The Looming Gold Derivative Crisis

One of the scares at the time of the Lehman crisis was that insolvent counterparties risked collapsing the whole over-the-counter derivative complex. It was for this reason that AIG, a non-bank originator of many derivative contracts, had to be bailed out by the Fed. By a mixture of good judgement and fortune a derivative crisis was averted, and by consolidating some of the outstanding positions, the gross value of OTC derivatives was subsequently reduced.

According to the Bank for International Settlements, in mid-June last year all global OTC contracts outstanding were still unimaginably large at $640 trillion, a massive sum in anyone’s book. It is unlikely to have changed much by today. But in bank balance sheets only a net figure is usually shown, and you have to search the notes to financial statements to find evidence of gross exposure. It is the gross that matters, because each contract bears counterparty risk, sometimes involving several parties, and derivative payment failures could make the payment failures now evident in disrupted industrial supply chains look like small beer.

Deutsche Bank’s 2019 balance sheet gives us an excellent example of how they are accounted for in commercial banks. It conceals derivative exposure under the headings “Trading assets” and “Trading liabilities” on the balance sheet. You have to go into the notes to discover that under Trading assets, derivative financial instruments total €80.848bn, and under Trading liabilities, derivative financial instruments total €81.910bn, a difference of €1.062bn This is relatively trivial for a bank with a balance sheet of €777bn.

But wait, there is another table that breaks derivative exposure down even further into categories, and it turns out the earlier figures are consolidated totals. The true total of OTC derivatives and exchange traded derivatives to which the bank is exposed is €37.121 trillion. That is nearly thirty-five thousand times the €1.062bn netted difference in the balance sheet. And when you bear in mind that valuing OTC derivatives is somewhat subjective, or as the cynics say, mark to myth, it invalidates the valuation exercise.

Clearly, by taking the mildest of a positive approach to derivatives held as assets, and a slightly more conservative approach to valuing derivatives on the liabilities side, that 35,000:1 leverage at the balance sheet level can make an enormous difference.

Now let us take our imagination a little further. A large number of these derivatives will have commercial entities as counterparties, businesses that have been shut down by the coronavirus since the balance sheet date. With the German economy already heading into recession before the coronavirus closed down much of the global economy, Deutsche Bank’s risk of losses arising from its derivative position could turn out to be in the trillions, not the one billion netted difference shown on the balance sheet.

Not only is there the emergence of counterparty failures to deal with, but there are ever-changing fair values, which will particularly reflect interest rate spreads increasing for Deutsche Bank’s €30.25 trillion interest rate-linked derivatives. We cannot know whether it is net positive or negative for shareholders. And with balance sheet gearing of assets 22 times larger than share capital very little change could wipe them out.

Deutsche Bank is not alone in presenting derivative risk in this manner: it is the elephant in many bank boardrooms. As a weak link, Deutsche is a relevant illustration of risks in the banking system. Since the Lehman crisis, its senior management has been on the back foot, retreating from businesses they could neither control nor understand. They have also made very public mistakes in precious metals, which is our next topic.

Gold derivatives in crisis

While a struggling bank like Deutsche provides us with a laboratory experiment for how a derivative virus can kill a bank, we are now seeing it kill off bullion banks in real time. A rising gold price, out of the control normally imposed by expandable derivatives, has effectively gone bid only in any size. We are told this is due to COVID-19 shutting mines and refineries and disrupting logistics, and so is purely temporary. The LBMA and CME which runs Comex have been issuing calming statements and even announced the introduction of a new 400-ounce gold futures contract alleged to ease the supply shortage.

In short, the gold derivative establishment is panicking. The swaps position on Comex shows why.

With their net short position in very dangerous territory, Comex swaps are badly wrongfooted at a time when the Fed and other central banks have announced unlimited monetary inflation, signalling a paradigm shift in the relationship between sound and unsound money. For ease of reference and to understand their relevance, a swap dealer is defined by the Commodity Futures Trading Commission, which collates the figures, as follows:

An entity that deals primarily in swaps for a commodity and uses the futures markets to manage or hedge risks associated with those swap transactions. The swap dealer’s counterparties may be speculative traders, like hedge funds, or traditional commercial clients that are managing risk arising from their dealings in the physical commodity.

Therefore, a swap dealer is one that operates across derivative markets, and typically will trade in London forwards as well as on Comex. In a nutshell, it describes a bullion bank’s trading desk.

