As Financial Tremors Reverberate, Focus on Counterparty Risk

Aug 10, 2007 – A new but inevitable twist has emerged in the escalating subprime woes. Bank solvency is now being called into question.

As a rescue package was being put together for a failed German lender, that country’s central bank denied that it was holding emergency talks to discuss problems at West LB, a big government-controlled bank rumored to be holding large amounts of US subprime paper. Then after BNP, a leading French bank, yesterday announced that it was suspending redemption of three of their so-called asset backed funds because the funds were unable to sell their US subprime paper to meet the demand of its investors wanting to cash-out, a ferocious storm hit global money markets.

News accounts didn’t mention the word, but the BNP funds were in effect suffering a “run”, causing people everywhere to worry whether these events were the first steps of what could turn into a 1930’s-style domino collapse.

Not unexpectedly, the ECB opened the money spigots. According to London’s TimesOnline: “The European Central Bank was forced today to wade into the eurozone’s money markets and inject €94.8 billion of funds to stabilise overnight interest rates after a new bout of credit jitters saw these spike upwards.” Meanwhile the Federal Reserve pumped $24 billion into US money markets, but were these amounts enough? It seems to me that the value of subprime assets held by banks and funds is dropping faster than these additions, leaving liabilities to depositors and fund holders greater than the value of the now diminished subprime mortgage assets.

What’s worse, the contagion is spreading in unexpected ways. The Wall Street Journal reports that US money-market funds are the latest victim of the subprime fallout. Some of the commercial paper owned by money-market funds, according to the Journal: “may be fairly racy, containing mortgage-backed securities that could include chancy subprime loans.” It then went on to mention what it called a couple of “staid funds” that had reported owning this tainted paper.

Given these deteriorating conditions in global credit markets, counterparty risk becomes of primary concern. Counterparty risk is often ignored and misunderstood. But it can only be ignored at one’s peril, particularly now that the subprime mortgage blow-up is looking more and more like a mushroom-shaped cloud.

The knock-on effect from the initial subprime defaults will I expect lead to more defaults, notwithstanding the Pollyanna’s at the Treasury and the Federal Reserve who say the problem is “contained”. But then again, what else would you expect them to say? Or as one wag put it, the Treasury really means that the subprime fallout is ‘contained’ to the known universe. So don’t expect them to highlight the growing counterparty risk that the financial markets are facing.

To understand counterparty risk, it is necessary to first lay out some basic definitions. Indeed, it is first necessary to define that all-important objective we all strive for – wealth. The point is that while wealth comes in many different shapes and sizes, it can be broken down and grouped within basically two generic categories of assets – tangible assets and financial assets.

Tangible assets do not have counterparty risk. Tangible assets are not dependent upon someone’s promise. A tangible asset has a utility inherent within itself, which we value and want to use. We therefore are willing to exchange other wealth to acquire this utility.

For example, a house has value because it provides shelter. That is its utility. And clearly, a house is a tangible asset. The shelter the house provides is not dependent upon someone’s promise. Its utility gives value to this tangible asset, which does not have any counterparty risk. But now compare this form of wealth to any financial asset.

Financial assets are fundamentally different. Their value is always dependent upon some promise. Therefore, financial assets have counterparty risk.

For example, the dollars you have on deposit in a bank are dependent upon the bank’s promise to return that money to you when you ask for it to either spend it or to transfer it to some other bank. Another example of this dependency aspect of financial assets is a government debt instrument like a Treasury bill or note, as these are dependent upon the government’s promise that it has the financial capacity to repay their debt to you when it comes due. The same risk exists with bonds issued by companies, and of course, the BNP funds that have been suspended.

We are seeing a flight from financial assets, but it is still in the early stages. There is more to come. Worsening inflation and growing monetary problems of all sorts mean that people are looking for alternatives to preserve their wealth. Increasingly they are turning to gold, the traditional safe haven for wealth, and the only money without counterparty risk.

To the worsening inflationary pressures debasing the dollar, we can now add the problems of the subprime mortgage market and the knock-on effect it is having on hedge funds, banks, and other financial institutions. This new ‘contagion’ is spreading worldwide, which demonstrates the success of Wall Street in selling this junk paper to the four corners of the globe.

Consequently, people everywhere are now evaluating and reconsidering counterparty risk and in many cases moving their money to other forms of wealth considered to be safer. Gold will continue to benefit from this flight to safety, and the dollar will likely suffer as US bank asset quality is increasingly called into question. Any flight to quality will ultimately hasten the flight out of the dollar, adding to the likelihood of its eventual – and in my view, inevitable – collapse.

While a collapse of the US dollar may appear to be a frightening prospect, it should not be so for those who are prepared. Just like those who were prepared survived the widespread bank failures of the 1930’s, financial storms can be weathered. More to the point, the collapse of the dollar represents a phenomenal opportunity to own gold, which is the world’s only time-tested and enduring money.

No one yet knows how big the subprime problem will become. In fact, we really don’t even know for sure how big it is at the moment because the absence of asset transparency has masked much of the problem so far. Nevertheless, given the reckless lending by the banks over the past several years that fueled the housing bubble, it seems to me that it is both safe as well as prudent to assume that the losses will be much bigger than those incurred by the banks during the S&L crisis two decades ago.

The quality of bank assets and those of other financial firms like brokers and finance companies is deteriorating. The capacity of these firms to repay their liabilities depends upon the quality of their assets, and for banks, government deposit insurance in case the liquidation of assets erodes a bank’s equity. Those are thin reeds to rely upon in an environment where financial tensions are growing.

So the way to protect your wealth is clear. One should own tangible assets in preference to financial assets. By following this strategy, you avoid counterparty risk, which will become an increasing threat to the viability of financial assets in the weeks and months ahead.