"The politicians have no incentive to act...unless faced with some sort of existential threat." -- Simon Mikhailovich Gary Spector for Barron's
Mikhailovich, who emigrated to the U.S. from the Soviet Union in 1979 with just $100 in his pocket, issued early warnings in 2007 about the impending collapse of the derivatives market, and the coming financial crisis. Convinced the worst is yet to come, Eidesis, which also is managed by Jim Wang, now invests mostly in gold bullion in various locations around the world outside of the banking system. To understand why, read on.
Barron's: What's your view of the current macro picture?
Mikhailovich: The U.S. has so far succeeded in going slowly to allow an orderly deleveraging of financial assets. But the policy measures—essentially zero interest rates—are like antibiotics. The effectiveness wears off over time, you need to take more and more to achieve less and less, and eventually they stop working. Our concern is that excessive indebtedness around the world is driving governments to try to perpetuate a protracted deleveraging, because short-term deleveraging is very painful. But there are some natural limitations. Interconnectedness in markets—now higher than it has ever been—has been created by disruptive new technologies, which aren't very well understood.
One technology is securitization, such as CDOs, where high-risk debt is recharacterized into investment-grade securities. The other is over-the-counter credit derivatives, which are basically grossly under-reserved insurance. When you combine the government policies with the level of interconnectedness in markets, it creates a recipe for disaster.
What are the short-term chances that we see a meltdown comparable to 2008?
Chances are high. Although there's faith in the U.S. and its ability to help Europe navigate this situation financially, the U.S. itself has a big pending problem of the debt ceiling, of automatic tax increases, of the presidential election. There's tremendous uncertainty. Many things have to go right in the short term to delay the eventual resolution, if you will. Based on recent precedent, it's clear the politicians have no incentive to act unless they are faced with some sort of existential threat. A compromise will only delay the problem, because it's a problem of excessive indebtedness and you can't solve a balance-sheet problem without solving it, except by delaying it.
So the risks are greater than 2008?
Yes. The disruptive technologies and government policies have created an extremely highly correlated environment with all financial markets and all financial institutions. The risks were manifest in 2008, but rather than defuse them, government policies have since increased the interconnectedness. Too big to fail is now too bigger to fail. Northern European countries have been trying to figure out how to bail out Southern European countries, which increases their interdependence. The Federal Reserve is opening credit lines to the European Central Bank, and essentially supporting the ECB and providing liquidity to the European banks. Rather than enable a quick but extremely painful deleveraging, Western governments are trying to delay it by borrowing significant amounts to supplement economic activity. Debt increases the risks by increasing the interconnectedness of financial institutions and governments. Correlation is a measure of risk. That poses threats that have never existed before to the stewards of capital.
What can the government do?
My approach is what investors should do to protect themselves from the consequences. Investors need to examine old ideas about diversification, and to realize that both bonds and stocks have become much more highly correlated than ever. Investors should look for alternative sources of uncorrelated assets or assets whose value is less correlated, as opposed to simply looking at the price of those assets. The hidden cost of deleveraging proceeding without a blowup is that it transfers value from savers to debtors. It creates perverse incentives because it breaks the price mechanism, which is the most important signal in a free-market economy. We don't know the real cost of misallocation of capital. Meanwhile, people are making valuation decisions based on these bad signals.
Where do you allot assets if you are concerned about correlated risk?
There are two roles of uncorrelated sources of returns, or reserves, in a central banking sense. Reserves are essentially hedges or protections, they're monies or some value that is sitting on the sidelines that can be pressed into service if something happens and you need to rely on these stores of value, for two reasons. One is to protect the value of part of the portfolio, and the other is to have access to liquidity during market disruptions when you can profit by being able to buy when others do not have access to liquidity. We concluded such an asset is physical gold bullion—not paper or derivative instruments—held securely outside the financial system, which is potentially subject to a disruption like we saw in 2008, and geographically diversified to provide access to various markets, where the hope is that at least one or some of them would be liquid. That is a very intelligent way to allocate part of your portfolio to this sort of reserves.
Central banks all have gold reserves, and they've been increasing them. Recently, the Swiss National Bank announced that it holds its reserves in diverse locations around the globe. A spokesman explained that the main reason is to protect against a crisis scenario.
They aren't comfortable storing their assets in their own country?
A cardinal rule of risk management is, don't put all your eggs in one basket. If anybody is an expert in safe-haven assets, it is the Swiss National Bank. The U.S., for example, holds its gold reserves outside the financial system, at Fort Knox and at West Point.
We came up with a vehicle that enables investors to do the same thing. Our specialty is structured credit, and credit derivatives are mispriced because the rates are at zero and are subject to potential significant disruptions. We have just seen an example of that. Despite the fact that JPMorgan Chase was lauded as the most capable risk-management institution, it is facing potentially very large losses. Their trade wasn't a hedge. It was a very specific bet on a very specific set of outcomes that is not panning out.
Can you imagine another Lehman event?
