Saving Greece’s Sinking Ship

March 5th, 2010

Followers of the financial markets remember what happened to Lehman Brothers during the two weeks leading up to its collapse and sub sequential shock to the global economy. The question is: has the world learned lessons on how to handle this type of crisis?

It seems that in our current market place we are divided into two teams – winners and losers. But instead of competition being held on a balanced playing field, where skill and position decide the outcome of the game, we have a game that is more like American Gladiators, where one team is made up of contestants and the other team is made up of gladiators. Gladiators do not compete against competitors, but instead act as blockers or impediments designed to stop competitors from achieving any type of goal. The American Gladiator arena is basically how the market for Credit Default Swaps (CDS) has been operating. The buyers of CDS, specifically buyers who don’t own the underlying security, are trying to be blockers of Greece achieving its goal of stabilization, as they stand to make a significant winning if Greece is unable to recover and subsequently defaults.

A default by one Euro country could be disastrous for all European countries and this is because of contagion. Contagion is ultimately what led to the currency crisis during the 1990s in emerging economies. The effect on the market occurs because investors begin to treat securities that are similar as identical comparisons, which leads to major sell-offs in indices and underlying securities that are related to the original security. If Greece defaults, investors will look to withdraw from the rest of Europe’s PIIGS (Portugal, Italy, Ireland, Greece and Spain) because they will view these countries as equally susceptible to the risk of default. As a result, the European Union economic zone would risk collapse as after time investors will start to pull away from stronger countries within the European Union. The best recent example of this is what happened to Goldman Sachs during 2008. Goldman Sachs was never at risk of collapsing and they are (and were arguably) the most stable bank within the financial institutions industry and yet their risk of default increased and their stock began to fall simply because weaker financial institutions were beginning to default. Europe has an obligation to itself to rescue Greece and put it on the right track to stability, as it risks its own demise if Greece fails. The European Union, International Monetary Fund and European Central Bank are expected to save Greece if their government makes difficult, but appropriate budgetary choices. If they succeed in staving off a collapse then Europe will be stronger for having done so, as the world would’ve just watched a coordinated effort across the continent to address real concerns, something that many would argue Europe has not done since the birth of the European Union.

The Euro currency has so far been the only real victim in this Greek drama, as it has fallen 3% over the past month. Gyrations in currencies often bring positive effects and negative ones. A falling Euro is good for the European export market as it makes their goods more competitive around the globe, however it is generally bad for the European import and consumer market as cheap discretionary goods become more expensive. The area where this could cause the largest dent to the European consumer is that of energy costs. A significant portion of the natural gas that Europe consumes comes from Russia and the already high fuel prices in Europe could increase further as a result of a weaker currency.

The US has experienced a weakening currency over the last 8 years, which has led to higher energy prices in the domestic market, but it has also benefitted our recovery, as US exports are very competitive in the global market. The relative strengthening that the US dollar has been experiencing is because of a greater global uncertainty (on a relative basis) in other developed countries. If the Greek crisis has shown anything at all from a US perspective, it’s that the US treasury market is still very robust and is considered to be the safe currency. But in saying that, we must remain cautious because if Europe cannot contain the Greek crisis, which ends up causing the Europe crisis, we must be wary that the sentiment does not spread to the US. If there are signs of a collapse, leap into the stable investments such as gold and US treasuries to protect yourself from what could be called the double dip.

Re-paying the TARP

December 16th, 2009

December 16, 2009 – The Troubled Asset Relief Program  (TARP) was initiated to save the United States, as well as the world, from a complete financial meltdown that would have certainly lead to a depression, which would have been comparable to the Great Depression of the 1930s.

After all this time, we know the story of how we got here and we are still struggling to get out of it.  However, a lot of progress has been made since Q4 2008. Although, banking institutions are still going out of business (133 so far this year) and the FDIC has slipped into the red for the second time in the agency’s history, the economy has stabilized with the help of TARP.  The financial markets have more or less normalized and the financial services industry has retuned to producing strong profits. The actions taken by former US Treasury Secretary Hank Paulson in October 2008 were necessary in bringing the market back into a more stable trading period. The Treasury forced “too big to fail” institutions to accept TARP money in order to prevent another market shock, which would have sent the economy into a steeper tailspin. This collective action, concealed the worst banks from the best banks and prevented another Lehman Brothers collapse from happening.

Since then, the “too big to fail” institutions have been racing to pay back their share of TARP funds. Goldman Sachs was the first of the top eight initial institutions and the others have since followed culminating with the December 14th announcement that Citi and Wells Fargo are repaying $45 billion in TARP funds. This is good news for the US government and for the US taxpayer because the government can get out of the business of owning banks. However, this is not necessarily good news for the investor looking to put capital to work in these institutions.

