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The lesson from silver and mortgages: Too many people looking for safety can be dangerous
05/13/2011 8:30 am EST
How is the recent crash in the price of silver like the crash in the mortgage market that almost took down the global financial system?
The two are of very different dimensions, certainly. The silver crash simply took silver from near $50 an ounce to $35 and set off a one-week selloff in the price of other commodities that roiled the U.S. stock market. The mortgage crisis took down Bear Stearns and Lehman Brothers—and almost got American International Group and Citigroup. It took massive intervention by the Federal Reserve and the world’s other central banks to keep financial markets operating at all and we’re all still paying the price of the Great Recession that followed.
But they have a curious and important similarity. Both involve an attempt to hedge away risk—that itself actually created exactly the kind of explosive financial downdraft that the hedging was intended to make impossible or at least unlikely.
The lesson here is that the flight to safety carried to enough of an extreme by enough investors can turn into its own financial bubble. Safety carried to excess is the exact antithesis of safety.
Let me explain what I mean and then suggest what this tells us about the future of the financial markets.
What made the mortgage crisis so devastating wasn’t the number of mortgages extended to people who finally wouldn’t be able to pay for the amount of house they had just bought (often in the hope that they wouldn’t have to worry about paying this mortgage because they would quickly sell that house for a profit.)
The mortgage crisis was so devastating because so many people who should have known better (and quite possibly did) believed that they could take on the risk in increasingly shaky mortgages because they had laid off that risk onto other parties. Buying subprime mortgage paper that paid more than Treasuries (or debt backed by mortgages taken out by borrowers with better credit ratings) was a reasonable and responsible thing to do, the buyers maintained, because the buyers could also buy a derivative that passed on the risk that these mortgages would go bad in unexpectedly large numbers to some other party.
And that party, of course, would have bought a derivative from someone else that laid off their risk.
The result of this search for higher returns and safety was a not terribly surprising increase in risky behavior. If Monday’s risky investment in subprime mortgage debt—hedged with derivatives—hadn’t blown up by Tuesday, on Tuesday someone would push the envelope just a little further and take on a little more risk and pile on just a little more insurance in the derivative markets. The impulse would have been rendered almost irresistible because by Tuesday enough investors would have piled into Monday’s trade to make it less profitable than it had been. On Tuesday the only way to get Monday’s profits was to do a riskier deal—with the risk laid off in the derivatives market.
All this came tumbling down—or more accurately, all this turned into an avalanche that grew in size and destructive power as it moved downhill—when it turned out that the risk in subprime mortgages hadn’t really been laid off. This was insurance that no on really had the capital to pay off on when things went sour. And once it became clear that even a few parties couldn’t pay off on claims against them, the price of every investment plunged. They were riskier than the buyers had assumed, buyers wanted to sell, sellers didn’t want to buy at previous theoretically risk-free prices, and the pyramid collapsed.
Are there similarities between the episode and the silver bust?
The original impulse for the silver boom was a search for safety. Investors fear, absolutely justifiably, that the future is one of a dollar that falls in value, of rising inflation that erodes the value of all paper assets, and in which relatively few assets reliably hold their value.
Gold, silver, platinum, and other precious metals made up the bulk of those reliable hedges against the risk of that future although as this effort to find safety went on the definition expanded to include assets such as copper.
Buying gold, silver, platinum, copper, etc. had another great attraction. If you bought one of these hedges, you really could leave the rest of your investment strategy intact. I know the numbers don’t really add up—you can’t protect 90% of your portfolio by being 10% in gold and silver, but buying these hard assets was deeply reassuring to many ordinary individual investors. They had done something to respond to the risk.
Ordinary investors looking for a way to hedge risk weren’t the only ones attracted to these assets. Big traders weren’t especially attracted to these assets because they were worried about the effects of a falling dollar and rising inflation on the long-term value of their portfolios—their time horizon was much shorter than that.