In a further piece of disinformation this week, Jeff Christian, head of CPM Group, in an obviously staged interview for MacroVoices claimed that traders in London were forced by their banks to cover trading risk in the futures market as a condition of their funding. The implication was shorts on Comex are matched to longs in London’s forward market and therefore not a problem. This may be true of an independent trader looking for arbitrage opportunities between markets but is not how it works in a bank.

- Source, Goldmoney

Enter the Coronavirus Crisis, Banks to Be Overwhelmed With Debt Defaults

We have made the important point that before the coronavirus lockdown, the credit cycle was already turning down. Liquidity strains had surfaced last September, with the Fed routinely supplying tens of billions of dollars of liquidity through the repo market.

The monetary base, which represents the quantity of money in public circulation created by the Fed, is now growing at the fastest pace on record. But since January, a new problem arose: the disruption to production supply chains from the virtual shutdown of Chinese production due to the coronavirus.

The manufacture of anything requires multiple inputs, commonly referred to as supply chains. The concept of a supply chain suggests they are one dimensional: a series of production steps that go towards a single product. This is not the case. Supply chains are multidimensional and involve supplies from many sources in many jurisdictions at every production stage. The sequential shutdown of China, South Korea and much of South East Asia was followed by Europe, Britain and America. During these shutdowns almost all production and sales of non-food goods and non-essentials ceased.

While the assembly of a product progresses in one direction, payments flow backwards down the chain as each production step is delivered. The sum of the payments involved is far greater than the value of the final product. The global payment disruption is therefore significantly greater than the GDP number, which only consists of the sum total of final products bought by consumers. In the case of the US, an approximation of domestic payment disruption is contained in the gross output statistic, which is $38 trillion compared with a GDP of $21 trillion.

The US economy is significantly services-driven, with shorter supply chains on average than an equivalent manufacturing-based economy, such as China or Germany. If you add together supply chain payments abroad that feed into final goods sold in America, total payments for intermediate production stages in dollar-driven production probably add up to more than $50 trillion, the majority of which are now frozen.

To understand the impact of this new factor on bank credit, we must divide business customers into two classes; those with cash and those that depend on bank loans for working capital.

Both categories have establishment and other costs that continue despite the collapse in production. Those with cash liquidity draw it down to make payments, reducing bank deposits, which are recycled into other deposits which may or may not be with the same bank. When those deposits reduce existing overdrafts, bank credit contracts reflecting a loan repayment. When they amount to a simple transfer of deposit ownership, they do not.

The greater problem is with businesses that need loan cover for missed payments. There are so many of them with payment failures, bankers are being overwhelmed. Whether they realise it or not, they cannot afford to say no to demands for credit because Irving Fisher’s debt deflation problem is so urgent that to deny loan requests would likely end up wiping out the banks’ own shareholders’ capital and then some.

Supply chain payment failures are becoming a banking problem many times larger than the banking cohort shareholders’ capital. The ratio of US gross output to total equity capital for commercial banks in the US is nineteen times. In other words, unless the Fed can increase base money by at least that and somewhat more to compensate for a degree of bank credit contraction, the economy and the banking system will almost certainly crash.

In Germany, where the two major private banks shown in Figure 3 have balance sheet to equity ratios of 15.1 and 22.6, supply chain disruptions seem certain to lumber them with a fatal combination of dramatically widening commercial bond spreads and payment failures from the mittelstand.

Everywhere else, the problem is the same. The Fed has responded by reducing the cost of drawing down established central bank liquidity swaps lines, but they were only available to the ECB, the Bank of Japan, The Bank of England, Bank of Canada and the Swiss National Bank. Recognising the wider problem, on 19 March the Fed extended swap lines temporarily to the central banks of Korea, Australia, Brazil, Denmark, Mexico, New Zealand, Norway, Singapore and Sweden for six months. A notable absentee from the list is China, which one would have thought is the most important user of dollar liquidity based on trade. Politics trumps the delivery of monetary policy in defiance of the scale and urgency of the crisis.

The problems facing the whole banking system have never been greater. Individually, commercial banks are bound to take every opportunity to reduce their risk exposure before the market values of collateral, particularly equities, corporate debt and both residential and commercial property categories fall further in value. Banks will attempt to reduce their interbank exposure, particularly to European banks. Eurozone banks are likely to be the first to fail, needing state bail outs. Counterparty risk in over-the-counter derivatives becomes a major concern for all. And central banks are on a wing and a prayer if they think commercial banks will simply ensure liquidity gets to the right places in time to prevent a financial crisis.

