Gold, Coal & Debtland in Australia

After all that fuss about silver yesterday, here’s an interesting note about gold lease rates: they’ve gone negative. The reclusive Bill Buckler-reporting somewhere north of Melbourne, tells the story in a recent issue of his newsletter the Privateer.

“We have not until now seen a situation in which the central banks are actually paying the bullion banks, hedge funds, gold miners et al to borrow the stuff. And please don’t forget that, in this context, leasing gold is actually ‘shorting’ gold. Gold is not ‘leased’ to be hoarded, it is ‘leased’ to be sold for something that pays a far higher rate of interest … the practice of ‘leasing gold and silver’ by the central banks has been one of their best means of suppressing the prices of these precious metals for a long time.”

Are central banks selling gold in order to suppress it? Hmm. We don’t know. But we do know there are plenty of buyers, including Indian jewelry makers. It’ll be wedding season in India soon. And gold is wealth you can wear. When you can wear your dowry on your wrist, you know your capital is truly portable.

Let’s see. There are 35 ounces in a kilo. Gold is about US$920 per ounce. If you wanted to move about US$30k out of a country with capital controls-you’d have to wear kilo of gold jewelry. That’s a lot of jewelry. But would you have to declare it at customs?

U.S. Treasury Secretary Henry Paulson fronted the Congress with his new plan for a regulatory regime to make sure bad things never happen again. “We will move these deck chairs from here, to there,” Paulson said, pointing to a large pile of turned over furniture.

“The women and children will be moved from one side of the boat to the other,” he added. “All the mortgage lenders will be sent below decks and be chained to the boilers with the investment bankers. We are in radio contact with J.P. Morgan’s ghost. Trichet isn’t taking our calls anymore. Right full rudder…Full speed ahead…S.O.S…your orders Captain Bernanke? They never asked us to go down with the ship at Goldman Sachs…I serve at the discretion of the President…I quit…good luck with that.”

Happy April Fool’s Day.

Oh dear. Someone has used the “T” word. “The sad truth,” writes Charles Morris in his new report ‘The Trillion Dollar Meltdown,’ “is that subprime is just the first big boulder in an avalanche of asset writedowns that will rattle on through much of 2008.”

“Expect the landslide to cascade through high-yield bonds, commercial mortgages, leveraged loans, credit cards and the big unknown credit-default swaps, Morris says. The notional value for those swaps, which are meant to insure bondholders against default, covered about $45 trillion in portfolios as of mid-2007, up from some $1 trillion in 2001.”

Feeling queasy? This is the point made so well in last night’s Four Corners program on the ABC. Debt is like a bad hangover, it can have many root causes (credit cards, store cards, auto loan, home loans), but it always produces the same symptoms, cash-flow problems, insolvency, bankruptcy.

There are more disturbing reports from Australia’s mortgage belt (or Suburbistan, as we call it). But first, let’s take a look at the real economy for a moment. A broadside has been fired across the bow of the good ship Commodities Bull Market. It needs a response.

The short version of Gene Epstein’s Barron’s article is simple, though: some analysts believe commodity prices could fall by 50% as speculators unwind leveraged positions. Are they right?

The claim definitely bears some examination. But we think the commodity bears have both eyes on the financial economy and are missing the picture in the real economy. While there’s been investment demand for commodities that’s led to all-time highs in grains and metals, the demand in the real economy-and twenty years of underinvestment in resource production-are what’s driving currency scarcity and high prices.

There are also strategic factors to consider. On that score, the first hostile takeover of an Australian-listed share by a Chinese company moved forward yesterday. Chinese iron ore trader Sinosteel unveiled its offer for Midwest (ASX:MIS). The offer puts a A$1.2 billion price tag on the junior iron ore producer, or about $6 per share (the current price).

The Midwest board is hoping for $7 a share. But Sinosteel, as you’d expect, believes its offer fully values Midwest’s ore deposits in the Weld Range in Western Australia. Begging to differ, Midwest’s board claims the four other projects in the area-admittedly undeveloped-ought to be factored into the price.

What you have here is a good old-fashioned dog-fight over the value of real assets in the ground. What is all that future ore production worth in today’s dollars? What a refreshing argument to have. We’ve been reading so much about bad collateral and deteriorating asset quality, it’s nice to look at companies that have real assets than be transparently valued-or at least honestly argued over.

Whatever the outcome of this particular bid, you should be prepared for more of them (the hostile ones from cashed-up foreign companies, especially Chinese). While Australian boards want to maximise returns from shareholders, the actual capital to develop small and mid-sized resource projects will probably have to come from willing joint venture partners overseas.

This is one of those unintended consequences of the credit crisis…tighter conditions for equity and debt financing for Aussie firms.

And it’s not as if this hasn’t happened before. As Michael Sainsbury puts it in today’s Australian, “The Chinese are taking a very similar approach to iron ore, zinc and other resources such as uranium, as the Japanese took to coal in the 1980s. Buy up economic stakes to secure supply. While Huang wouldn’t touch the BHP/Rio deal, it’s clear that China’s strategy is to help develop alternative supply through second and third-tier players.”

