Matterhorn Asset Management

NO, THE EMPEROR HAS NO CLOTHES

by Egon von Greyerz

MELTDOWN

For anyone who has been reading our reports in the last few years it comes as no surprise that the banking system is crumbling. In the last week we have seen AIG being nationalised, Lehman go bankrupt, Merrill Lynch swallowed up by Bank of America and HBOS bought by Lloyds TSB. The week before Fannie and Freddie were nationalised.

We have been warning investors that the banking system is bankrupt and have named all the above names and some others as being vulnerable. So finally the world has realised that the Emperor Has No Clothes. What is happening now is not surprising. What is more surprising is that the unsustainable excesses have not come to an end earlier. The banking system has been a house of cards for years with totally untenable leverage and risk. But governments and banks as well as corporates have been engaged in a game of collusive back scratching. They have all had a vested interest in expanding the bubble whether it is based on power or greed.

“Mother of all financial Crisis”
So are we getting near the end? No we are at the very beginning of an implosion of the credit bubble.

Former Fed Chairman has called this “the Mother of all Financial Crisis” and George Soros recently stated: “I’m afraid we are not through it at all — in some ways we are still heading into the storm rather than heading out of it,” Soros also stated that the UK is likely to be the economy most badly hit by the crisis due to the reliance on the financial sector.
First the investment banks were saved by the sovereign wealth funds. But we remarked at the beginning of 2008 that these funds were not going to throw god money after bad. So the only lender of last resort was always the government. It started with Northern Rock in the UK being nationalised but now we are into the big stuff with the US Government being the biggest financial institution in the world after the purchase of Fannie, Freddie and AIG and planning to spend considerably more in their attempts to save the financial system.

Several down, many more to go
The investment banks had to be the first to go due to their excessive leverage of thirty times or more. But the real leverage is considerably higher since derivatives are not taken into account. The nominal value of derivatives in the investment banks runs into trillions of dollars. When these banks default, nominal value becomes real value. With the collapse of Lehman counterparties have potential liabilities of tens of billions, maybe hundreds. At this stage banks don’t even know their liabilities in relation to Lehman.

Two major banks (Merrill and Lloyds) have merged with commercial banks. Other vulnerable banks are in merger talks. The problem is that there are few banks big enough to take on the risk of acquiring a major investment bank or financial institution. Morgan Stanley or Goldman Sachs for example could be acquired by JP Morgan or a Chinese bank but UBS is too big for anyone without being broken up. The problem with UBS is that it is even too big for the Swiss Government to rescue.
So the world is running out of banks big or strong enough to rescue the failing banks. Commercial banks have so far avoided major writedowns but this will change. These banks’ exposure to the consumer, property and corporate markets will soon lead to substantial increases in bad debts which will make them vulnerable too.

Government, Lender of Last Resort – Consequences
It has been very clear to us for quite some time that there is only one lender/investor of last resort which is the government. The US government has so far stepped in to provide unlimited liquidity to the banking system and so have European and Far Eastern Banks. But all of these trillions of dollars have not even succeeded in keeping the financial system afloat. Except for the failures mentioned above there is the massive problem of an interbank market which is totally paralysed even after the continuous injection of trillions of dollars of liquidity by central banks.
The US treasury had to let one bank fail due to moral hazard. Otherwise it would have been worthwhile for all participants to take ever increasing risks since the government was always standing behind. But from now on it is unlikely that, if it can be avoided, any major bank or financial institution will be allowed to fail. (Smaller banks in the US fail almost every week).

US Government bankrupt
The consequence of saving every financial institution or buying toxic debt from troubled banks is a massive expansion of money supply and galloping inflation. Setting up a separate US government financed vehicle would have the same effect. Let us be very clear the US government has no money. They are already insolvent and totally dependent on foreign investors to finance their massive deficits. A vehicle that takes over all toxic debt would need to be capitalised at a minimum of $ 500 billion for starters. This is money that doesn’t exist and therefore must be printed. Foreign holders of US debt would then dump their dollar holdings making the dollar crash and US interest go up significantly. Another insoluble problem is that even if a government financed vehicle takes over all toxic debt it cannot take over the toxic derivatives of $ 1 quadrillion. A major part of $ 60 trillion Credit Default Swaps (CDS) is worthless and is too big for any government to rescue. Whatever rescues are undertaken in the short term the CDS market will eventually lead to catastrophic problems and defaults, including sovereign defaults, in financial markets.

PROTECTION, PROTECTION, PROTECTION

We have in the last six years warned investors that the current financial crisis would arrive. We have also advised investors to invest a major part of their liquid assets in precious metals stored outside the banking system. So far these investors have, since 2002, made between 100% and 200% return depending on their base currency. But this is only the beginning. Short term there will always be volatility and the correction that we have seen in the last two months is totally normal, albeit unpleasant. Over the next few years we expect precious metals to increase substantially in value, possibly even exponentially.
We are still not certain if we will first have massive inflation due to all the money printing to save the system or if the financial system can’t be saved in which case we will experience a systemic event with dire consequences.
In either case precious metals will be a major beneficiary and is one of the few investments that will benefit whatever the outcome. In addition it is one of the few investments, if stored outside the banking system, which fulfils the criterion of true wealth preservation. Investors who have not protected themselves in the current environment are exposed to risks which are both immeasurable and uncontrollable.
There is no change in our views on other investments. Stockmarkets will fall, probably dramatically, during the autumn. Government Bonds are a poor investment since money printing will destroy their value. The US dollar will fall substantially. Longer term the commodity boom is not over and especially agriculturals will resume their strong uptrend due to China and India.

Please remember the words of Mark Twain:
“I am more concerned about the return of my money than the return on my money”.

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