- Source, James Turks Goldmoney

The Destructive Force of Bank Credit

Never has it been more important to understand the psychology and motivation behind changes in the level of bank credit at a time when governments and central banks are relying on commercial banks to transmit Keynesian stimuli to distressed borrowers. And never has it been more important for analysts to differentiate between deflationary forces that come entirely from the contraction of bank credit and inflationary forces that arise from central banks’ monetary policy.

Whether policies to rescue economies from the financial and economic effects of the coronavirus will actually get to the intended businesses depends largely on the transmission mechanisms for base money. While special powers for direct funding of large corporations may be implemented and the extension of public ownership to prevent bankruptcies of large players is very likely, commercial banks will be expected to play a central role in distributing monetary stimuli to businesses of all sizes. But since they regard small and medium size businesses as either too risky or not worth bothering with, it will be a struggle to get them to deliver the financial support intended.[i]

In any advanced economy, a Pareto 80% of GDP is provided by small and medium-size enterprises. In a highly centralised banking system, for the banks that have access to the Fed through prime broker subsidiaries, SMEs are simply not worth bothering with. It leaves the majority of enterprises providing goods and services to the public out in the cold. Bankers looking through the dip will want to preserve more profitable relationships with large corporations and reduce their exposure to risky, expensive-to-administer smaller loans.

Despite the central banks’ generous intentions, the majority of businesses that rely on bank lending for working capital will therefore find finance frozen by bankers now driven by fear of risk instead of grasping lending opportunities underwritten by government support. Businesses with cash will learn that they are taxed by the debauchment of their money to subsidise failing competitors.

Investors who are used to getting positive returns solely on the back of expansionary monetary policies are now egging on the authorities to spend, spend and spend one more time. Penson funds and insurance companies in particular will now discover they are being lumbered with the cost of monetary expansion by an increasing depreciation of the currency, which escalates future liabilities. Ever since the investment industry pandered to the inflationary policies of central banks this outcome was inevitable, because both logic and sound economic theory tell us you cannot continually inflate your way out of trouble.

That end point is where we have now arrived. The state has come to rely completely on inflationary stimulation. The helicopters have warmed up and are ready to distribute monetary largess created by the magic of central banking, not just to individuals, but to their employers as well.

Mission impossible is to restore economic activity to where it was before the coronavirus shutdown. Politicians assume is can be achieved by deploying military precision. They have taken for themselves a mandate to sweep aside all bureaucracy and all objections to the role of the state. All it requires is for the banks as well as other critical actors to submit to their authority.
The credit cycle was turning down before the virus hit

It ignores the impact of the credit cycle, which was already turning down in the second half of last year. In response, the Fed first stalled its attempt to restore its balance sheet to normality and from September onwards was forced to publicly intervene to inject massive amounts of liquidity into the banking system through the repo market.

All was not well in wholesale dollar markets at least five months before the virus hit, so the problem is more complex than a simple return to normality when the virus passes. Furthermore, the authorities trying to keep the economy from imploding are out of their depth, so much so that individuals in the private sector are gradually realising it as well. Financial risk has escalated considerably, which has one effect: bankers will use every opportunity to reduce the size of their balance sheets. The authorities will struggle to get banks to hold fast, let alone distribute subsidies to producers and consumers alike.

Attempts at rescuing the global economy and supporting financial asset values upon which bank collateral is based will require massive inflation of base money, as outlined later in this article. But these attempts will have to fight bankers trying to control their lending risk in order to protect their shareholders’ capital from being wiped out. Their motivation to deflate bank credit will be greater than ever before.

An appreciation of the deflationary implications of the current phase of the credit cycle requires an understanding of how bank credit fluctuates and the predominantly psychological factors that drive it.
The origins of bank credit

The general public is not aware that there are two separate sources of money. The central banks are empowered to issue money, but commercial banks do so as well. One way they do this is by taking in deposits and then lending them to borrowers for an interest rate turn. When the borrower draws down the loan to make payments, more deposits are created as the payments are made.

