Systemic Risk


By: Simon Mikhailovich

A committed landlubber until ten years ago, I took a few sailing lessons on a dare and unexpectedly discovered the joys of sailing. When a friend later asked if I would stand in for a crew member on his 18' catboat during a Saturday race, I eagerly agreed, although his sturdy but slow boat didn't look much like a racer.  It turned out that being slow was not a problem in "one design" racing, just as it isn't in today's investment business.  When one competes within the same class, it is through relative, rather than absolute, performance that one wins a trophy. It also turned out that much like investing, sailboat racing is as exciting as it is challenging. I got hooked and started racing my own sturdy and slow catboat, while learning as much about life, teamwork and investing as sailing. 

This past Saturday, for example, we all drifted around the course hoping for a breeze. Indeed, the wind soon filled the sails, lifted spirits, and the boats started to move nicely... or so it seemed. After sailing briskly for about 15 minutes, we looked at the shore and realized we had been moving backwards! It happened because the prevailing tide was setting us back, even as our senses, the boat's wake and its speedometer were all indicating forward movement. This episode was nature's reminder that apparent progress should be never confused with making headway.  

This is why for 5,000 years, a mariner needed a clear view of the skies to gauge his true position. Without the stars as fixed reference markers, there was no way to know one's location. Similarly, for the past 5,000 years, market-set interest rates (the cost of scarce capital) and money anchored to tangible value have been financial stars that have guided capital allocation and served as a basis for setting asset values.

Today, reliance on the self-referencing economic models, epic debts, digital money printing and negligible to negative rates, have combined to blanket investors in the impenetrable fog from which no reference markers are visible. Having long forgotten how to navigate without models, investors and regulators are mesmerized by the virtual reality of computer-driven markets, where asset prices (including gold's) are based on manipulated rates and measured on a USD speedometer that conflates apparent, i.e. nominal, gains with the accretion of lasting purchasing power.  

Recently, the U.S. Navy showed that it had a lot better sense than the U.S. financial regulators. Instead of waiting for a GPS cyber attack or malfunction to imperil its fleets, the Navy, after a 20 year hiatus, has reinstated mandatory celestial navigation training for all officer candidates. As Lt. Cmdr. R. Rogers of the U.S. Naval Academy explained: "We went away from celestial navigation because computers are great. The problem is, there's no back up." 

As accurate as GPS is, economic and financial models keep proving to be anything but. Despite the Fed's perennial forecasts of imminent recovery and higher rates, neither have materialized. Yields continue to decline and the debts continue to increase. Global debts are up 40% since 2007 to stand at $200T; there are still ~$660T in derivatives; and the utterly inane $13T (and growing) in negatively-yielding debts defy history and common sense. To top it all off, unable to lift rates without crashing the markets, all major central banks keep taking turns at the digital printing presses.

Despite the present and clear dangers, the markets and the global financial system continue to navigate by the rigged markers and operate without any back ups. As stocks and bonds and the USD keep hitting all time or near all time highs, complacency rules. Neither the regulators nor the investors want to question whether the profits are real or merely apparent. My own answer was unexpectedly reinforced last Saturday afternoon - apparent returns won't fund your retirement any more than sailing against a faster current will get you where you want to go. 

Until the monetary fog lifts and un-rigged navigational markers re-emerge, physical gold remains the only hard reference point capable of providing an essential back up plan for one's nest egg.  After all, just as the Navy took protective measures after realizing that no one can hack a sextant, investors should realize that no matter how many fiat dollars get printed, no one can print gold bars. The time to take protective measures is before they are needed. Now is that time.  



As the winds of the next crisis are starting to stiffen, the Swiss are rushing to absolve themselves of the responsibility for their overgrown too big to fail (TBTF) banks. Credit Suisse and UBS are being prodded by the regulators to split off the Swiss-only domestic banking from their gargantuan global assets (and liabilities).

The Swiss are still reeling from bowing to the US pressure and ending bank secrecy, which had been the cornerstone of Swiss private banking for over 80 years. This happened, in part, because the two largest Swiss banks, UBS and Credit Suisse, have grown larger than the Swiss GDP, which made these banks not just too big to fail but also too big for the Swiss government to protect or bail out.

Last fall, an obscure Credit Suisse press release described a process whereby the bank would form and float a new separate banking entity that would exclusively service Swiss businesses and individuals. A well informed Swiss source told us today that Credit Suisse was further along in the process but that UBS was working on a similar plan. Our source also mentioned that FINMA (the Swiss regulator) wanted the Swiss-only bank to have 95% of its assets coming from the Swiss ultimate beneficial owners, which would exclude all non-Swiss nationals and all of the Swiss entities owned by the foreign interests.  

What does it all mean? The Swiss have realized that the next crisis is on its way and that they would have no ability to manage the situation should UBS or Credit Suisse were to fail. Their plan is to create an old-fashioned commercial and retail banking system that would serve only Swiss citizens and Swiss-owned companies. This way, when the next crisis triggers another round of TBTF bank failures, the Swiss government would have an option to let their TBTF banks' creditors, shareholders, non-Swiss counter parties and non-Swiss depositors, fend for themselves.  No one ever accused the Swiss of not looking out for Number One!

The Swiss are making contingency plans and prudent investors should do the same.