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Side By Side We Stick Together

What is collateral, anyway? The Latin etymology suggests it is something standing side by side with something else, like Collingwood fans sticking together to defend the Magpie name. But in the financial world, we take collateral to mean property, or something equivalent, deposited with a creditor to guarantee the repayment of a debt. The collateral gives the lender security against the risk that the borrower is unable to repay.

Why the language diversion to begin today’s Daily Reckoning? Well, we have a hunch that much of the banking system of the Western world is stuffed with garbage collateral. And meanwhile, banks are forced to provide real tangible collateral to get loan from the central bank of central banks (the Bank of International Settlements). If the garbage collateral really is garbage, the banks are more poorly capitalised than previously imagined, and may want some of that gold back. But how about some details?

Just for some context, remember last week when we mentioned that Australian mortgage rates may be pushed up regardless of Reserve Bank’s manipulation of the cash rate? The argument is that in a global financial market, the Reserve Bank isn’t really in control of the price of money, especially if Australian banks are borrowing that money somewhere else, where some other suit with an inflated sense of self belief is fixing the price of money.

The main point is really an argument that we believe the price of money, as expressed via long-term interest rates not set by central banks, is going up. One reason for that is that so many corporations and governments are due to refinance loans and lines of credit taken out at the height of the credit boom years, when interest rates were low and money seemed free.

Nothing is ever free, or at least without the cost being born by someone. Except perhaps solar radiation. It rains down on the planet every day. It’s what keeps the Earth from being a closed energy system. If we could just turn more of that free solar income into an energy stream, everything really would be fine.

But right now, at least in the world of European banks, matters are less than fine, although perhaps they are finely balanced between seeming normality and real chaos. Eurozone banks must refinance nearly $1.65 trillion in debt in the next 18 months, according to the Wall Street Journal. With all that European money and American investor money currently pouring into short-term U.S. government notes and bonds, the Europeans better start hustling, jiving, busking, and pan-handling for all the credit they can get.

But from whom will they borrow (each other?) and what can they pledge as collateral against a default?

That is not a rhetorical question.

Of course the government could guarantee that debt. But what does the government pledge as collateral when it borrows in the bond market? Nothing, really. Or more specifically, you. A continuous stream of tax revenues – property tax, income tax, corporate tax, GST, payroll tax, death tax – is why the government usually pays lower interest rates to borrow than corporations.

Corporations must make a profit in order to pay bond holders. To make a profit you have to actually provide the consumer of your good or service with something he wants. And you have to do it cheaper and better than your competitors. And you have pay your bills and your employees, whereas when the government needs money to pay bondholders it can just take it from someone else or print it.

A key point: every dollar taken from the private sector to pay a government bondholder reduces private demand. You could argue that interest on government bonds is somebody’s income. But the money multiplier suggests if you really wanted to stimulate the economy, you wouldn’t borrow money to give it away. You’d just let people keep more of what’s already there’s and spend less. But we digress.

Europe has large borrowing needs. So does America. So does Japan. Australia’s borrowing needs, by comparison, are more modest. But it’s going to have to get in line. It can jump the queue by offering higher yields to prospective investors/savers. But that’s going to push up mortgage rates. And now, we’re not just making this up.

Today’s Australian Financial Review has a story from Stephen Shore in which he reports that Australian corporations-not including the Big Four banks-have roughly $124 billion in debt which must be refinanced over the next three years. That figure comes from a GoldmanSachs JBWere estimate. It reflects maturing debt facilities.

It’s possible – in a deleveraging world – that corporations will not utilise or even have on hand debt facilities, meaning the $124 billion figure could be lower. But according the GSJBW there are, “42 companies with loan facilities maturing in the next two years that was greater than or equal to 20 per cent of market capitalisation. Of these, one-third were real estate investment trusts, five where infrastructure companies and four were utilities.

The worry is that falling asset values (provided they are revalued properly in the first place) and new bank capital regulations would force these companies to pay much more to refinance their debts and lines of credit. It kind of makes you wonder if there’s not a lot more fallout to come in those sectors of the Aussie economy that levered up during the credit boom.

And don’t think we don’t know who you are, highly geared sectors of the economy. We do.

This brings us back, in a roundabout way, to gold. It fell last week while we were in Sydney, seemingly confirming the gleeful speculations of the unimaginative investment establishment that gold was in a bubble. Morons. All of them.

The story that took a bit to digest was that some commercial banks have essentially pawned their gold holdings with the Bank of International Settlements in exchange for cash. Since December, some 349 metric tonnes of gold have been deposited as collateral by commercial banks in exchange for bright paper things. So why did the banks do it? And why did gold go down?