But they were attracted to these assets by the way that the effort to find safety was pushing up the prices of these assets. Gold and silver kept climbing because the dollar kept falling. And looking at the trends for the dollar and inflation, it seemed like the search for safety would keep driving up the price of these assets for a long time to come. (This trend became even stronger as central banks around the world stepped up their buying of gold to diversify out of dollars.)
And with the “search for safety” trend so clearly established and, apparently, of such longevity, it struck more and more traders as safe to buy more and more of these assets on margin. As the price of silver, for example, soared so did the amount of silver that was bought on credit in one form or another. Although individual investors had a preference for owning the actual asset itself (or for investment vehicles that did), the traders preferred forms of silver where they could use borrowed money to leverage already leveraged instruments such as futures contracts.
The “search for safety” trend was assumed to be so strong that many traders were willing to take on more risk even as silver prices rose toward the $50 range that marked the historic high for the metal. Many were apparently quite happy to look past the risk that the market would stumble once or twice as it tried to punch through that barrier.
And they were clearly willing to overlook the risk that the growth in the use of leverage to buy silver even as the price climbed would stir the folks who ran the markets to clamp down on cheap margin money. That is what ultimately crashed the price of silver as the CME Group raised the margin requirements, the amount of cash a trader needed to put up to buy a silver contract, again and again and again until enough traders pulled back that the price of silver and the action in the futures market declined.
What began in an utterly reasonable effort to find safety wound up encouraging risky behavior. Not in a volume that threatened global financial markets but certainly enough to shake commodity and stock prices for a week.
I think this is a pattern for our time. The world is awash in cash looking for a home. The sources of that cash? All the fiscal stimulus put into the global money supply to stave off a chance that recession would turn into depression. The near 0% interest rates in Japan and the United States that makes borrowing yen or dollars to buy other assets so easy (and lucrative). The huge global imbalances as oil producers continue to accumulate cash and as China builds up an ever-larger trade surplus.
That cash is confronted by a world where returns in safe investments are extremely low. In many cases once you subtract the effects of inflation, the returns are negative.
And so this cash is always on the hunt for a safe investment with a higher potential return.
When it discovers one of these, the money piles in. What was perhaps a decent opportunity when first discovered becomes a crowded market with participants wiling to push the frontiers of risk in order to get a return like the early entrants received. As the crowd grows, first the higher returns vanish and then the safety that was the original attraction to this market or asset class diminishes as well.
Finally, there’s a rush for the exits as market participants re-assess risk. These markets then become like the restaurant that Yogi Berra once described: “It’s too crowded. Nobody goes there any more.”
If I’m right and this pattern is embedded in the economic and financial systems of our times, then it’s logical to ask where it will crop up next. My candidate is somewhere in the bond world and my preferred asset in that world is U.S. Treasuries. Right now investors in and outside the United States are so interested in safety that they are lining up to buy Treasuries. The Treasury market is so liquid (making it easy to get in and out with big sums) and so transparent that is attracting tens of billions of dollars from investors who want that kind of safety.
The volume of buying has driven yields low and sent prices high. In the short-run the latter reinforces the perception of the safety of Treasuries.
But to think of U.S. Treasuries as safe, you have to be willing to look past such issues as the huge U.S. budget deficit, fiscal dysfunction in Washington, and the prospects for a falling dollar.
At some point, Treasury yields are so low, or U.S. fiscal problems so large that they become impossible to look past and the tide reverses. Or the Federal Reserve finally starts raising interest rates, bond prices fall, and bondholders reassess the risk of this market. Or perceived risk in other markets, such as the euro market, falls and investors decide they have a more attractive alternative.
My schedule for this reassessment is sometime in 2012.
Does the reversal of the flows into Treasury’s take down global financial markets? I don’t think so. Does it cause a pyramid of bankruptcies? I don’t think so. Does it radically reshape the global economic and financial landscape? Absolutely. It lowers economic growth in the United States and by raising interest rates make the U.S budget crisis that much bigger.
What the reversal of the flows into Treasuries doesn’t do, however, is end the pattern of great waves of global cash sloshing through the financial markets in search of higher safe yields. And then bidding the higher yields out of existence and turning the search for safety into new forms of market risk.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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