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.
Can that be true?
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:
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.
Although economists were expecting a $23 billion inflow of capital due to foreign purchases of all US securities, recent Treasury International Capital data showed there was a net outflow of $31.2 billion.
This means that foreign investors are less willing to subsidize the US economy in general. An important subset of this total is the market for US Treasuries and T-Bills since the market for this debt sets the interest rate benchmark for all other debt.
China is the single largest foreign holder of US Treasury debt – to the tune of $776 Billion out of a total of $3.4 Trillion and China reduced this holding by approx $25 B from May to June 2009. Interestingly Russia, the 7th largest holder of US Treasuries, has also reduced its holdings by $20 B since March. Maybe the commies aren’t so dumb when it comes to economics after all.
As China’s appetite for U.S. Treasuries wanes the yield for U.S. Treasuries will have to go up. This will suck more money out of the economy just as the Fed is trying to pump it up to prevent further economic collapse. The other alternative is for the US to devalue its currency either overtly (not likely) or with the help of inflation (far more politically expedient).
This is bad news for the Canadian high tech and manfacturing sectors that depend heavily on a low Canadian dollar. A devaluation of the USD means a higher Cdn dollar and also the illusion of higher prices for oil, resources, and gold which are normally denomiated in USD.
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.
Originally published October 9, 2008 in Facebook.
The US subprime mortgage market was approximately $400 B. Nearly half of these loans were enhanced by so-called piggyback loans to help borrowers pay for the equity portion of the first mortgage. It was common for a first mortgage to cover 80% of home value (underwritten by Freddie Mac) and instead of the 20% buyer equity, the piggyback loan (usually from the same bank) would cover the difference – i.e. a second mortgage but with virtually no lien on the property.
Since the first morgage was secured by Feddie Mac, it was easy for the originating bank to sell it to other institutions, so the bank only needed to fund the piggyback portion of the loan. And since, those banks operated with 10x leverage ratios, they only had deposits & equity to cover 1/10 of those bad loans. 1/10 x 20% x $400 B = $8 B. Trouble indeed as the estimate for defaults on those mortgages has esclated from approx 20% to 40%.
The first mortgages in turn were purchased by large lenders who pooled loans of varioius quality which were sold to investment banks who in turn issued preference tranches on each pool. Top tranches would be paid out first, lower tranches would be paid out later, thereby artificially creating different instruments with different levels of credit grade. Since major banks operate with a leverage ratio of appoximately 6:1, the securitized MBS must have had a book value of approx 6 x $400 B x 80% = $2 Trillion.
At the start of the crisis in 2007 as defaults mounted on the mortgages, the market for the MBS securities started to dry up. As shown in the chart above the estimated total impact of impaired MBS securities is $160 B. The immediate problem facing banks was the rapid increase in their funding requirements when they could not securitise or otherwise distribute their loan warehouses. Banks began to hoard liquidity to meet actual and potential increases in these funding requirements, causing interbank rates to spike during August and September 2007.
Towards the end of 2007, banks began announcing substantial losses on their own holdings of structured credit products. That $2 Trillion of market value was starting to unwind. Current estimates (see below) show that the structured credit market losses are in the vacinity of $400 B (so far).
An element of counterparty credit risk began to influence interbank lending decisions. Some banks could not gain unsecured funding, amplifying their financing difficulties. As the end of the year approached, banks sought to increase their liquid asset positions, in part to strengthen the appearance of their reported balance sheets. This was a major contributing factor to the rise in London interbank offered rates (Libor) internationally in early December. This was alleviated to some extent by co-ordinated central bank action on 12 December 2007 causing money market conditions to improve during January 2008.
In February and March 2008, however, money markets tightened again as banks reported significant additional write-downs on ABS and the prospect of losses on exposures insured by monolines increased. Central banks provided a second round of co-ordinated liquidity provision on 11 March 2008.
However, by Aug/Sept 2008 not just the originating bad lenders have gone under, but also the major investment banks and large US lenders that created the MBS mess have failed (or been forced to merge). This has extended the counterparty risk substantially to international banks and the dominos continue to fall.
We are now seeing bank failures in UK, Germany, Holland, and Iceland. These will in turn extend the imprint of counterparty risk and cause even more bank hoarding. Banks hoard by declining to deal with other banks and by raising credit costs to businesses and consumers. The impact on business is growing with each passing week. Already 20% of all US car dealers are facing bankruptcy as they cannot finance their inventory due to tighter credit imposed by their banks and a drop-off in spending by consumers who can’t afford to pay the rising interest on their mortages.
Substantial interest rate cuts will be necessary to improve bank margins (making it easier for them to hoard cash) but don’t expect to see any of it in your personal credit card, car loans, or mortgages and certainly not in your business lines of credit, lease rates, etc.
Coupled with over $1 Trillion so far in bailouts in the USA and UK to guarantee the bad loans and ensure bank creditworthiness, we can expect serious degredation in the buying power of cash. Only by devaluing the purchasing power of the dollar can the central banks suck excess liquidity out and devalue the bad loans at the heart of it all.
So don’t be surprised when everything costs a lot more this time next year.