Tuesday, November 28, 2017

"Waiting for the Avalanche"

"The Fed's Built a Financial 'Maginot Line'"
by Jim Rickards

"Over the coming months, I believe we could see an economic meltdown at least six times the size of the 2007 subprime mortgage meltdown. That’s right: I believe we could see an economic meltdown at least six times the size of the 2007 subprime mortgage meltdown Circumstances lead me to believe it could play out like the meltdown I experienced in 1998 after Long Term Capital Management (LTCM) failed. This time, however, there will be several crucial differences that will leave investors and regulators unprepared.

In the national defense community, military commanders are known for fighting the last war. They study their prior failures in preparation for the next conflict. The problem is that each war inevitably involves new tactics for which they’re completely unprepared. The most famous case was the backward-looking Maginot Line in the 1930s. In response to Germany’s rapid advances in WWI, France built a line of concrete and steel fortifications and obstacles on their border to buy time to mobilize if Germany tried to invade again. Hitler made the Maginot Line irrelevant by outflanking it and invading France through neutral Belgium. The French were unprepared. A few weeks later, German forces occupied Paris.

The same mistake is made in financial circles. Financial regulators are no different than military commanders. They fight the last war. The last two global meltdowns, in 1998 and 2008, are cases in point. In 1998, a financial panic almost destroyed global capital markets. It started in Thailand in June 1997 and then spread to Indonesia and Korea. By the summer of 1998, Russia had defaulted on its debt and its currency collapsed. The resulting liquidity crisis caused massive losses at hedge fund Long Term Capital Management.

I know about the losses because I was there. As LTCM’s lead counsel, I was at every executive committee meeting during the height of the crisis that August and September. We were losing hundreds of millions of dollars per day. Total losses over the two-month span were almost $4 billion.

But that wasn’t the most dangerous part. Our losses were trivial compared with to the $1 trillion of derivatives trades (2017 estimates of global derivatives range from $1.5 to 2.5 QUADRILLION- CP) we had on our books with the biggest Wall Street banks. If LTCM failed, those trillion dollars of trades would not have paid off and the Wall Street banks would have fallen like dominoes. Global markets would have completely collapsed.

I negotiated a bailout with the leaders of the 14 biggest banks including Goldman Sachs, JPMorgan and Citibank. Eventually, we got $4 billion of new capital from Wall Street, the Federal Reserve cut interest rates and the situation stabilized. But it was a close call, something no one ever wanted to repeat.

It was a valuable lesson for me, because soon after, regulators set out to make hedge fund lending safer. Regulators believed this would prevent the next crisis. When the panic of 2008 hit, however, they were surprised that problems were not in hedge funds but in something new - subprime mortgages. The mortgage market collapse quickly spun out of control and once again brought global capital markets to the brink of collapse.

After the 2008 debacle, regulators again set out to fight the last war. They made mortgage lending much safer with a number of regulations. But once again, regulators today are fixing the last problem and totally ignoring the next one.

The next financial collapse will not come from hedge funds or home mortgages but from somewhere they’re not looking. And I believe it’ll be here soon...

In my latest book, "The Road to Ruin", I use 2018 as a target date primarily because the two prior systemic crises, 1998 and 2008, were 10 years apart. I extended the timeline 10 years into the future from the 2008 crisis to maintain the 10-year tempo, and this is how I arrived at 2018. Only this time the Fed will have much less ability to respond to this crisis the way it has before. It’s mostly out of “dry powder.”

I spoke to a member of the Board of Governors of the Federal Reserve a couple of years ago and said, "I think the Fed is insolvent." This governor first resisted and said, "No, we're not." But I pressed her a little bit harder and she said, "Well, maybe." And then I just looked at her and she said, "Well, we are, but it doesn't matter." In other words, here's a governor of the Federal Reserve admitting to me, privately, that the Federal Reserve is insolvent, but that it doesn't matter.

It doesn’t matter? Really? When the next crisis hits, the Fed will soon realize that it does matter. A lot. Below, I show you three “snowflakes” that could trigger the next financial avalanche. Each one is a realistic possibility. Read on."
"Waiting for the Avalanche"
By Jim Rickards

"I’ve often compared the causes of financial crises to snowflakes that can trigger an avalanche. A massive amount of snow can accumulate before that one final snowflake comes along to start the chain reaction. The climbers and skiers at risk can never know when an avalanche will start or which snowflake will cause it. But it helps to know what to look for. Let’s look at three of the most likely snowflakes that could trigger the next financial crisis, all of which are likely in my view. These are by no means farfetched.

Snowflake #1: Credit Crisis in China: China, believe it or not, is in more of a credit bubble than the United States. The United States has got lots and lots of problems. But China is actually much worse -and they don’t have as much experience with this type of credit bubble. I believe they’re naïve about how bad this can get. They’re over relying on the ability of Communist Party officials to keep a lid on it. I was out in the countryside south of Nanjing not too long ago, visiting some of China’s famous ghost cities.

