13 August 2008

Whats with Gold going down

With gold pushing down toward $800 an ounce, and perhaps only days from testing that level, a lot of the discussion can be found on the internet discussion groups that goes to the idea that there is some mysterious group of ultra-rich who manipulate the price of this thing, or that, in order to screw the vast majority of folks out of their retirements and small life savings. But, is this a credible view, or is there an alternative explanation; one that's every bit as real - and achieving the same thing, but more in keeping with the notion of a rational marketplace?

As luck would have it, a few weeks back a friend of mine for many years sent me a draft of his new book which is an insider's account of what is really going on in the market from the professional standpoint.

Now, when I say professional, I really mean it. Although I can't use his 'name, my friend Mr. X. actually invented some of the types of debt instruments that are in the process of either blowing or, or just being 'repriced', depending on how much you know. He was one of the players who brought PC's to Wall Street and used them early on to get a leg up on bond trading. And yes, he knows a lot of the players mentioned in "Liar's Poker". Most would know his name, too.

His book explains in great detail how things work in financial markets. I don't mean how things kinda work, I mean how things really work right down to which hedge fund managers hang out at which bars in Greenwich, which as it turns out, is more the center of the financial world lately because it's mostly from there that the US-run private fundsoperate without transparency from offshore places like the Cayman Islands.

We were talking this weekend about how low this commodity, or that, might go, and my friend was explained how the real world worked and I made some comment, which was interrupted with a stern admonition: "Will you stop thinking about fundamentals?" Not wanting to appear an idiot, I shut up and listened.


"There are two chapters in my book that explain exactly what's going on in the financial markets today and it has almost nothing to do with fundaments," he began. "You really need to read the two chapters called "The Great De-Levering" and "Invisible Leverage". You can even paraphrase some of it on your site, but I'm still looking for a literary agent for the book, so no exact quotes because I'm still working."

Fair enough.

Let me sketch out where we are at the moment. We're in a world awash with excessive leverage and the world has to "de-lever" in order to get things back in balance in the world of high finance. Think of it this way: When times are good, a high quality securitized bond can be had for as little as 2-cents on the dollar. That's 49 to 1 leverage. More typical was the slightly lower rated securitized assets where leverage was a more modest 19 to 1, but still, that means putting 5% in to control the position.

What is happening with The Great De-levering" underway is actually a double whammy. First, the value of the securitized assets is dropping, so instead of a tranche being valued at 100-cents on the dollar, it might drop to perhaps 92-cents on the dollar. And then, to make matters worse, the lenders were (and are) demanding the hedge funds have more 'skin in the game'.

So say you had a MBS (mortgage backed security) that was valued at $1.00 and held with 49 to 1 leverage. Your hedge fund puts up two-cents for each $1.00 controlled. Just add zero's to the concept and you're there.

Next, because of foreclosures and jitters, you get "the call" (a telephone call that's a margin call) from your banker who's been putting up the 98-cents as a loan. The call goes something like this:

"Hi, George? That $1.00 MBS is no longer going to be marked to model. Instead, we are marking to street price and that's now 87.5-cents. And, because capital is getting more dear, we're also going to increase your margin requirement to 5% from the current 2%."

Look at what this has done to my hedge fund P&L: I used to show $1.00 of assets on the strength of my MBS but since it has been repriced, This asset just dropped 12½%/ And now, to stay in the game, I will need to put up 5% of the 87.5-cent asset or 4.375-cents instead of the two-cents I had in earlier. My hedge fund sudden looks like a poor lending risk - and that would trigger more margin calls in itself. Yikes!

Now, you need to ask this simple question: "How many hedge funds can lose 12½% and more than double their actual cash in the game to hold that position? Answer: Effectively None.


Placed in this position, the hedge fund, which has been enjoying great profits from this trade before repricing, now finds that they are upset down, so the only way to get out of the trade is to sell the repriced assets into the market to liquidate the position, but that sale will happen at the new lower price. And then, if there's any kind of gap left, they will have to sell off other assets, too. Things become self-reinforcing on the downside.

You can see what happens now, right? One asset class going toes up means that assets that were maybe just fine (and fairly priced) have to be sold off to balance the books. And because that asset is sold at a discount (like gold contracts, or silver, just as a hypothetical) those prices begin to move down.

My friend's book explains how on March 16th of this year, one of the lenders, Bear Stearns, got into trouble because so many hedge funds were trying to get so many dollars out. Being crafty folks, some of the smart folks involved noticed the Bear was bleeding and decided to lay on some serious put options betting that Bear shares would go down.


Although there are lots of headlines around this morning asking "Who bought $1.7 million "Lottery Ticket" on Bear Streans collapse?" like it was some kind of 'inside" job, there were ots of people on the Street who sensed what was happening and could have placed off-setting bets. And this one happened to pay off - BIG. To the tune of $270-million.