Although these financial institutions are comparable in size and scope they certainly are not equal. It is no surprise that the banks that repaid their TARP package the quickest are the highest earning and today’s most fiscally sound financial institutions.  However, even when the best-equipped banks announced that they were re-paying their TARP funds their stocks did not increase dramatically. 

As an investor, it is important to not lose sight of the fundamentals of financial stocks. Re-paying the TARP shouldn’t be the decisive factor that brings the investor back into the market. The repayment of TARP really only enables the bank to lift the pay restrictions connected to management. It does not make the financial institution free of government oversight, since the government regulates the industry. In fact, government regulations are expected to tighten with the passage of the financial regulatory reform bill, which was passed by the House of Representatives last week. The fundamentals that investors should be looking at are the banks’ business models, capital ratios and book values.  These fundamentals have improved in some of the banks since they re-payed TARP because of the earnings that they have generated. However, the immediate impact of raising capital to replace the government’s investment is a dilutive to current shareholders. The capital raise also causes a decline in the banks capital ratios and book values.

The Bullion Investment

December 9th, 2009

On December 3, 2009, gold reached a record high of $1,226.10, as investor fears about the US economy and speculation in the weakness of the dollar grew. Since then the Labor Department released its November jobs report that showed the fewest job cuts since the recession began in December 2007.  The November jobs report showed the economy only lost 11,000 jobs compared to the 125,000 job losses that were expected. As a result of positive indicators in the economy, gold has experienced it’s largest two-day drop during the Dec. 4-5 period since Oct. 2008. This reaction can be expected as investors see signs of a recovery and would like to realize their returns. However, there are still some factors that continue to put upward pressure on the price of gold.

Inflation
Gold has long been viewed as an inflationary hedge and if the increase in global financial liquidity, due to historically low interest rates, begins to take a larger hold we can expect investors to continue to pursue gold as an inflation hedge over the long term.  Gold is likely to remain at high levels until inflationary worries are relaxed. Globally, gold is not necessarily an inflationary hedge as many currencies have appreciated relative to the price per oz. of gold. Some of these countries include South Africa and Australia (recently raised interest rates), which are the number one and number two gold producers, respectively.

Stability
The global gold buying spree also has been brought on by volatility in the marketplace. It has in a sense become the high growth treasury bill. When there are signs of volatility in the market place investors flock to the assets that hold their value over the long term and precious metals, especially gold, has become that asset. In November Paul Mercier, the deputy director general of market operations at the European Central Bank, said at the London Bullion Market Association conference, “…gold is no longer important from a monetary point, but is important as an asset. Gold makes sense as a contributor to risk diversification. Even if some central banks continue to sell and there is a new potential seller with the IMF, I wouldn’t conclude that gold holdings in central banks will decline in the coming years.” Currently, there is a lot of uncertainty in the global environment due to increasing global deficits, a thriftier US consumer, a high unemployment rate and a change in tax policy.

Supply & Demand
Supply & demand conditions will also put upward pressure on gold prices in the near term as production declines and countries such as India or China pursue more gold reserves (recently India bought 200 tons of gold from the IMF).  Mine production is expected to remain low in the near term but pick up again in the medium term as companies successfully ramp up their gold production and rely on more efficient technology, which yields more gold from the mine.  As a greater supply becomes available, gold prices are expected to decline. Returning to the near term, if the recent appetite for gold remains at its current level or increases with another 200-ton purchase of gold from the IMF, gold prices can be expected to rise above their record highs.

The New Normal
Is a surge likely to continue in gold prices?  Or is the market currently experiencing a commodity bubble, which will likely lead to a collapse in prices as the global economy recovers?  There has been speculation of gold reaching the $3,000/oz mark. Recently David Tice, a market strategist at Federated Investors, offered his outlook on the possibility of gold reaching $3,000/oz. His investment thesis is based on an increase in emerging market gold reserves. On CNBC he explained “the emerging markets generating all the free reserves only have 2.2 percent of the reserves in gold, where the developed countries have 38 percent. If [the emerging markets] increase their percent to 5 percentage points, gold could go to $2,000 to $2,500 easily.” He speculates that two years from now gold would reach $3,000/oz as fear will increase and “there will be a global currency disaster ahead”.  The potential for a bursting bubble is also a relevant investment thesis as many see gold as an overbought asset that has increased in value too quickly and is likely to burst as global stability returns to the marketplace and the dollar appreciates. As an investor, it’s important to understand the short-term pressures and the medium to long-term pressures on gold prices. The supply of gold is declining in the near term, interest rates remain low and the global economy continues to see signs of weakness, which could lead to further increases in gold prices. In the medium to long-term we can expect the miners to increase gold production to try and take advantage of high prices, which will in effect increase supply and put downward pressure on the asset.  Currently producers have not been ale to take advantage of the high prices as they have seen a decline in production. In addition, if we see more positive indicators of a global recovery there could be a rapid sell off as investors move quickly back into other areas of the market.

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