July 11, 2007

More thoughts on selling off assets to raise cash, hedge fund blowups and getting ready in a post-housing-bubble world

In Manias, Panics and Crashes, the most important words to remember for what always happens during a boom and bust are these:

The final phase is a self-feeding panic, where the bubble bursts. People of wealth and credit scramble to unload whatever they have bought at greater and greater losses, and cash becomes king.

I know a lot of us struggle with the idea of "rushing" to US dollars, and cash. What about gold! What about oil! What about other commodities! What about foreign currencies and stocks! What about baseball cards!

Yes, intuitively that feels right. But at the end of the day, when the hedge funds, pension funds, banks and foreigners find themselves in the inevitable selling freefall during the Great Unwinding, they'll sell their most liquid assets first (gold, stocks, bonds, commodities, etc) to raise cash to avoid margin calls and total wipeout. So everything - EVERYTHING - will fall in dollar terms initially as investors raise dollars.

And then the illiquid assets go at firesale prices - anything to get them off the books and turn them into desperately-needed cash. I think the biggest unresolved question pertains to the definition of cash - and the US dollar. I think the dollar is an asset class to itself, and foreigners during the panic may rush to the dollar as a flight to 'safety', or they may dump dollars in favor of 'safer' currencies. That's the great unknown.

As a final exercise, weigh this "rush to cash" concept against these words regarding the CDO/Bear Stearns/Hedge Fund disaster underway:

The risk to the financial system was not merely that some large brokerage firms may have been forced to write down a couple of hundred million dollars – they may still have to do that. But had the fire sale gone through, market values would have been available to the securities sold.

This in turn would have forced other lenders to revalue the collateral they hold; and as the collateral is worth less, the brokers will lend less money. That would have triggered further margin calls, further forced liquidations.

When hedge funds implode, they tend to sell off more liquid assets first; at the end of the sale, the prices of the liquid assets are depressed, yet the fund may still be left holding illiquid securities.

To illustrate this, take the example (this is not the Bear Sterns fund) of a hedge fund that may make bets on CDOs and, say, the price of oil. As such a fund needs to raise cash, it would close out the more liquid oil positions, causing a spike (or drop – depending on which way the unwinding works) in the price of oil.

The resulting volatility in the markets would be most painful for leveraged investors in the oil market, although the crisis originated in the CDO market.

Too many leveraged investors have become complacent because the low volatility we enjoyed in recent years. Aside from the short-term volatility, the high leverage employed by many hedge funds would need to be reduced permanently. As speculators pare down their leverage, they sell off assets to raise cash.

30 comments:

decaffeinated said...

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Every time there's been a "prolonged" sell off in the stock market in the past two years, gold and silver have sold off as well. And yet, and yet, the gold/silver bulls tell us over and over again that precious metals are true money.

When the next market dislocation occurs (whether it be bonds or equities or both), I expect just about every asset class to get pounded. Why? Margin calls at hedge funds. Remember, the hedge funds hold a diverse collection of assets.

In this current sea of liquidity, I don't believe there are any safe havens other than cash held in a currency (or currencies) of your choice.

Anonymous said...

Watch out!!! Wolf is coming ... coming... since past 2 years.

Stock futures up.

Anonymous said...

dude you have been saying the "big one"is coming every month for 2 years. WTF is it already

Concerned Citizen said...

My sense is that investors who short the gold are the same ones who prop up the stocks and buy CDOs. If that is the case, things may not be as bad as you think for gold.

Anonymous said...

concerned citizen makes the good point. Us regular folk usually focus on the long position, but It all depends which way the bet goes. Liquidation of short positions can cause a "short squeeze" requiring the shorts to be covered at any price and therefore sky rocketing values.

slingshot said...

The problem with your "panic selling" scenario is you assume the existence of buyers for the toxic paper and CDOs. These are not liquid like stocks, and no efficient markets exist that could move them easily. Much of the downgraded paper will probably just sit there, imparing the ability of its owners to access additional credit.

As for the USD, it is the world's reserve currency, what would the "dumpers" use as an alternative? In any major crisis, I'd expect the USD to strengthen, not weaken as you suggest.

The obvious solution is for the central banks to inflate this problem away. Inflation, even severe or hyperinflation, is far better than a deflationary depression.