A second course of money creation is simply by lending money into existence. In this case, the loan is created first, and as it is drawn down, deposits are created. This is regarded as the more usual practice, hence the description of the process being the expansion of bank credit. Any imbalances that arise between banks are resolved through the interbank market.

By these means a bank’s own capital becomes a fraction of the bank’s expanded liabilities, hence the term fractional reserve banking. Figure 1 shows the barebones of fractional reserve banking, with a bank’s balance sheet measured in monetary units (mu), early in a phase of credit expansion.

This balance sheet reflects a cautious approach to bank lending. Shareholders’ equity is valued at one third of customers’ deposits and is covered twice by government bonds, which will all be less than five years to maturity and is regarded in the banking system as the risk-free investment standard. At this stage of the credit cycle and with the banking community generally risk-averse, lending margins are profitable. The ratio of total assets to shareholders’ equity is five times. Put another way, profits and losses from changes in asset values are multiplied five times at the shareholder level.

Figure 2 shows the same bank’s balance sheet towards the end of the expansion phase of the credit cycle.

The economy has responded to both monetary stimulation from the government’s deficit spending and interest rate suppression by the central bank. The cohort of bankers has seen a lessening of lending risk and has responded by actively seeking lending opportunities among large corporations. Bankers are now lending increasingly to medium size corporations as well as investment grade rated borrowers where the margins are better. Falling unemployment and growing economic confidence decreases lending risk for credit card and other consumer debt, and the bank has extended additional credit for creditworthy customers. Liquidity from government bonds and bills has been drawn down in order to increase allocation to higher-yielding corporate debt. The balance sheet has expanded to give an overall gearing on shareholders’ equity of 12.5 to 1.

This means a two per cent margin averaged across total assets yields a 25% profit on share capital. But by the time this snapshot is taken, competition from other banks will have likely reduced lending margins generally, and the bank has responded by taking an even more aggressive lending stance, so lending margins overall are likely to be less generous than at the start of the credit cycle and loan quality will have deteriorated.

While shareholders are enjoying excellent returns, it has become a highly risky situation for the bank. The slightest pause in the economic outlook, whether it be from interest rates being raised by the central bank attempting to control the boom, or perhaps an exogenous factor, such as trade tariffs being raised between the bank’s jurisdiction and a major trading partner, will cause the directors of our bank to switch from greed to fear in a heartbeat. In our example, all it takes is losses of 12.5% of the bank’s assets to wipe out shareholders’ equity.

If one bank suspects there may be a deterioration in trade conditions, it is certain that others will as well, because they have similar business information. Due to the dangers of balance sheet gearing, bankers are exceedingly prone to groupthink.

When it happens, the switch from greed to fear travels like wildfire. But some banks are likely to be caught out, having been aggressive lenders trying to increase the size of their bank, often with a chief executive on an ego trip. Fred Goodwin at Royal Bank of Scotland was a recent example. Ignoring all signs of the ending of a cycle of credit expansion, Goodwin pushed through a consortium takeover of ABN-AMRO in October 2007, with RBS’s portion funded by debt. The bank’s balance sheet gearing became twenty-four to one.

With gearing of that sort very little needs to go wrong to wipe out shareholders equity, which is what happened. Failures of this type are an acute risk when the banking cohort has been lulled into a false sense of lending risk by a prolonged period of business stability combining with the siren’s beckoning of a financial bubble.

Reducing bank balance sheets without creating economic instability is virtually impossible. Driven by their groupthink, frightened bankers will seek to reverse credit expansion all at the same time. They sell corporate bonds in a market with no buyers. Spreads, the difference in yield between government bonds and riskier corporate debt, blow out, catastrophic for book values. Business and personal loan facilities are capped and withdrawn, driving many companies into the hands of insolvency practitioners. It can become a race between bankers to reduce the size of their balance sheets before their competitors, as the rapid withdrawal of bank credit triggers bankruptcies and unemployment. It has happened repeatedly for the last two hundred years.

The economic effect was summed up by economist Irving Fisher in the 1930s, who is forever associated with the theory of debt deflation. As the oxygen of credit is withdrawn, businesses get into trouble and banks begin to liquidate collateral. Liquidation of collateral drives their values even lower, exposing additional formally secured lending as no longer secured. Further collateral sales follow, driving collateral values down even further. And so on.

