices make the task of cutting
interest rates (as demanded by banks) less
defensible.
More important, central banks
in the US and Europe have lost credibility with
investors. They are no longer trying to prevent
inflation, but appear more concerned with
preserving the lot of bankers. This suggests
greater value destruction for global investors,
particularly for Asians investing in financial
assets in Europe and North America.
Neither the US dollar nor the euro has any
credibility in this situation, which means that
the average Asian saver has no option but to
purchase gold as a store of value. Even as US
dollar bills proudly carry the motto "In God We
Trust", I think it's time for Asians to put their
trust in gold instead.
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