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October 2011 Investment Journal 


Risk markets snapped back in October, with the S&P 500 up an astounding 11%. Bonds were up slightly, with the Barclays Aggregate Index rising 1%. Commodities and gold recovered as the US Dollar weakened, with the DJ UBS Commodities Index up 7%, and gold rising 6%.

The signs are all around that this is a market driven by extreme emotion and little to no conviction. When volume dries up as it has done, and large moves become commonplace, you know that something is up.

The next casualty in the Euro banking travesty fell in October as the Belgian state bank Dexia collapsed on Oct. 7 and required 90 billion Euros of bailout money, cobbled together by the French and Belgium governments, who are the majority shareholders.

Then European leaders announced yet another deal for bailing out Greece in mid-month, and markets raced ahead as if all the world's problems had been solved (while Greek two year Notes traded north of 60% -- that is not a typo). Is something wrong with this picture? You bet there is.

First and foremost, the powers that be can't decide whether or not a "default" has actually occurred. Sorry, but last time we looked, when private investors are told to "voluntarily" reduce the permanent value of their holdings to 50 cents on the dollar, the other 50 cents has effectively been vaporized. If that isn't a default, we don't know what is.

And, it turns out, this lucky deal only applies to the private banks who hold Greek bonds, not to sovereign and public authority investors like the ECB and the German Land Banks, so you can apply the word "selective" to "default" to see how tortured the logic gets.

The as yet unexploded ordinance that lies amongst this minefield gets ignited if an "event of default" is deemed to have occurred, which then starts the domino chain of "trillions" in payments required under credit default swaps (CDS), all of which were privately negotiated, traded and collateralized in the OTC markets (as a means to protect against a decline in value of Greek bonds - precisely what has occurred!) No one knows who owes who what because there is no standardized contract with daily settlement of "debit balances", and no disclosure of position sizes or limits. It is truly a black hole.

The powers that be know this. The domino effect has the potential to eviscerate global markets. They will therefore do or say anything to extend and pretend that Greece is not insolvent. This would include measures like banning short selling and writing any more insurance on bond downgrades (both of which are natural hedges to lower risk or for essential price discovery). If there are no ways to protect your investment, you will sell. They never learned this in Brussels, Berlin, or Paris.

Meanwhile, the Irish nation is questioning why the German, French, Greek etc. public investors just got a pass when the ECB and IMF handed them a bill for similar shenanigans in 2009. Life ain't fair eh? Try to envision how this is going to play out in Rome, Lisbon, and Madrid as the Euro debt bomb keeps ticking. We don't know when, but it is a becoming more certain that the U.S. Fed will be forced to intervene to support the Eurozone. At that point, Peoria and Dublin can throw a joint misery party! To say that won't go down well with US voters is also a given.

So our view is that many markets have an exceedingly unattractive risk/reward profile, and that if something does give, it will have an outsized impact on returns. The see-saw pattern of large up and down months is the telltale sign that reveals how tenuous investors have become, and patience is indeed wearing thin. Real progress on reforms need to be made now.

Meanwhile, in a little noticed story from early October, the FT described how physical gold will now be accepted as collateral by a major global clearinghouse which is increasingly uneasy about holding bonds and currencies. It is truly a "tectonic plate shift", so we are presenting the whole story below:

LCH.Clearnet to accept gold as collateral

Clearing houses are moving to beef up their financial ballast amid market volatility by allowing more gold to be used as collateral to back transactions processed through them by traders.
The move is a sign that volatility in the markets and regulatory pressure for higher collateral in over-the-counter derivatives markets are prompting clearing houses and their customers to reassess the value of relying largely on cash and government bonds as collateral.

A clearing house stands between parties to a trade, using assets such as cash and government bonds as security, or collateral, posted at the clearing house by its members to help bail out a defaulting member or their customer.

Gold, which investors perceive as an increasingly "safe haven" asset, has only recently been considered worthy of use as collateral by clearing houses.

LCH.Clearnet, the Anglo-French clearing house, on Thursday became the latest clearer to allow gold as collateral. It said the service was available to customers that had signed up to clear OTC gold bullion and gold contracts on the Hong Kong Mercantile Exchange.

"Globally, gold has seen rapid growth in investment and regulators are looking for more OTC derivatives to be cleared," LCH.Clearnet said.

It added that the initiative "is supported" by the World Gold Council, the gold mining industry lobby group which recently suggested the metal could be included in banks' "Tier 1" capital reserves - the buffer of safe assets meant to protect banks from losses on their investments.

David Farrar, director of commodities at LCH.Clearnet, said the move had been under consideration for some time and was largely the result of demand from customers using the London Metal Exchange, whose trades are cleared at LCH.Clearnet.

"Banks now want to use gold alongside cash so they can optimise returns and they typically have large holdings of gold. The background is increasing margin liability that has to be put up to us because of volatility in the markets," he said.

LCH.Clearnet's move follows that on Monday by CME Group, the US-based operator of futures exchanges and clearing houses, to increase the amount of gold accepted at its US-based clearing house.

CME, which first accepted gold as collateral in October 2009, raised the amount that can be posted by a member to $500m, from $200m. It said this was "in response to customer demand" and was done "in conjunction with regular review of market volatility to ensure adequate collateral coverage".

The financial world is scrambling to find "safe" assets as nations deal with sovereign debt issues and seek to devalue their currencies. Some large banks now offer "collateral transformation services" promising to turn less-liquid assets, such as corporate bonds, into cash that can be used by their clients as security at clearing houses.

New rules such as the Dodd-Frank act in the US and the upcoming European Market Infrastructure Regulation (Emir) are driving increasing use of clearing for OTC markets, which in turn is putting pressure on market participants to put up more collateral than before.

JPMorgan began accepting gold to satisfy collateral requirements in so-called repo transactions, meaning banks could use it as security when lending to each other under JPM's framework.

IntercontinentalExchange, a CME rival, started accepting gold at its London-based clearer, ICE Clear Europe, in November last year. It is used to back trades in energy and credit default swaps. ICE does not yet accept gold at its US clearing houses.
ICE Clear Europe last year also introduced a "triparty collateral management arrangement" with Euroclear Bank, the international central securities depository, through which European government bonds may be used as collateral to fulfill initial margin requirements.

Both the addition of gold collateral and the availability of collateral via Euroclear Bank were intended to "enhance the stability and flexibility of the clearing house, particularly during periods of intensive economic stress, while providing alternatives to customers," ICE said at the time.

Lastly this month, we can't help but note the fall of Tyrant #1 in North Africa, Ghaddafi, has been greeted with enthusiasm all around. In the slow motion world of geo-political alliances, it can be hard to see the forest for the trees. However, with Tunisia electing an Islamic slate of candidates for their representative government, and the same trend emerging elsewhere (Egypt and Turkey), it should be apparent that an emerging Islamic arc is establishing itself across North Africa to the Middle East, with profound implications for the West. From resource security to secure travel, it looks like the start of a fundamental realignment that will see the West less able to influence the outcome.  We will explore this topic more in future journals, especially as it relates to the oil market.

Thank you again for reading our Journal, and we'll be back to you again next month.

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