That was in the depression years, and Fisher’s point was to link the collapse of businesses, asset values and also the failure of banks themselves with the contraction of bank credit. Subsequently, central bank policy has focused on trying to anticipate and stop the deflation of bank credit in the first place, always ready to turn on the money spigot. The government then subsidises the economy by increasing its spending without raising taxes. By using the stimulus of unfunded government spending and central bank money creation, the government and its central bank are following the Keynesian economic playbook, which now sets the relationship between the state and private sectors.

Despite everything attempted by statist intervention, we still have periodic bouts of bank credit deflation. But matters have evolved from the simple model illustrated in Figures 1 and 2 above. Banking has become highly regulated, and banks now lend on a formulaic basis, set globally by the Basel Committee (we are on rules version 3) and by local regulators.

Earlier versions of these controls permitted Fred Goodwin to take the RBS balance sheet gearing to credit hyperspace. They say lessons were learned, but the only lessons learned by the regulators were new ways to keep their eyes shut and ears plugged. Stress testing of bank balance sheets assumes little more than a moderate recession and denies the likely consequences of anything worse. The economic crisis starts with a change in banking cohort groupthink, and not, as regulators with their useless stress tests assume, a decline in GDP, a rise in unemployment, a rise in price inflation, or Heaven forfend, an unexpected financial crisis. And if you think extreme bank leverage would have been controlled following the Fred Goodwin episode, think again. Figure 3 shows current balance sheet to equity ratios for a selection of major banks. Through the magic of modern accounting practice, they are almost certainly higher than reported.



From the few examples in Figure 3 we can anticipate bank failures to originate in Europe in the event of a general contraction of bank credit. Despite reducing its balance sheet significantly in recent years, Deutsche Bank is in Fred Goodwin territory, closely followed by BNP and Barclays. And the credit cycle has very obviously turned down again. The regulators persist in behaving like the three wise monkeys, wholly unaware there is a credit cycle and what these ratios indicate.

The large American banks are not so heavily geared, but that will not protect them from the global credit contraction that will now intensify...

- Source, James Turks Goldmoney

Gold Starting A Historic Rise, Huge Gains to Come

"Looking again at the chart pattern, at the moment the right shoulder is being formed. Again the price movement captured in this chart reflects what’s happening with investor psychology. 

As I mentioned earlier, the forced margin selling has ended. Gold has not made a new low and is starting to rise.

Now that investors once again have liquidity in the form of US dollars and other fiat currency, they are asking themselves what is safer: Physical gold with its 5000-year track record? 

Or fiat currency that is likely to see an accelerated rate of debasement in the months immediately ahead? Owning physical gold and silver in my view is the safer alternative.”

- Source, King World News

James Turk: Gold Should Hurdle $1700 In Days, But This Will Be The Big Surprise

“This chart of Jun’20 gold futures is powerful, Eric. It’s the chart I mentioned in our KWN interview that you just posted on the weekend. 

My experience has been that head-and-shoulder patterns are usually reliable. The chart pattern is not yet complete. That won’t happen until gold hurdles above the neckline around $1680 or so.

Reverse Head & Shoulders Pattern On Gold

Points To A Massive Rally

The Big Surprise

Nevertheless, though incomplete the pattern now being formed is communicating a clear message. Gold is forming a huge base of accumulation, and bases like these result in higher prices, which signals the margin liquidation in the gold market has ended. 

Looks like it should only be days before gold hurdles $1700. But the big surprise for investors will be that when this happens the gold market will see new record highs above $1910 very quickly…

The head is usually formed at a selling climax, and we just went through one of those. 

The recent low in the gold price was reached as a result of liquidation and forced margin selling as a consequence of too much debt in our world’s over-leveraged financial system. 

The low in the gold price was not the result of any deficiency or problem with gold. Gold is still a safe haven because physical gold does not have counter party risk.

- Source, King World News

James Turk On The Next Bubble To Burst And Free Market Gold

“Free market (governments call it ‘black market’) is taking control of gold, just like after the March 1968 collapse of the central bank cartel called the London Gold Pool. CBs quoted an official price below real price. Fed still books its gold at the ‘official’ price of $42.22/oz.

All price trends eventually end and record low yield on Treasury Bonds could be the next bubble to burst. Printing by Fed has so far kept US gov’t liquid and appearing solvent but something has to give. Higher yields seem inevitable if there is any pretense to preserve US dollar purchasing power."

- Source, King World News