I was with some Communist Party officials and provincial officials who were behind it all. Everything I saw, construction as far as the eye can see, magnificent in scope, was all empty. I’ve seen it firsthand. I turned to one of these officials and said, “This is all debt finance. This is all empty, so you have no revenue to pay the debt. So how are you gonna pay the debt?” And he said, “Oh, we can’t. But Beijing’s going to bail us out.” Not we hope Beijing will bail us out - but Beijing will bail us out.

That isn’t an isolated viewpoint. It’s widespread. But Beijing has its own problems. Whether it’s wealth management products, shadow banking, real estate finance, crony capitalism of the worst kind, flight capital, oligarchs taking all they can and then funneling it out to Vancouver and Australia and Park Avenue, etc., the problems can no longer be papered over. This has all been happening on a massive scale. It’s going to collapse. But China doesn’t really know how to deal with it.

Snowflake #2: Failure to deliver gold: This is almost definitely coming. So much of the gold market is “paper gold.” This paper gold market is so manipulated, we no longer have to speculate about it. It’s very well documented. But it all rests on a tiny base of physical gold. I describe the market as an inverted period with a little bit of gold at the bottom and a big inverted pyramid of paper gold resting on top.

The [available amount of] physical gold is getting smaller, which surprises many people. The might say, “Gee, there’s 2,000 tons of mining output per year, and the gold that exists doesn’t go anywhere, so why isn’t that little brick getting bigger instead of smaller?”

And the answer is you have to distinguish between the total supply and the “floating supply.” The total supply gets bigger every year by about 2,000 tons. People don’t throw gold to the bottom of the sea. They don’t blow it up with explosives. They hoard it. And so all that gold’s still around, and new gold keeps coming into the system.

Yes, the total supply grows every year, and when they move gold bars from a warehouse in London to the Chinese warehouse in Shanghai, the impact on the total supply is zero. But the floating supply shrinks. Now, what do I mean by the floating supply? The floating supply is the physical gold that is available to back paper transactions.

When you take gold from a London warehouse and put it in Shanghai, for example, there’s no impact on the total supply. But you have shrunk the floating supply. I’ve seen this firsthand. I was in Switzerland not long ago, and I met with one of the big four “secure logistics” firms in the world. These are the people that handle the actual physical metal. They’re building vaults as fast as they can. They’ve been negotiating with the Swiss Army. Over the years, the army’s hollowed out some of these mountains in the Alps to build these extensive warehouses and storage facilities and tunnels that will withstand nuclear attack.

So these vault contractors have been in negotiation to lease the mountains - these nuclear bomb-proof mountains - from the army. My source told me, “We’re building vault space as fast as we can. But we’re running out of capacity.” I asked, “Where’s the gold coming from?” He said, “UBS and Deutsche Bank and Credit Suisse, and customers are taking it out of the banks and giving it to us.”

Now there’s another example where the total supply is unchanged, but the floating supply is reduced. These logistics firms keep the physical gold. Bullion banks like UBS, on the other hand, take physical gold and sell it 10 times over. That means there are ten claims for every ounce of physical gold.

So how does this end? Someday, probably sooner than later, somebody is going to show up and say, “I want my gold, please,” and the custodian won’t be able to give it to them. What if a major institution wants its gold but can’t get it? That would be a shock wave. It would set off panic buying in gold, and inflation expectations - now subdued - could spiral out of control.

Snowflake #3: A geopolitical shock: People yawn and say, “Gee, haven’t we had enough of those lately?” The stock market keeps on going higher, no what seems to happen in the world. But that’s only true - until it isn’t. The fact is, things could easily spin out of control. And then everyone will wonder how they missed it.

When a rogue North Korea builds a nuclear program capable of targeting the world’s sole superpower, that’s a snowflake. When China asserts territorial dominion over the South China Sea that pits it against key U.S. allies, that’s a snowflake. When Saudi Arabia is roiled by internal strife and seems on a collision course with Iran throughout the entire Middle East, that’s a snowflake.

I make the point that a snowflake can cause an avalanche. But of course not every snowflake does. Most snowflakes fall harmlessly, except that they make the ultimate avalanche worse because they’re building up the snowpack. And when one of them hits the wrong way, it could spin out of control.

The way to think about it is that the triggering snowflake might not look much different from the harmless snowflake that preceded it. It’s just that it hit the system at the wrong time, at the wrong place.

To switch metaphors, it’s like the straw that breaks the camel’s back. You can’t tell in advance which straw will trigger the collapse. It only becomes obvious afterwards. But that doesn’t mean you can’t have a good idea when the threat can no longer be ignored. The system is getting more and more unstable, and it might not take that much to trigger the avalanche.

These are the three snowflakes to watch for: Chinese credit collapse, failure to deliver gold, and the geopolitical shock. And any one of them could start this cascade that I’ve described. I should add the Federal Reserve. It’s now attempting something it’s never tried before: to raise interest rates while reducing its balance sheet at the same time. Why should anyone believe it’ll be able to thread that needle? One false step could trigger an event. To top it all off, we’ll have a new Fed chairman in just over two months, Jerome Powell. We’ll have to see if he’s up for the job.

My advice is to prepare now for the avalanche, before it’s too late."

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