Crisis Progress Report (14): Global Margin Call, by Robert Gore

A tedious ritual this time of year is lengthy Review and Preview articles, in which financial publications and websites highlight the year’s winning picks, acknowledge the losers, and prognosticate about the coming year. Does anybody read them? Probably not. The only way SLL’s Review and Preview will get read is if it’s short, so here goes. The year 2015 in review: SLL pretty much got it right (see Debtonomics Archive for confirmation). Preview of 2016: things will get much worse. There, that’s out of the way.

The global economy has been sucked into the event horizon of the black hole of debt. The world does not enough assets and cash flows to service $225 trillion in debt, or almost three times gross world product, and sustain economic growth. Most financial assets are somebody’s debt, an increasing percentage of which is impaired, and mounting debt service is taking a larger share of cash flows. Consequently, trend growth rates are declining, with some countries already in recession (e.g., Canada, Russia) or depression (Brazil).

This is the margin call phase of debt contraction. When speculators employ leverage, they put up some percentage of the initial speculation, called equity, and borrow the rest. The loan is secured by the speculative asset. If the price moves against a speculator and equity shrinks, the lender will demand that the speculator put up more money (or “margin,” hence the term margin call). If the speculator is unable to maintain the required equity, the lender liquidates the collateral-asset.

Here we have the dynamics of debt contraction writ small. The initial extension of credit supported a speculation; the price moved in the undesired direction; the creditor restricts credit to the speculator; the speculator, creditor, or both sustain losses, the speculator has less money, and so will the lender if it shares in the loss. The loss may have ripple effects throughout the economy if one or the other or both curtail future speculation, lending, or consumption.

The most leveraged sector of the economy receives the first margin calls. There’s always a story that supports the rush to grant unwise extensions of credit. In 2006, the story was that house prices never go down. In 2014, the story was China, whose perpetual hyper-growth would supposedly fuel a commodities and raw materials supercycle. When the Chinese economy slowed last year, miners, oil drillers, and other raw materials companies that had borrowed heavily to fund expansion for the Chinese market got the margin call.

Cash-strapped borrowers facing margin calls have only two options: borrow more or sell assets. Behind almost every graph showing a vertiginous drop in the price of an asset are leveraged sellers trying en masse to repay their loans. Such drops in a number of commodities were dismissed at the end of last year in various Reviews and Previews as isolated and aberrational, but they were the first margin calls. SLL said at the time: “The future is now. The carnage in the oil sector, where a glut has knocked over a third off its price in less than five months, is not an aberration, but a harbinger—the shape of things to come across sectors and around the world.” (Oil Ushers in the Depression, 12/1/14).

These margin calls have commodities and raw materials producers on the ropes. In the debt-based global economy, there is no way a margin call in a large sector will stay contained to that sector. Most assets are either encumbered with debt or are in fact debt. When a significant part of the interconnected debt matrix runs into trouble, it spreads to the rest of the matrix.

The prices of debt issued by commodity and raw material producers have crashed and their debt has been downgraded by the ratings agencies. The margin call is rippling; the yield spread between junk bonds and US Treasury benchmarks has widened for all issuers. Last week a junk mutual fund and a junk hedge fund, faced with mounting losses and customer withdrawals, refused to honor further redemption requests for an indefinite time period. They cited fire sale prices for junk debt and illiquidity: the failure of the market to provide deep enough bids for them to unload their positions. However, the liquidity they were counting on is funded by debt. When debt contracts, that pool gets shallower and eventually evaporates, usually just when sellers are stampeding to get out.

Evanescent liquidity in financial markets is funded at close to the Federal Reserves microscopic interest rate target on federal funds, now between zero and twenty-five basis points, or one-quarter of one percent. This week the Fed will most likely raise its target rate twenty-five basis points. That raises the cost of doing business for leveraged speculators, which will impair liquidity to an unknown extent. Many are treating the Fed’s hike as a defining moment for financial markets and the economy. David Stockman, with whom SLL is generally in agreement, said: “Yes, the end of the bubble does begin on December 16th.”

While the Fed may finally mark up the cost of credit to leveraged speculators this week, they are following, not leading, credit markets, which have already marked up the cost of credit, and by a lot more than twenty-five basis points, to leveraged speculators in oil, natural gas, coal, iron ore, aluminum, steel, container ships, railroads, trucks, factories, infrastructure projects, buildings, and more. The Fed move may be the coup de grâce for stock prices, which for most companies are already well off their highs, but with all due respect to Stockman, the end of bubble arrived over a year ago.

There may be an interesting twist to this margin call and debt contraction. Usually debt supports long positions in assets. Figures indicate a preponderance of speculative short positions in the gold, and to a lesser degree, silver futures markets. Leverage can fund short positions as well as longs. Claims have been made that central banks and the banking industry have a vested interest in suppressing the prices of precious metals and have in fact done so. This, so the argument goes, has created a massive imbalance between the amounts shorted on paper in the futures market and actual physical precious metals available for delivery.

SLL does not dismiss this speculation because it may be right. If so, those leveraged speculators who are short the precious metals could get caught up in a margin call reflecting the general contraction in debt and fall in asset prices. In the reverse of the usual situation, they would have to close out their positions, buying either futures or the physical metals. We may see some spectacular short-covering fireworks, sending the prices of precious metals explosively higher while everything else is going down. This is conjecture, not a bet-the-ranch proposition. SLL has been bullish on the precious metals for some time, and this may be yet another reason for bullishness.

Baron Rothschild, a 19th century member of the banking dynasty, is credited with saying: “The time to buy is when there’s blood in the streets.” Since then, speculators have tried to catch falling daggers, rationalizing that financial losses already sustained by other speculators amounted to “blood in the streets,” but usually only impaling themselves. Rothschild meant that one should wait to buy until there is literally blood in the streets, crimson rivers of it. Full-bore bear markets and depressions are accompanied by wars and tectonic political shifts, even revolutions. During these troubled times, most of us should stick with cash, provisions, firearms, and some precious metals, reduce or eliminate debt, and avoid speculating from either the long or short side. However, nothing lasts forever and eventually the financial landscape will be dotted with screamingly cheap survivors of the carnage. When to dip a toe in the investment waters? Follow Baron Rothschild’s advice.

A GREAT NOVEL, A GREAT CHRISTMAS PRESENT

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