Hedging Risk with Gold

A little less than 12 months ago, the world’s biggest financial players suddenly found they could not turn some $1.3 trillion of their assets into cash.

These assets — bonds backed by U.S. homebuyers with low (or no) incomes — had become utterly illiquid. No one would buy or lend against them, not at any price. And an asset you can’t sell or borrow against is worth precisely nothing.

The resulting mayhem? It would have sounded frivolous two years ago. But the subprime crisis caused the first run on a British bank in 130 years, a forced collapse in U.S. interest rates, and the fire sale of Wall Street’s fifth largest investment bank for just 16 cents on the dollar.

“[Now] it seems that the financial system is slowly working its way through this subprime shock,” writes Gillian Tett in the Financial Times. “The largest banks and institutions have written off almost $200 billion and raised more than $100bn-odd of capital to plug this gap.

“Indeed, the write-downs have been so vast that some analysts expect to see some write ups in the next set of results.”

Crisis over? That key marker of investor anxiety, the gold price, fell 15 percent from its top of mid-March to the end of April. The preceding surge had taken gold bullion up from $650 per ounce in August to above $1,030 the day after Bear Stearns was sold to J.P. Morgan.

The proximate cause for gold’s jump — and then setback — was the Federal Reserve’s decision to slash U.S. interest rates. Gold turned sharply higher as the Fed began cutting rates in Aug. ‘07. It only flagged when Fed policy-makers implied a pause in their war against the Dollar (albeit it temporary) seven months later.

That’s why a significant portion of new gold investment since last summer has gone into physical metal — owned outright — rather than simply into paper promises or credit arrangements.

What makes physical bullion stand out for the growing number of private investors choosing outright ownership instead? Gold futures or options would, after all, give them leverage to the gold price, super-charging their gains if they call the short-term direction correctly.

Repeated studies also prove gold’s safe-haven appeal on the basis of its “non-correlation” with securitized assets, such as equities and bonds. Gold prices move independently of the broader financial markets — neither together, nor in opposition. This lack of correlation makes gold a crucial component of any diversified portfolio.

Owning the metal outright — whether as gold coins in your pocket or large bars held securely in market-approved storage — takes you “off risk” with regards to the solvency of banks and brokerages. And it leaves you holding a highly liquid physical asset that’s instantly valued just by checking the gold spot price online.

“While the subprime shock may be ebbing,” continues Gillian Tett in the Financial Times, “the problem is that…as the U.S. economy slows, there is a good chance defaults will soon emanate from the corporate and consumer debt world.

“And the more that banks are forced to tighten credit as a result of the subprime mess or other losses, the greater the risk that this second wave of defaults will emerge — creating the risk of a vicious spiral.”

The current lull in the gold price says fewer investors are worried today. But only this week, Moody’s Investors Service — one of the three credit-ratings agencies now blamed for letting investment banks issue toxic subprime bonds as “triple-A” bonds — warned of a sharp rise in U.S. corporate-bond failures. It sees the default rate on low-rated junk bonds quadrupling to four percent by the end of this year.

Wherever the subprime shock has hit hardest, municipal debt also looks weak. Council members in Vallejo, California voted on Tuesday to file for bankruptcy, thanks in no small part to “house prices in Vallejo and the surrounding area falling some 26 percent on a year ago,” reports The Independent here in London. “The city is expecting $1.6 million less in property sales taxes.”

And all this while — 12 months on from the first trouble at UBS and Bear Stearns — the final cost of the subprime shock itself is still pending. Chairman of the Federal Reserve, Ben Bernanke originally put a $100 billion forecast. The International Monetary Fund (IMF) has since set the ceiling at $945bn.

But there are hidden costs too, as Bloomberg reports this week. Now State Street, the world’s biggest institutional fund manager, faces more than $625 million in lawsuit damages, for instance, after being sued by four insurance companies for putting their cash into subprime bonds without their approval.

Let’s imagine all of your wealth is sitting safely outside the next subprime-style blow up. A loss of confidence in one sector can still become a system-wide crisis. And the failure of subprime bonds to pay up should have reminded us all that counterparty risk remains very real, no matter how clever derivatives salesmen become.

A growing number of private investors, in contrast, would rather hold at least some of their wealth in a liquid, tradable asset, entirely free from the risk of default. What price they pay should depend on what they think will happen to interest rates.

But the value of gold as a portfolio back-stop remains hard to beat, even 15 percent below the last all-time high of mid-March.

Regards,
Adrian Ash
BullionVault
May 13, 2008