It's just a matter of time. This financial system is completely unsustainable. The level of interconnectedness, the level of misapplied incentives is again unprecedented in history. If you were offered a game of chance where when you win, you win, and when you lose, you are given another chance to throw the dice, then, of course, everybody would play that game and essentially that is where the financial system is. That isn't capitalism. That creates distortions, misallocation of capital, and mismanagement of risk, and we are seeing it time and time again.
Should the U.S. break up the big banks?
The most important thing for the government to do is admit the truth: that we have all participated in overspending through various means and that our standard of living exceeds our ability to pay for it. As with any emergency, this requires a tremendous amount of leadership. Before you can solve the problem, you have to admit you have a problem. And it is critically important to restore the confidence of the population in the fact that the system is not rigged.
It's absolutely disgraceful that 2008's consequences haven't been the same as, let's say, savings and loans in the 1990s. Unquestionably, things were done that were illegal in many cases, certainly grossly negligent. By various fiduciary and criminal standards, we should have seen a tremendous number of prosecutions and successful lawsuits. The U.S. system was built on a very simple premise: if you take a chance and succeed, you reap the rewards of your success. If you take a chance and fail, you have to take the consequences of your failure. When you disconnect greed and fear, greed runs rampant.
What's the endgame for the euro?
I don't know; nobody knows. If we step back from everything that is going on in the U.S., and in Greece and Europe, one can say that the endgame ultimately is devaluation of financial assets. It is almost as if these disruptive financial technologies enabled overproduction of financial assets. They increased productivity and they created oversupply, and that excess supply needs to be liquidated. But the liquidation is what governments don't want to allow. So they are trying to support the prices of goods and services that have been overproduced, which are financials. That is the endgame. Greece has overproduced credit…. There is a huge vulnerability. What about Spain? What about Portugal? What about Ireland? These are irreconcilable issues, and the only way they can be reconciled is by printing more money for the moment. The ability of governments to sustain the unsustainable ultimately rests on their ability to maintain faith in their creditworthiness, and faith is something that takes a long time to crumble. But once it goes, it can go very quickly. Here is the paradox: Governments are borrowing more and more, and the spreads of government securities are getting tighter and tighter. So the creditworthiness is getting worse and the cost of funding is getting better.
How do you explain it?
Very simple. It is faith. It is muscle memory. It's normalcy bias, a psychological phenomenon that prevents people from seeing unconventional threats. People overestimate their previous experience and they underestimate future experience…. But there may come a moment when it doesn't work, and then what's a safe haven? lt is gold. It's silver, diamonds, Rembrandts, Picassos, real estate. It's agricultural land. It's the means of production.
But you have to consider the Philadelphia problem. In the movie Trading Places, the hero is trying to sell his very expensive Swiss watch at a pawn shop in Philadelphia, and he is told that in Philadelphia it's worth 50 bucks. The benefit of land and of paintings and other stores of value is that they are not financial assets and they do preserve value over an extended period. But they are not liquid during times of disruption. You can't get a fair price; they're unique, whereas gold is ubiquitous. It's divisible. It's measurable. It's testable. There is a global market for it. So you will never have the Philadelphia problem. You may not like the price, but it is never going to be a rip-off.
So, gold is going to rise over time.
The price of gold never rises. It is the value of financial assets that declines. Gold is a store of value. Gold is not an investment. However, in the current environment, gold can produce tremendous real returns because it's an asset that doesn't produce any cash flow. Its valuation is driven exclusively by supply and demand. In the 10 years through 2010, a study has shown, 80% of physical demand for gold came from emerging markets and only 20% from the developed world, and half of that was for jewelry. Developed markets that are the repositories of most of global financial wealth have hadde minimis demand for physical gold. If this devaluation of financial assets proceeds apace and the moment of clarity comes for many investors in the West who realize they need to diversify into assets that can protect against devaluation, demand for physical gold has the potential to rise dramatically.
What about commodities?
It is very difficult to own commodities physically, and therefore you are subject to market disruptions and counterparty risk. MF Global's clients thought they owned commodities. They even thought they owned U.S. Treasuries, and they ended up being paid 70 cents on the dollar for their Treasury holdings. Lehman clients couldn't get full value for assets they didn't think were at risk. They thought they were simply in custody of Lehman Brothers. That raises another problem with financial technology—re-hypothecation—where banks make money by lending out collateral. Every asset and every dollar that is in custody in a bank, unless specific legal arrangements are made, is re-lent, and as we saw with MF Global and with Lehman, ultimately it is the customer or the investor who bears the counterparty risk.
Do you have any of your money in a bank?
Of course. But I try to diversify. This isn't about the end of the world. Armageddon is a physical end of the world, financial disruption is financial disruption. Many countries have gone through financial disruptions and had their currencies devalued and had all sorts of economic problems, even in the last 20 years. Russia, Argentina, Brazil—it didn't extinguish life in those countries.
But you're talking about a greater correlation between the financial system and these financial weapons of mass destruction.
They destroy money, not lives. Human history ultimately is the history of ebbs and flows of wealth, and the ability to preserve wealth over time requires a very proactive approach. Secular changes that disrupt technologies are traditionally very, very difficult, and many will lose. But some people will win. Tremendous wealth was created during the Great Depression. The idea is to position oneself to survive financially and potentially enhance one's position.