Gold News & Press Comments
The Banking Crisis & Gold - 2008
We only realised in 2010 that we had not created a page specifically about the recent banking crisis, and realised we should remedy the omission.
Chain of Events
The 2008 banking crisis was not, of course, a single event, but a series of events. Each was not necessarily directly connected, but there were familiar patterns and themes running as threads through most of the constituent events.
Sub Prime Mortgages
Subprime mortgages are those where the home owners are not good credit risks. Low interest rates tend to lead to house price increases, because borrowers can afford to trade up and buy a bigger, better, or more expensive home, perhaps in a better neighborhood, than they normally would, helped or encouraged by low repayments. House price rises allow borrowers to refinance, or sell and purchase a more expensive home with their larger deposit. This cycle can feed on itself. The rising prices create more demand, especially because borrowers can get highly leveraged loans. If a $10,000 deposit buys a $100,000 home, and the value increases by $20,000; the initial investment has trebled in value. Everybody wants to join in, and the market appears to be self perpetuating.
There were many critics and commentators warning that US house prices had become a "bubble". This was also repeated and reflected in housing market in many other countries including the UK.
Problems start when interest rates start to climb, and more borrowers start to struggle to keep up payments. Banks, building societies, and other financial institutions suffer because their cash inflows from borrowers slows down, and they start to repossess. Their asset backing drops, their credit rating is downgraded, they have to pay higher interest rates, and their losses grow, adding to the downward spiral.
Leveraging is investing or spending more money than you have by borrowing. Low percentage deposits mean highly leveraged loans. If times of rising property prices, this can happen easily, and both borrowers and lenders start to take greater risks, and the amount of leverage increases. Some lenders were offering 100% mortgages, and even higher - up to 125% in a few cases.
In the case of a 90% mortgage, if values drop by 20%, the lender is facing a 10% loss or more in the event of default. Because banks often have as little as about 5% shareholder capital compared with their total assets and liabilities, this would make many banks technical insolvent.
A borrower is also in a position where he may be facing a loss of two or three times his initial investment (deposit). This may be survivable if he can afford to maintain interest payments, but if the cause of dropping values was increasing interest rates, the borrower may default, and his negative equity becomes a problem for him and the lender, who may have to write off the deficit, or at least make provisions against it.
Drexel Burnham Lambert
Founded in 1935, bankers Drexel Burnham Lambert Inc issued the first CDO (Collateralised Debt Obligation) in 1987, and was active in leveraged takeovers, and the junk bond market. In 1986, it became embroiled in an insider trading scandal involving Ivan Boesky and others. It made over $500 million net profit in 1986, and employed over 10,000 people at its peak. By 1990, it filed for chapter 11 bankruptcy.
A bank run developed on UK bank Northern Rock on 14th September 2007, and it was nationalised on 22nd February 2008.
Founded in 1923, Bear Stearns employed over 15,000 people worldwide in the years before its collapse. In 2005, it was rated as the seventh largest securities firm by total capital. It too was an active player in the sub-prime market, issuing and trading asset backed securities. For some reason, it increased its exposure to these markets. It was saved from total collapse and acquired for $10 per share by J.P. Morgan Chase in March 2008, shortly after its shares had been trading at over $133 each.
Coming into being in 1850, Lehman Brothers was an important commodities trader, and corporate finance broker. It was sold (floated) by American Express in 1994, becoming another major player in the sub-prime mortgage market. On 15th September 2008, Lehman Brothers collapsed and filed for bankruptcy protection, after the Federal Reserve failed to organise its purchase or takeover by a number of other international banks. This single event probably created the shock wave which went on to become the credit crisis. Banks stopped or severely curtailed lending to each other. Many bank depositors withdrew funds from banks.
Rush to Safety & Gold
In troubled and uncertain financial times, investors avoid risky investments, and switch in secure and liquid assets, such as hard commodities, and particularly gold.
Gold, in US dollars rose from $740.75 on 11th September to $905 by 26th September. Despite this large and fast rise, it dropped back and finished the year at $865. At times during the tremors and aftershocks, when we would have expected gold to jump, it unexpectedly fell, and it turned out many large investors were having to sell strong assets like gold to meet margin payments on riskier investments, or to provide collateral for assets whose value had fallen sharply. In these case, gold did then rise, but only after an initial sell-off.
Premiums on Physical Gold
The premium (percentage over intrinsic value) of common gold bullion coins jumped sharply starting in about August 2008, and only fell back towards previous levels in late 2009.
Krugerrands and sovereigns, which previously sold at around 4% premium for large quantities, shot up to 10% or more, on top of higher gold prices, and even at these raised levels, were in very short supply. We noticed a single Krugerrand sell (on eBay) for 27%! Although this was only a single coin, we observed at the time that buyers were paying too much, and sellers naturally taking advantage. We warned our customers, and website viewers, to avoid paying excessive premiums, and avoid lemming-like behaviour. Most of the time, we had alternative bullion coins available. If we had chosen to do so, we could probably have sourced and sold two or three times the volume of gold bullion coins during some periods of the stampede. To do so, we would have had to pay what we regarded as unsoundly high prices on sovereigns and Krugerrands, and pass on the higher prices to our buyers. We preferred to take a more considered approach, which we thought was a better longer term solution for both us and our customers. This boiled down to offering secondary market sovereigns, Krugerrands, and other bullion coins, at premiums only very slightly ( 0.5 to 1%) above our normal rates, to be delivered when available, or newly minted coins, usually of our choice, at a further slight premium increase (around 2%), available from stock, or as quickly as we could ship them in.
We were delighted to know that many of our customers were happier to trust us with their money than they were to leave in on deposit in various banks. We are happy to report that we repaid this trust by delivering all gold bullion coins we contracted for, even though at one stage we had a backlog of about six months.
The Rise and Fall of Krugerrands
Although we would never argue against buying and owning Krugerrands, before 2008, they were usually the cheapest of all the common gold bullion coins (by percentage premium). At the height of the rush, in the last quarter of 2008, they were in big demand, with many buyers inexplicably wanting only Krugerrands, and were changing hands at higher premium than many of our other newly minted coins. Now the market is back to normality, Krugerrand supply is in surplus, and the premium on them is once again lower than on other bullion coins, proving we were right to warn about paying too much.
As we write this, we have more than 100 one ounce Krugerrands surplus stock. This is not excessive compared with our stock levels at various times, but we also have surplus half ounce, quarter ounce, and tenth ounce Krugerrands, plus Canadian maples in all four main sizes.
Because of the chaotic state of the market from August 2008, we started to offer "our choice" of one ounce gold bullion coins as our best deal (lowest premium), and extended this to other bullion coin categories such as fractional (half, quarter, tenth ounce), and sovereigns; not only in secondary market (secondhand) coins, but for newly minted coins also. Most of the worlds bullion mints were working flat out to meet demand. "Our choice" meant we were able to jump in and buy whatever coins we could get, knowing that we had buyers for them.
We have retained "our choice" as our best buy for most gold bullion coin investments.
The market for "small" (up to one kilo) gold bars also dried up at the same time as coins, and most producers struggled to keep up with demand. Most of the comments we have made for gold coins also applied to gold bars throughout this period.
Spot Gold Chart in US Dollars - 2nd November 2007
Image Source - The Bullion Desk London
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