The Lesson From a Scandal

By Dan Denning, Editor, Australian Wealth Gameplan 

Is it just me or has everyone forgotten the whole scandal emanating from MF Global about hypothecation and rehypothecation?

A new financial term seems to enter into common use every few months or so. This is probably the nature of a financial crisis that originated in a credit crisis with lots of exotic financial instruments. Hypothecation and rehypothetcation are the latest terms. But what do they mean?

Hypothecation is simply when you pledge some sort of collateral to secure a debt. This happens all the time if you set up a margin account with a broker. Margin accounts require you to post some sort of collateral when you trade on margin to short stocks, for example. Since you're borrowing someone else's shares and selling them, the margin covers the cost of buying the shares back if the price moves up instead of down. 

Without getting too technical, most margin accounts allow the broker to loan whatever assets are in your account to other customers. You consent to this when you trade on margin. As strange as it is to borrow something that's not yours, sell it, get the cash, and buy it back at a lower price for a profit (if your trade works), this is just one aspect of the world of margin lending.

The basic idea is that you can make a lot of money without having a lot of money to begin with. This, of course, is the whole idea behind leverage: boosting your financial returns by borrowing cheaply to bet on a big outcome - and being right. 

Using Your Collateral as My Collateral

What we've learnt is that brokers at MF Global were taking collateral pledged by clients and using it as their own collateral for another leveraged bet. Apparently this is all legal. The same collateral is supporting two separate bets on asset prices. One of the bets is yours. The other bet is the broker's. 

Because MF Global's bets on European government bonds went bad, the counterparties to its trades scooped MF's collateral up. The trouble was, MF's collateral was also the clients collateral. This saw some client's apparently have their trades wiped out and their money delivered to the counterparties on MF's trades. 

One MF victim was US commentator Gerald Celente. Celente is a gold bug. He'd been building to his long-term gold position by buying gold futures contracts, rolling them over at expiration, and eventually taking delivery of physical gold (which is possible in the futures market). Only in this case, MF pledged his futures contracts as collateral for one of its own trades. 

Whether or not other brokers are doing what MF did is another subject. And even if they are, MF was grossly over-leveraged at 30-1 (assets 30 times capital). But Celente's experience would have been enough to cause at least some gold speculators to reconsider whether a margin account and gold futures are the best way to invest in gold. 

You'd presume these speculators have concluded that the futures market is no longer the best, cheapest way to leverage up returns on a higher gold price. 

Gold Stocks A Better Bet

There are two investment takeaways from this whole discussion. 

First: gold is not an investment. It's money. The biggest benefit from owning it as a wealth preserver. In my view, this means taking at least some physical possession of gold bullion.

The second takeaway is that if you're going to speculate on gold through financials then gold shares are currently a lot better way to do that than gold futures.

Yes, gold stocks have their own risks. But at least in the chain of ownership of an actual underlying (physical) asset, the gold companies may own physical gold (assuming they have it). Unless they have sold it forward through hedging, your claim as a shareholder on the earnings from that gold are less far removed from the real asset than your claims as a holder of a futures contract.

Here's a warning. I admit my understanding of the futures market is limited. Probably, in a normal futures market, you could take delivery of your commodity instead of rolling over the contract. This means the futures contract, in a normal market, is a pretty safe claim on an underlying asset. (Assuming your counterparty can deliver the commodity in question.) 

It all comes down to counterparty risk. As a shareholder, your counterparty risk is basically the company itself and its managers, geologists, and financiers. Can they find the gold, extract it, and sell it a profit? It all depends on the company, its people, and the quality of the assets. 

But in the bigger picture, gold shares could be the big winner from the MF mess, since people who want to invest in gold will see that it's much better to do it through shares than futures or even ETFs. Gold miners can lie to you just as well as futures brokers. But at least you have your choice of liars in the share market.

The other big risk to investors in gold shares right now is what impact system wide deleveraging is going to have on stocks and precious metals. Coupled with the move I'm expecting in the Aussie dollar the answer is: a pretty big one.

The bottom line is that all of this chicanery in the futures markets undermines confidence in the financial system as a whole. Over the long haul, I believe that really promotes bullion and hard money (gold and silver). It also means that gold and silver companies may finally stretch their legs and become the preferred way for the investing public to participate in the gold bull market.

If it's correct, this observation will be really useful in 2012. 

The US Treasury must refinance nearly $6 trillion in debt over the next four years. Based on that, I have no doubt the money printing is coming and that it should drive bullion prices higher. 

Between now and then, deleveraging will inflict so much pain on leveraged speculators and stock indexes that the public will practically beg Ben Bernanke to print money. When he does, gold and gold stocks will make new highs. 

Dan Denning
Editor, Australian Wealth Gameplan