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When the Search for Safety Backfires
05/13/2011 9:09 am EST
The recent crash in silver is only the latest proof that when too many nervous investors seek refuge in the same asset class, a dangerous bubble can result.
Let me ask you a riddle.
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 merely took silver from near $50 an ounce to $35 and set off a one-week sell-off in the price of other commodities that roiled the US stock market.
- The mortgage crisis took down Bear Stearns and Lehman Brothers—and almost got American International Group (AIG) and Citigroup (C). Only massive intervention by the Federal Reserve and the world's other central banks kept financial markets operating at all, and we're all still paying the price of the Great Recession that followed.
But the two crashes have a curious and important similarity. Each involved an attempt to hedge away risk—an attempt that actually created the kind of explosive financial downdraft that it was intending to make impossible, or at least unlikely.
The lesson here is that a 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.
Remembering the Mortgage Mess
What made the mortgage crisis so devastating was not the number of mortgages extended to people who ultimately 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, this time 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 they could take on the risk in increasingly shaky mortgages because they had passed 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 along the risk that these mortgages would go bad in unexpectedly large numbers to some other party.
And that other party, of course, would have chosen to pass off the risk, too, by buying a derivative from someone else.
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 passed 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 passed off. This was insurance that no one 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 where the dollar falls in value, rising inflation erodes the value of all paper assets, and 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. As this effort to find safety went on, the definition expanded to include assets such as copper.
NEXT: False Reassurance|pagebreak|
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 were, too. They 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. (Most of them look for strategies that will work for the next few weeks or months.)
But the big investors were attracted to these assets by the way the effort to find safety was pushing up prices.
Gold and silver kept climbing because the dollar kept falling. And looking at the trends for the dollar and inflation, it seemed that 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.)
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 soared, for example, 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 (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 growth in the use of leverage to buy silver 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, increasing the amount of cash a trader needed to put up to buy a silver contract, traders eventually pulled back, and the price of silver and the action in the futures market declined.
What began as 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.
NEXT: Living in a Low-Risk, Low-Return World|pagebreak|
Living in a Low-Risk, Low-Return World
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.
There are interest rates near 0% in Japan and the United States, which makes borrowing yen or dollars to buy other assets easy (and lucrative). There are 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.
Thus, this cash is always on the hunt for a safe investment with a higher potential return. When it discovers one of these, it piles in. What was perhaps a decent opportunity when first discovered becomes a crowded market with participants willing 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 reassess risk. These markets then become like the restaurant that Yogi Berra once described: "It's too crowded. Nobody goes there anymore."
A warning about US Treasuries
If I'm right, and this pattern is embedded in the economic and financial systems of our time, then it's logical to ask where it will crop up next. My candidate is somewhere in the bond world, and my suspected asset in that world is US Treasuries.
Right now, investors inside 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 it 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 US Treasuries as safe, you have to be willing to look past such issues as the huge US budget deficit, fiscal dysfunction in Washington, and the prospects for a falling dollar.
At some point, Treasury yields get so low, or US fiscal problems get 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 Treasuries 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, makes the US budget crisis that much bigger.
What the reversal of the flows into Treasuries doesn't do, however, is end the familiar pattern: Great waves of global cash slosh through the financial markets in search of higher safe yields, and then bid the higher yields out of existence and turn 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 column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.
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