Anonymous said...

So I should sell the dollar to get into cash ???

hmmmm ....

Consider the dollar is 2 points off it's all time low. Maybe we should all buy hard assets ? You know, like real estate ... LOL

Anonymous said...

Yes Keith, you should sell all your EUR, GBP, CAD assets and buy USD. That should work out really well for you. Will we break 80.5 today folks? Methinks so. Will we break bottom of this bear wedge in USD? Yah, I think. Please, guys, buy my USD. I'll take whatever.

-Matt C

David said...

I've just recommended that some clients put of $1,500,000 in cash, $1,400,000 in World Bond Funds that hold currently about 1/2 U.S. Gov. shorter maturity bonds and 1/2 Gov. bonds of other major countries, including Europe, Japan and England. The Remaining $100,000, we've put double short the Nasdaq. My idea is that if interest rates or oil prices spike, that will kill the stock market and boom up the price of the opposite the stock market investment. If there is a rush to quality assets, then high quality, shorter maturity soverign debt may become desirable as investors seek to pay debt and move to more secure assets. The percentage of U.S. v.s. non-U.S. bonds and the durations are constantly being adjusted by the fund's multiple managers. This seems reasonable to me, but probably not to some of you. Any comments??

Anonymous said...

Keith is like Fred Sanford of Sanford & Son:

"This is the big one!" "You hear that, Elizabeth? This is really the BIG ONE!!"

Anonymous said...

Laura Vell said: I'm long on gold and gold stocks - however, not right now. Seems to me, companies/hedge funds that are behind the leverage ball will have to sell all assets to cover losses on these CDO's and other toxic investments.

Anonymous said...

This whole crash thing is taking longer than I thought it would. I've been holding cash for 6 months and the stock market is still going up. What gives? I feel safer with cash, but I would like to feel justified for cashing out of the market. Things are not slowing down here in the Norfolk/Virginia beach area (lots of money being spent on everything)

Anonymous said...

I know that gold is up, but has anyone bought ammo lately, it must be up 80%, are lead prices up that much or is a supply/demand problem?

Anonymous said...

Gold in not a hedge against inflation. Gold's price is a measure of fear.

There are two main risks now:
1) A Financial system crisis
2) Inflation

Cash will work best as safe haven for any Financial system crisis, but not a for the long term problem of Inflation.

For long term Inflation, the only solution is land. Not real estate, not McMansions. Land.

I suggest asset allocation of 50% cash, diversified amoungst the top 5 currencies. Take no single currency position more than 20%.

I suggest you buy undeveloped land just outside major metro areas. Not vacation property area. Not city land. Suburbs land.

Anonymous said...

got shadenfruede?

Anonymous said...

In my opinion, you have to assess your market weight in each of these asset classes.

I think itulip's Ka-Poom theory is most likely what will happen. Here's an article about Ka-Poom

http://www.itulip.com/forums/showthread.php?t=417

A short period of deflation (all asset classes lose value) and then a Poom period of massive inflation (100% inflation over 4 years) as they inflate new bubbles elsewhere (they're predicting alternative energy as one of the new bubbles).

Massive inflation means the dollar is continuing to lose value. I think this means commodities, gold and oil will be going up as the dollar falls. Foreign currencies are also a good choice, foreign sovereign debt and equities are also risky, but could be good choices as well.

Jymkata

vegas crash watcher said...

I think interest rates will rise before gold falls, then rates will come down as gold sellers and everyone else seeks a safe haven in the US$. For those complaining about the timing (the crash has been predicted for too long) the crash won't start until the last buyers (the people complaining) have given up an bought. Only then will there be no more buyers.

Bismark said...

Gold mirrors the world reserve currency: U.S. Dollar. Inflation = gold goes up. Deflation = gold goes down. Unwinding is deflationary. People/firms rushing to cash not going to spend cash. Hold onto it. Deflationary. Govt will turn on the printing presses to get the economy out of the nose dive. You will get killed holding dollars in a hyperinflationary depression. Can always sell gold for ANY fiat currency.

Ryan said...

Can anyone help me? Are there any banks that offer savings accounts in the states that will allow me to keep a balance in Euro. If not, any recommendations on which European banks offer the highest yields??

Anonymous said...

