A Valuable Backstop for Wealthy Investors
By Adrian Ash
May 10, 2008
Why are wealthy investors
swapping gold futures for physical metal that they own
outright...?
A LITTLE UNDER twelve 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 US home-buyers
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 run in 130 years, a forced collapse
in US interest rates, and the fire-sale of Wall Street's fifth
largest investment bank for just 16¢ 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% 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 US
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.
Cheap money and the inflation it causes makes gold
bullion an attractive asset. Central bankers can't print it;
investment bankers can't promote it to destruction. But "in
addition to being generally positive for gold prices, the credit
crisis brought counterparty risk to the fore," as Nikos
Kavalis of the GFMS
consultancy in London reminded us here at BullionVault
by phone this week.
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.
"In many cases, we've actually seen investors
moving away from positions they already had in place, moving out
of both unallocated accounts and gold derivatives, and into
allocated metal," says Nikos.
"Largely as a result of the crisis in the
credit markets, a number of high net worth individuals have
invested in physical gold."
Unallocated gold is the Gold
Market's major concession to financial trickery (a.k.a.
"innovation"). Merely a book-entry on a credit ledger,
it works much the same as a bank account – only without
deposit insurance – representing a loan from the buyer to the
brokerage.
That leaves the investor very much "on
risk" with regards to the brokerage's financial survival.
And it's been estimated to us here at BullionVault
that well over 95% of the world's daily Gold
Dealing is still done on an "unallocated" basis.
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.
But leverage pays nothing if your counterparty
defaults. And for investors with money to lose, physical gold
bullion sits in a much-needed asset class all of its own.
First, the physical Gold
Market centered in London is one of the deepest and most
liquid capital markets in the world. Turning bullion into cash
is easiest for investors dealing warranted gold bars. Kept in
professional storage to retain maximum resale value, gold held
in the form of these large 400-ounce bars also avoids wide
dealing spreads and commission fees, too.
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.
Finally, physical gold bullion – provided that it
is owned outright – is unique amongst tradable assets; because
it's almost entirely devoid of counterparty risk. You'd be
surprised how many investors, both private and professional,
fail to realize the difference.
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 US 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 US corporate-bond failures. It sees
the default rate on low-rated junk bonds quadrupling to 4% 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% 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% below
the latest all-time high of mid-March.