Why cash is a great place to be right now

November 7, 2011
Manila, Philippines

[Editor’s Note: Sovereign Man Chief Investment Strategist Tim Staermose is filling in for Simon today.]

Last week, I sent my 4th Pillar subscribers an issue warning them of a sharp rally in the US dollar. Since then, the euro has fallen from above 1.40 to 1.379.  The pound weakened from 1.6165 to 1.603.  And the currency we watch most closely in the 4th Pillar, the Aussie dollar, dipped from above 1.06 to 1.0375.

I issued this warning because it is becoming abundantly clear to me that we’re in for another prolonged bout of deleveraging in global financial markets.   You’ve heard this term “deleveraging” before, no doubt.  But, let’s step back discuss in simple terms what it actually means.

The way the modern banking system works is that banks use their depositors’ funds to make loans or purchase securities.  Regulators require them to hold a certain amount of capital against these “assets,” and the amount is known as the “Capital Adequacy Ratio.”

The idea is to ensure that the bank will still have money on hand if its asset portfolio goes bad.

Now, things are fairly predictable in the day-to-day course of banking business.  Money is lent out, paid back, deposited, and withdrawn. To guard against fluctuations in activity and imbalances that arise in the normal course of business, the bank keeps a certain amount of liquid cash (and near-cash instruments) on hand as a buffer.

When sudden volatility strikes, the amount of liquidity banks wish to hold goes up… sometimes dramatically.

With all the turmoil in Europe’s debt markets right now, and the collapse of the global futures broker MF Global last week, we’re in a heavy period of volatility right now.  Banks are all scrambling to get their hands on cash in order to have larger buffers against system shocks.

Moreover, longer-term factors are at play beneath the surface, which reinforce this trend.
Capital adequacy ratios are complex calculations, but the basic idea is that the riskier the loan made, or security purchased, the more capital a bank should set aside against it.

However, in their wisdom, the bureaucrats at the Bank for International Settlements (BIS), which sets global capital adequacy standards for the banking industry, deemed ALL bonds issued by ANY Eurozone governments to be “risk free.”

You don’t need to be Einstein to see the problem here.

The government bonds of Ireland, Portugal, Spain, Italy, not to mention Greece, have ALL fallen dramatically in value.  In the case of Greece, an official write down has already been agreed to.

As a result, banks around the world– most notably the German, French, and Italian banks– are going to see huge holes appear in their balance sheets FOR WHICH THEY WERE NOT REQUIRED TO SET ASIDE ANY CAPITAL.

These losses are very real, however, and they will have to be paid for out of banks’ capital.
As a result, to maintain their mandated capital adequacy ratios (risk-weighted assets/capital), the banks need to do one of two things.

1.  Raise fresh capital (increase the size of the denominator).
2.  Shrink their at-risk assets (reduce the size of the numerator).

Right now, most banks either cannot raise fresh capital, or do not want to do so at current depressed share prices (as it dilutes the stakes of the guys who make these decisions).
That means option 1 above is largely off the table.

So instead, they are all going to try and tackle the problem from the other side of the coin and shrink their assets instead.   That means they are calling in loans, selling securities, dumping collateral that they’ve seized, and so on.

All of this is draining liquidity from the financial system and setting off a huge scramble for cash.

It won’t work. Since the banks are all trying to unload assets at the same time, the price for those assets will plunge, which in turn means they will have to take losses.  And losses are just hits against capital. Which puts them back to square one. It’s a vicious circle.

And that’s why I believe that right now, the best place for you to have the bulk of your investment capital is in CASH.  That’s the asset in greatest demand in the global financial system right now.  Its value is going up.  And the value of most stocks, bonds, and other securitized debt is going down.

The 4th Pillar Model Portfolio (which I manage) is 65% in cash (half in US$, half in A$) at the moment.

Ironically, government bonds of the USA, Japan, and the UK, which are all heavily indebted, and either being downgraded, or on watch to be downgraded, are all still considered “risk-free” in the computation of banks’ capital adequacy ratios.  So they will probably also benefit from the scramble for safety and liquidity… for now, at least.

The next shoe to drop will be when these other sovereign bonds issuers go the way of the PIIGS.  I don’t expect that to happen any time soon.  But, one by one, the “risk free” instruments in which the global investment herd can park its money are being eliminated.

When this does, you can plan on a triple-digit silver price and five-digit gold price.

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