The reason the bankers and government (Fed/Treasury) had to bail out Bear was that as one of the largest market makers of Credit Default Swaps (CDS) if Bear hadn't been saved with your $30-billion of taxpayer bailout, we would be in the midst of the Second Depression right now today. As it is, the slower unwinding may be a little more easy to deal with and it will keep at least most of the 'blood' off the hands of the oil party. We're years from this being over.


Most taxpayers aren't going to 'get it' and will be quick to adjudge that if someone who's smart can make a quick $270 million, how come we're getting stiffed for $30-billion? Ignorance has its price.

The really knowledgeable players already knew who the key fund lenders were - and because of Bear's key role, the funds were watching and knew when the withdraw money, so I'm not inclined to think criminal conspiracy so much as think it's a more or less natural outcome of "The Great De-Levering." Smart folks make money, dumb folks lose and sheep get sheared.


So how far is down? My friend, who's background in finance qualifies him to answer the question better than 99.9% experts, isn't sure. He's looking for it to continue on for probably a couple of more years and in that time, we'll go through episodes of relative quiet (like now) or we will hit another downdraft, by my reckoning perhaps this fall.

"We've got about $500-trillion in synthetics to de-lever, but some of that is double-counted, and some is counted four times, but it's still lot of money," he explains. "And the hedge funds only have about a trillion to play with. So you can see there's a lot of downside potential."

As good as my confidant is at running numbers out, there's no way to tell when it will all stop. But if you're looking for a wild-*ss guess, try this observation: "There are about 9,000 hedge funds out there right now. I wouldn't think the de-levering is over until maybe 6,000 of them have gone broke...and the 3,000 that remain will be a mix of winners and those barely hanging on..." That's only a guess. No one knows for sure.

What's going on right now in the markets - and it's spreading across all kinds of commodity markets and resulting in massive price deflation -- is also pushed along as the result of what my source calls "Invisible Leverage."

Here's why it's going on even as we speak. If I give you $200 to invest in stocks, and you put $100 on each of two stocks and one doubles, while the other falls to half its value, how does your return look?

The answer is the first $100 goes to $200, while the other goes down to $50, so at the end of the day, your stock picks are worth $250 - or a hefty 25% return, even if you get only 50% right. Sweet, huh?

Since stocks can make a great return with 50/50 odds on the upside, the hedge traders make their long side bets in the stocks, but because the odds of success run more like 25-1 against you on the long side of bonds, they make their bearish bets in bonds... they couldn't do this until the CDS (Credit Default Swap) market developed, which allowed traders to "go short" in the credit markets.

What was developed to be a hedging product turned out to have such a good risk/return profile for bears that we now have the weird situation where the short-side bets against some bonds can be 10 to 50 times the size of the bond issues themselves. It is the limited capital needed to enter the CDS that gives the market its "invisible leverage" -- the cash market is only allowing 1-1 or maybe 3-1 leverage (look at CDO sale to Lone Star with financing by Merrill), but CDS protection buyers (the bears) can still get 19-1 leverage . JP Morgan got a nice 29-1 leverage from the taxpayers on Bear Stearns' mortgage portfolio, but that's another story...


There's a lot of 'pile on' in play, too. The lemming-like behavior of the retail customers is apparently nothing when compared to the lock-step behavior of hedge funds. All it takes is a word here or there at those particular places in Greenwich, and 'poof!' A whole asset class gets whacked, and thanks to the circular nature of the game, everything else de-levers to some extent as margin calls come in for the players 'caught out'. A failure here, means pressure there, kind of thing.

You won't get to see all this working out in real-time, though, because the offshore funds don't have to report like the regulated players in the US, even though many of the plays are phoned in from Connecticut.


Right now, I'm trying to bottom fish a few $17.50 December commodity call options for my personal account. I think the predictive linguistics have laid out a pretty good scenario for what may happen, and if they're right, a quick flight to hard assets might come about before Thanksgiving due to Middle East events to come. But, if it doesn't, I wouldn't be surprised by that outcome, either. I think of it as a $1,500 scratch ticket.

As my friend's book points out, there's nothing wrong with leverage at modest levels, like the 20% down conventional loans to buy a home - that's still a great use of leverage. But 2% (and less) to control huge financial abstractions? That's coming to an end. Painfully.


What's hard for people to conceptualize is that a sell off of one commodity (or stock) generates margin calls in others, which in turn drives selling in non-related markets, and those in turn cascade in slow motion which might more properly be called a "Crashcade" although I haven't spied that term (or "Debtberg" in my friends book, yet.

But, before the Second Depression becomes apparent, I'm betting the Oil Party will start another international distraction going and we'll all be blaming some group in another country and getting all whipped up into a frenzy to carpet bomb there. Late October, maybe?

The distractions to come may serve to blame-shift, but I think you can see now that the "PowersThatBe" might readily be described as hedge fund managers reacting to market forces at work.

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