Browsing the archives for the Balance Sheet tag.

Demystifying The Price of Gold

Economic Reality, Financial Crisis

Putting long-term savings into GICs is turning out to be riskier than investing in hard asset such as precious metals, land, or other commodities such as oil, copper, etc.

The World Gold Council just published a historical view of central bank “balance sheets” since the 2007 crisis: (click on the chart if you need to make it larger)

A central bank’s “balance sheet’ is a relative measure of money supply.  Although there are more exact measures of money supply, when you see a central bank’s “balance sheet” tripling in the case of the USA, or quadrupling in the case of the UK, it really doesn’t matter which one you use and this one is good enough to understand the price of gold.

The buying power of money over time reflects the forces of supply & demand in an economy.  Basically you have money supply on the one side and economic demand for money on the other (i.e. the size of the economy).  If these are not in balance, then inflation or deflation will occur.

  • Suppose a country has $1 T dollars and an economy measured using a hard asset (like gold) worth $1 T dollars.
  • If the economy grows, as it has since 2007, by roughly 2% compounded per year, it will have grown 10.4% after 5 years – i.e. to $1.1 Trillion.
  • If money supply had stayed constant, each 2007 dollar would be able to buy 10% more in 2012 than it did in 2007 since there is more economic value for the same amount of dollars.
  • But if the money supply tripled over the same time period, as it did in the USA, there would be $3 T dollars to balance that $1.1T in economic activity.
  • So each 2012 dollar is actually worth 1/3 x 1.1 = $0.37 compared to its buying power in 2007.

Can that be true?

  • Consider that the price of gold on Jan 2, 2007 was $639.75 in USD.
  • On Oct 18, 2012 it is $1752 in USD.
  • Deflating back to 2007 dollars, we get $1752 x 0.37 = $642.33!
  • Not quite spot on since we used an average of 2% for economic growth over 5 years instead of individual values.  But you can plainly see what has happened.

By inflating the money supply beyond the natural growth in the economy, the buying power of our long-term savings has dropped by 60%.  The reason why we haven’t seen prices radically increase depends on the type of good:

  • Any commodity which is consumed by economic activity (oil, copper, iron, etc.) will have its price primarily determined by the forces of supply and demand for that commodity (to establish a value) and secondarily by the buying power of money (to establish a price for that value).
  • As an example, we’ve seen a significant increase in the cost of oil & gas but this increase is also affected by global consumption of the fixed supply of oil.  Recently global consumption has been dampened by the global recession being experienced everywhere except Asia, causing a drag on what would otherwise be a soaring price.
  • A manufactured good contains both commodity and labour as inputs.  While the input commodity prices in a manufactured product like a refrigerator or car has increased, the labour cost has decreased since most manufacturing has moved to low cost labour centres such as China, Thailand, and Vietnam.
  • Cheap labour has acted as a brake on inflation in developed economies – effectively exporting the inflation problem to Asian economies.  As an example, the official inflation rate in China has been 2 – 4x the North American rate since 2007 and the actual rate is widely believed to be higher than the official numbers.
  • A precious metal such as gold, or a non-consumable good such as land, will act as a perfect reflector for the buying power of money.  For example, although the value of land in the USA was artificially depressed by the explosion of the housing market bubble in 2007, the price of housing in economies unaffected by that crash, such as Canada, has soared.
  • Much of this increase is not due to another bubble forming, but due to the decline in the buying power of the dollar.  In other words, the house is still worth what it was in 2007, it just takes more 2012 dollars to buy it since a 2012 dollar buys less than a 2007 dollar.

So if you think that the banking crisis is over in Europe and that the USA can afford its ridiculous debt levels without either raising taxes or cutting military spending, then go ahead and invest your hard-earned savings in GICs.

Or you can invest some of your savings in gold as a safe hedge against further erosion of your buying power in future.

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Bank of Montreal Credit Rating Slips

Financial Crisis

Credit Downgrade

Moody’s announced that they were reviewing the BoM’s credit rating in anticipation of downgrading it this week.  They are concerned over the health of BoM’s US-based Harris banking unit but otherwise do not appear to be concerned over the BoM’s asset quality.

That is not a view shared by the DBRS rating agency whose most recent credit ratingreport indicates that they are very concerned over the BoM’s continuing exposure to $6 B in loans to prop-up off-balance sheet Structured Investment Vehicles.

In fact the DBRS report bluntly states that they rate the BOM’s debt as high as AA(low) only because they believe that the Canadian government will offer “systematic and timely external support” to BoM.

Other analysts are also concerned over the continuing SIV exposure.  This is due to the  fact that:

  • the market value of these derivatives is significantly less than the bailout loans provided by BoM and
  • the BoM continues to publicly deny that they have a problem here.

SIV Exposure

So how much of a problem does the BoM have with SIVs?  It’s on the same scale as the Israeli problem with Iran’s nuclear program.

According to the BOM’s published Q3 Supplementary Financial Information, the total Regulatory Capital of the bank is $24 B.  That’s the amount of real investor capital put into the BoM.  As previously described in earlier posts, banks inflate this asset by also counting the loans that they have made as “assets” since those loans generate interest revenue.

The total BoM’s “asset” base of $334 B includes $65 B of derivatives of which $49 B are securitized assets.  According to the Q3 Supplementary Report, 90% of the $49 B is impaired and a full $37 B is rated as having a high risk of default ( Risk weight >7%).

Prudently the BoM has reserved $735 M of capital against this risk, however, that provision will be about as effective as a fart in a thunderstorm should these derivatives prove worthless.

Given the recent signs of economic recovery, it is likely that not all of the $37 B will tank.  A risk weight of >7% means that roughly 1/2 of these loans will likely default in 5 years (1.07^6 = 1.50).  Many analysts believe that the $6 B in SIV loans made to support Link SIV and Parkland SIV are at greatest risk however.

To put the danger posed by $6 B in bad loans in perspective, the BoM’s entire quarterly revenue in Q3 was $3 B and its net income is currently approximately $1 B / quarter.

Hence, a $6 B default can cause a life-threatening liquidity crisis that would require a government bailout to prevent outright bank failure.

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Bailout Madness

Financial Crisis

According to the New York Times, the US government has committed $3.1 trillion as an insurer, $3.0 trillion as an investor, and $1.7 trillion as a lender.

However, the Times omits roughly $5 trillion in guarantees made by Fannie Mae and Freddie Mac that are now officially on the government balance sheet.  The total of commiitted bailout funds (without any auto industry funding) is now at $12.8 Trillion.

US GDP is about $14 trillion per year; the budget deficit in recent years has been running in the half-trillion range.  So that means that the total government spending is roughly 13.3 / 14 T = 95% of the entire US GDP!

The US government is betting that actual spending will be less – provided that that banks can repay some of these loan guarantees and preferred securities.  But with dominos now falling across the US auto and other manufacturing sectors, and with the housing and construction sector in the toilet, it is not hard to imagine a second phase to the banking crisis that serioiusly impairs these repayments.

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