How did this "cash" work out for citizens of Weimar Germany? Oh, not so well.

Stagflation Stan said...

What happens in the short run is very difficult to predict. Are the hedge funds long or short gold? More to the point, are the hedge funds that will get into the most trouble net long or short gold? That is why it makes sense to hold a prudent mix of asset classes and have *enough* of your local currency of choice (probably the one that's used to pay for food, gas, and rent) to avoid having to sell your gold and silver at (possibly) temporarily depressed prices.

In the intermediate to long term, it is clear that gold and silver will outperform dollars, euros, etc... They can't print gold, and when the inevitable downturn comes, you can bet the policy response will be inflationary. Maybe some of you need to go back and re-read the speech that earned the current Fed chair the nickname of "Helicopter" Ben.

The result will probably be some version of stagflation - a wonderful environment for the true hard currencies, namely gold and silver.

Note that by holding fiat "cash," you are losing money to inflation every day since interest rates are below the true rate of inflation. Going to anywhere near 100% cash in the hope of being able scoop up some deeply discounted gold and silver just doesn't sound like too good of an idea.

Anonymous said...

>> How did this "cash" work out for citizens of Weimar Germany? Oh, not so well.

And what about the gold? Yeah, that's right - it was confiscated (at gun point).

Anonymous said...

Anonymous said...
>> How did this "cash" work out for citizens of Weimar Germany? Oh, not so well.

And what about the gold? Yeah, that's right - it was confiscated (at gun point).

July 11, 2007 8:45 PM

--------------------

If you're trying to allude to FDR's gold confiscation, tell me, what percentage loss did gold holders take? Hint: it was a lot less than 100%, especially considering that prices of just about everything (stocks, real estate, etc.) were cratering during the 1930's.

That sure beats having your precious "cash" in a bank that folded (no FDIC insurance back then) or having 99.99999999% of your savings' value inflated away.

Me, I'll take gold over paper.

Out at the peak said...

Ryan: Everbank.com allows you to keep cash diversified. They have savings as well as CDs in many different currencies. You can also mix this with USD and see all assets with their "OneView". I've used them for over 18 months now.

Joel said...

I bought 1800 rounds of ammo (some 7.62x54R some .30 carbine some .45 ACP) and yeah, it's gotten really expensive. Maybe I should've just spent money on a reloading setup.

Kenduffelsniffenspotzen said...

I was driving around Green Bay today, and was amazed at all the "For Sale" and "For Rent" signs that I saw. Where did everyone go?

joe barley cairs said...

I'm glad these nitwits who invested in subprime and Alt-A bonds lost their arses. Yes folks, high yield, low risk investments are a scam pushed by boiler room types.

RJ said...

Slingshot said:
"The obvious solution is for the central banks to inflate this problem away. Inflation, even severe or hyperinflation, is far better than a deflationary depression."
-----------------------------------
I don't know Slingshot. It's sort of like asking,"Which is worse? Getting shot in the heart? Or getting shot in the head?"
Hyperinflation will in fact lead to a depression or contraction of the economy. You can't buy goods when money is worthless. I agree that central banks will inflate when they run out of options but hyperinflating is just as bad as excessive tightening of credit. Just bad in a different way.

Anonymous said...

When is the crash going to happen ?

In the Bay Area, house prices in the Santa Clara prime areas of Sunnyvale and Cupertino are still going up beyond 15% a year. $1M for a SFH in Sunnyvale where the same house could be bought for $450K in 1999.

slingshot said...

"I don't know Slingshot. It's sort of like asking,"Which is worse? Getting shot in the heart? Or getting shot in the head?"
Hyperinflation will in fact lead to a depression or contraction of the economy. You can't buy goods when money is worthless. I agree that central banks will inflate when they run out of options but hyperinflating is just as bad as excessive tightening of credit. Just bad in a different way."


Yes, both are bad, but inflation is self limiting. There is no lower limit to a deflationary spiral, unless you count death by starvation as an end game. Look at what happened in Japan -- ten years of hell for one of the most advanced and savvy groups of people on the planet. That's why Bernanke vowed to never allow deflation in the U.S. economy.

In today's electronic economy, I think we could probably deal with high levels of inflation better than the days when cash and paper check transactions dominated.