The answer to the first question is that the best time to borrow against the value of an asset is when the asset is worth a lot. Does this means commercial banks are borrowing against the value of their gold now because they believe it has reached a peak and they can buy it back later at a cheaper price (although we’re not certain that’s how the swaps work).

Or does it mean banks are so desperate from cash they can’t borrow in the open market at attractive prices that they’re literally hawking the family gold to stay liquid?

Hmm.

The gold market freaked out because – and we’re just guessing here – it viewed the 349 metric tonnes of gold as the sort of inventory that could be dumped on the market to suppress prices. The fact that gold has remained at or above the US$1,200 figure shows you how strong the support for gold is.

Commercial banks are hoping the value of their loan portfolios – collateralised by government debt, commercial real estate, and residential estate – improves. In the meantime, they’re willing to pawn the one real tangible asset they own to raise cash. It shows you how stupid some bankers continue to be and just how little the financial system has recovered from the leveraged boom of the last 30 years.

Of course there’s a chance that in the coming bust the price of gold falls. But is it a bubble? No. The morons who are saying that believe, among other things, that paper is money and that it’s the job of central banks to support asset prices and that central banks can actually do so. This is the position taken by imbeciles. The price of their ignorance will be very high.

In the meantime, evidence is mounting that no matter how lucky this country is, it cannot escape what’s going on. In late June, Westpac raised $800 million in five-year funding at a price 35 basis points higher than a deal seven months earlier, according to today’s Australian. You can bet the banks don’t want to raise mortgage rates faster than the cash rate before the election. But you can also bet that what an Australian bank charges you for money will be determined by the global cost of capital, not the RBA’s cash rate.

Except in a world of fiat money with fractional reserve banking, nothing cannot come from nothing. You can pretend that it does, but only as long as everyone pretends along with you. When the pretending stops, what will you have left to hold onto?

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning is the Editor-in-Chief of The Daily Reckoning Australia and the author of 2005’s best-selling The Bull Hunter (John Wiley & Sons). He began his financial publishing career in 1997 as a small-cap analyst. From 2000 to 2005 he was the managing editor of Strategic Investment, where he recommended gold and warned of the US housing bubble. Dan has covered financial markets from Baltimore, Paris, London and, beginning in 2005, Melbourne Australia, where he is the Publisher of Port Phillip Publishing. To follow Dan's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
Dan Denning

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12 Comments

  1. SV says:

    “morons”, “imbeciles” – great language for a “family-oriented” newsletter. Also conveys your ideas very well.
    There could be some people here, forgive them, who think money is something you can exchange for your daily bread, or something you use to repay your mortgage.

  2. antisoc says:

    Belittling the opposition and calling them names only weakens the argument against them. Stick to reporting the facts and providing your theories and insights, its what DR is good at and why your readers keep coming back. I have sensed a hint of backpedaling on the prophesied economic armageddon in DR lately and resorting to name calling only reinforces my suspicion that DR is becoming less convinced of their own rhetoric. Nickolai Hubble still hits the mark and Dan Denning only wanders off track part of the time however Mr. Bonner’s articles are becoming more and more like the rants of a social malcontent by the week.

  3. Evermore says:

    “SV” and “antisoc” must be a comedy duo – very funny :))))

    So SV, when did TDR become a “family-oriented” newsletter??? …personally, I appreciate life and comment without such political correctness or petty nit-picking such as your comments reflects! Morons and Imbeciles are perhaps the only words appropriate.

    And Antisoc, don’t worry too much about Dan’s timing or Bill’s comedic rants, just be thankful for every spare moment you have to prepare your finances till economic armageddon hits – because it surely will.

    The guys (Denning, Bonner, Keene etc) opinions on all this is like reading the report of structural engineers!
    Eg: They calculate that a 3 TRILLION+++ kilogram downward pressure is being held up by a couple of bricks. They know the forces of mass/gravity will win this contest but they just can’t say WHEN!!!

    Like the old shampoo commercial said…. “It may not happen overnight BUT IT WILL HAPPEN!”

  4. SV says:

    Evermore, I read about family orientation in its sister publication, Money morning on 2-June-2010 in article “The Losers Take All”:
    “The word ‘duplicitous’ springs to mind. Along with a load of others that we can’t print in this family oriented newsletter.”

    I assumed the “G” ratings should equally apply to DRA, but this article goes towards M+ (frequent coarse language).

