United States currency notes carry the motto “In God We Trust”. Well, not anymore, we don’t. Put a letter “l” into the second word and you just may have a winner.
With the global financial system basically dysfunctional, the issue for hardworking Asians is where to put their money. I would suggest looking at physical commodities such as gold and oil, if only the prices hadn’t already jumped. The price of gold surged above US$700 an ounce on Thursday to its highest level since May 2006.
How the system works
In a previous article,  I explained how banks typically function as intermediaries for risk and liquidity across the system. Over the past few weeks, though, banks have come up against a wall of their own making, namely the failure to trust one another in terms of overnight lending.
Typically, central banks set a target rate, which is observed by banks lending to one another in the overnight window to balance total cash in the system. In proportion to their deposits, banks must hold reserves with the central bank, on which a specific deposit rate – usually 100 basis points below the target borrowing rate – is paid. When a bank runs short of such a cash amount, it has to borrow from another bank to maintain the level of reserve; such borrowing is priced at the target rate. Failure to source enough borrowing from another bank would push the cash-short bank to borrow from the central bank itself, at a penal rate that is usually set 100 basis points above the target rate. This is called the discount-window rate.
The interbank market is a different kettle of fish, as this is where banks borrow from one another for all other purposes, including funding their overseas assets (for example, European banks buying US-dollar-denominated assets will need to borrow US dollars from one another). Rates at which banks will borrow from one another determine the London Inter Bank Offered Rate (LIBOR), which is set daily in London based on a poll of 16 prime banks. The theory is that borrowing rates should not exceed the penal rate mentioned above (ie, target plus 100 basis points usually) because then banks could simply approach the central bank for funds.
In the staid world of banking, though, this borrowing from a central bank therefore carries a stigma, ie, that the bank is not trusted by other banks and therefore needs to approach the central bank for money. Hence many banks would rather pay over the penal rate in the interbank market than risk their reputation by approaching the central bank.
Of course, it is not just banks that individual depositors can go to. In many cases, they go to money-market funds, which offer higher deposit rates than banks do, and typically provide a form of principal protection in excess of the cap that is in place for deposit insurance in many countries. This normally attracts wealthy people and companies with excess funds on their balance sheets for any operational reason. Such money-market funds typically buy commercial paper.
Commercial paper (CP) is a slight variation on the theme of interbank borrowing. The idea is to expand the pool of potential borrowers in the market, and this is achieved by issuing short-term notes that are typically of high quality. With a CP program in place, borrowers can access the funding market that will tap both banks and money-market funds. Asset backed commercial paper (ABCP) refers to CP programs where some form of collateral, usually of very high quality, is used to underpin the quality of the program and thereby provide increased safety for anyone buying notes issued by the entity. Typically, ABCPs are used by financial entities to arbitrage between short-term borrowing rates and longer-term yields available on such securities.
Now that we are this far into the alphabet soup, I might as well add structured investment vehicles (SIVs) to the mix. These are specialized financial entities that invest in higher-risk (but still highly rated) assets, such as derivatives issued on financial assets such as mortgages and credit-card debt outstanding. These securities have a lot of mind-numbing abbreviations such as RMBS, CMBS, ABS and CDOs, but in effect, all point to the same thing: a financial derivative on relatively illiquid underlying assets.
How it broke down
In the past few weeks, as European banks started disclosing the level of their potential losses from buying US subprime assets, two things broke down. First, the various money-market funds started facing redemptions once it turned out they too had exposure to derivatives written on US subprime assets. They then had to stop purchasing ABCP and CP in the market, putting the onus on banks to carry the entire burden.
Banks, of course, were the main sponsors of SIVs, although some of the largest ones facing the biggest issues now are actually run by non-bank financial entities such as brokers and hedge funds. In any event, once the SIVs could no longer fund themselves in the CP market, their game was up – their assets were illiquid because of the current level of losses in the underlying securities (borrowers defaulting on their obligations much more frequently than was initially assumed, which helps to drive the price of derivatives down a whole lot faster).
This meant that many bank-sponsored SIVs had to be absorbed by their sponsors, which in turn caused the banks to record both investment losses and stretch their capital. Under the rules of global banking, having assets ranging from loans to derivatives attracts various degrees of capital requirement to ensure that banks have enough of their own equity at stake in investments rather than only risking the money from depositors or other banks that help to fund their own book. When risky assets are purchased wholesale, no one knows for sure how valuable these assets are and therefore how much loss the banks have to take.
In this environment, banks stopped trusting one another. LIBOR has jumped well past the circuit-breakers such as penal overnight borrowing that exist, because of this lack of trust. Even as the US Federal Reserve cut its discount rate to just 50 basis points over the target rate, banks found it difficult to convince one another of their stability and solvency.
That lack of confidence among banks has put paid to any central-bank efforts to hike rates, as required by looking at rising global economic growth and inflationary pressures. Instead, the Federal Reserve has signaled a willingness to cut rates this month, and the European Central Bank, which pre-announced a hike for September just last month, had to backtrack hastily this week and keep rates on hold. Even all of that flip-flopping has not helped in the interbank market, because LIBOR remains stubbornly high.
What to do
When trust breaks down across banks, investors have no option but to walk away from financial assets. This has already happened, as gold prices surged above $700 an ounce, and oil prices hit a new high for the year (US$77 a barrel). The preference for commodities is bothersome for central banks, as high input prices make the task of cutting interest rates (as demanded by banks) less defensible.
More important, central banks in the US and Europe have lost credibility with investors. They are no longer trying to prevent inflation, but appear more concerned with preserving the lot of bankers. This suggests greater value destruction for global investors, particularly for Asians investing in financial assets in Europe and North America.
Neither the US dollar nor the euro has any credibility in this situation, which means that the average Asian saver has no option but to purchase gold as a store of value. Even as US dollar bills proudly carry the motto “In God We Trust”, I think it’s time for Asians to put their trust in gold instead.
1. Asia and the vicious cycle of bank bailouts, Asia Times Online, August 11, 2007.