    To me, calling the central bankers imbeciles does not explain anything. Hope at least you find it meaningful.

  5. Stillgotshoeson says:

    Gold is up 16 bucks on the downgrading of Portugal..
    There is manipulation in the release of these downgrades.. Common knowledge of the countries in difficulties but the downgrades are being “filtered” through months apart as not to “shock” the markets into a sudden and severe decline.. they are going to decline, the charts as they say do not lie.. the speed of the decline is the unknown.. Personally I think it can only get so close to the edge until the fall speed increases at a geometric rate that will not be able to be manipulated back until hit hits bottom…

    Tending to think the same with house prices in Australia too, more specifically Melbourne and Sydney.. support for them will see a slow pull back/cooling of prices and then the rug will come out and the “house” of cards will fall.

  6. AnnoyingOrange says:

    I also believe that name-calling reduces the arguments. I’ll read the dumb comments under YouTube videos if I want name-calling.

    Besides, most of those “moron bankers” probably have bigger cars, boats and houses than us.

    I would like to see DR acknowledge more of the good economic news around, and explain it in the face of this apparent coming economic armageddon.
    It would help carry the downside argument.

    I enjoy DR a lot, but I am getting a little tired of hearing various bear websites banging the same old drum.

    Different angles are needed keep it interesting. Perhaps some tongue-in-cheek Bonner advice on dealing with economic armageddon, and zombies. What stocks do you buy after a crash? Which types of companies best survived the Great Depression? (I was told that selling flowers is a winner during a depression).

    I am also curious about the proliferation of bear websites – do they deal out the bad news as a service, or are they just helping add turmoil so prices keep going up and down, so profitable trades can be made? Or are they there because the news really is all bad?

    Yours Truly
    AO (Who lost it all in ’87 and survived)

  7. Ned S says:

    “DR acknowledge more of the good economic news around” – Austrian economics is based on ‘logic’, rather than ‘scientific method’ apparently:

    ‘Mises wrote of his economic methodology that “its statements and propositions are not derived from experience… They are not subject to verification or falsification on the ground of experience and facts.”‘

    ‘Additionally, the prominent Austrian economist, F. A. Hayek, stated his belief that social science theories can “never be verified or falsified by reference to facts.”‘

    Won’t put the link in – It’s a wiki one and DR nails them from what I’ve seen in the past – Just google ‘austrian school criticism wiki’ and you’ll find it.

    I’m not saying they are wrong in this, but I am suggesting it is probably unreasonable to expect Austrians to waste a whole lot of effort considering evidence of positives when their logic tells them that as things aren’t being done the way they should, it will all end up falling over.

    There’s some fans of the Austrian school commenting on the wiki article here:

    http://mises.org/Community/forums/p/16610/330782.aspx

  8. Lachlan says:

    The root of all the problems discussed here is in the way people relate to each other. Our politicians and money systems are just a product of that reality. I am guilty of name calling myself still I’ve always thought DR would be a more effective publication without it. Some websites are increaingly slanging off at bankers and politicians. Whatever they have done this is not a good development.
    Simple truth without the emotion is best.
    As far as the bearish news I find it mundane at times but I imagine life without it, as it was not long ago, like life in the matrix. The only information to consume there is propaganda and falsehoods of every kind. No thanks.

  9. Ned S says:

    Politicians and Bankers – “Anyone can become angry – that is easy, but to be angry with the right person at the right time, and for the right purpose and in the right way – that is not within everyone’s power and that is not easy.” – Aristotle

    I’m not sure what the right way is either, but to say Everything is just fine and dandy and will you please give me some more of the same please fellahs does not get my vote.

  10. 89peterg says:

    yes, DR is in serious hazard of falling into the governments Rufused Classification (whatever that will come to mean) internet censorship regime.
    If you want to shock the kiddies, bring back Mugumbo and his acidic acronyms.
    I liked the picture of the US election with a protestor outside the Republican Convention holding up a placard “Get a Brain, Morans (sic)”.

    http://3.bp.blogspot.com/_86-X5Fn-0UA/SyayYVgV04I/AAAAAAAAEtc/IgrUzGrMNqY/s320/morans.jpg

  11. moondoong says:

    Maybe it is time to take a long term short position on the big 4 + Macquarie and make big bucks…………

  12. Stillgotshoeson says:

    Comment by moondoong on 14 July 2010:

    Maybe it is time to take a long term short position on the big 4 + Macquarie and make big bucks…………

    Rio and BHP are coming on the radar for shorting too..

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