So yes, there’s some speculative froth in futures prices. But on the ground, there’s real demand and a contest over resources that are much in demand.

Speaking of iron ore, today, as we mentioned above, is April first. The new benchmark price for iron ore usually begins on this date. But China and Australia have failed to agree on what iron ore is actually worth.

China’s steel mills (represented by Baosteel) are holding out for lower prices while Australia’s two big ore producers (Rio and BHP), are happy to sell more ore into the spot market and wait the Chinese out.

If an agreement is struck between now and June 30th, contract price will be backdated to April first and the world can keep on turning. If no agreement is made by June 30th, Aussie ore producers can, at least in theory, simply walk away from the negotiating table.

We think it’s more likely they’d try the old “divide and conquer” strategy, negotiating with smaller Chinese mills one at a time for a 65% to 70% increase in the ore price. But for that to happen, cracks would have to appear in China’s negotiating strategy. Can the central government keep the smaller mills in line? It’s a pretty stressful time for China’s central planners, isn’t it? And the Olympics haven’t even started yet…

While we’re talking steel, let’s talk coal. “Coal miners start eyeing each other,” reports Stephen Wiesenthal in the Financial Review. “The takeover speculation swirling around Australia’s coal producers has heightened even though their exports have been held back by transport bottlenecks and down the east coast. Despite rising coal prices and piles of excess cash, there is little point in local coal miners building new projects until there is a way to get more production into market.”

As if having too much cash was a bad problem to have. Well, actually…it is. You have to make hay while the sun is shining in the commodities markets. It would be better if the coal producers could increase production, export it overseas, and report higher profits for shareholders.

As is, management must put the idle cash to its best business use. What will they do? We don’t know. But we know having cash to spend is a better problem that having no assets at all. We’ll take the Diggers and Drillers over the financials any day of the week.

The Four Corners special on the ABC last night was truly dispiriting. Though we’d seen and heard much of it before, the stories told in “Debtland” are still a bit shocking when you put a human face on an abstract subject. It’s tempting-and uncharitable-to call borrowers “stupid” for taking on loans they clearly couldn’t afford on houses that are trading at grossly inflated prices due to an expansionist monetary policy by the central bank. There’s plenty of stupid go to around these days.

While technically correct, it’s also worth remembering how ruthless the banking system is in identifying new customers to lend to. It sort of reminded us of the Matrix, where the thinking machines build pods to harvest the heat produced by human beings. The world becomes a vast energy farm in which people are herded into non-thinking stasis by their machine overlords.

And really, how different is the modern banking system of household finance? From the day we are born, we are herded into debt. And there we are kept, paying off the interest but never the principal, until the day we die (unless we learn better and escape earlier).

The dirty little secret of America’s housing boom (and probably Australia’s too, before it’s all over) is that people never really “own” their own home. They merely lease it for a lifetime from the bank. You can find all the evidence of this in the declining amount of equity people actually own in their homes.

The bank owns the home and leases it back to the mortgage owner. If asset prices go up, the borrower can tap the “equity” in the home as a source of current home, transferring ownership of the asset to the bank in exchange for current expenses.

If it sounds like a modern version of indenture servitude, it certainly is. And what’s disappointing about the era we live in is how readily many people accept debt as a way of life.

We only dwell on the point because we believe there’s a direct correlation between freedom and wealth, happiness and not owing other people for the rest of your life. Money doesn’t buy happiness. But if you grow and preserve wealth, it gives you choices that you don’t have if you must ultimately answer to your creditors.

And it’s not just new home-buyers in over their heads. Even the very wealthy are being taken to the cleaners by Wall Street’s giant wealth-transfer machine.

The Wall Street Journal reports that, “One of the world’s biggest brokers is about to force its clients to take a haircut on a type of securities that investors had believed to be as safe as cash. UBSAG began on Friday to lower the values of so-called auction-rate securities held by its clients, a move that will be a jolt to customers who had been told they were investing in a “cash alternative.”

This once again proves that only cash is cash. “Near cash” may not be near enough.

By the end of the credit crisis, the only thing that may prevent investment bankers from being dragged out of their offices and hung from lampposts is that most of their high net-worth clients prefer a more traditional method for exacting vengeance: the lawsuit. “UBS, Deutsche Bank AG, Merrill Lynch, Morgan Stanley and Citigroup have been sued in U.S. District Court in Manhattan for allegedly deceptive marketing of auction-rate securities. More lawsuits are expected over the coming weeks.”

By the way, the auction rate securities market is about US$300 billion.

This loss of paper net worth in Western financial markets accelerates what called The Money Migration in our 2004 book, The Bull Hunter. We reckoned that high debt and the collapse of America’s housing market would eventually lead foreign investors to forsake America’s capital markets for better, non-wealth destroying investments elsewhere. And so it’s begun.

“Investors worldwide pulled close to $100bn (€63.3bn) out of equity funds in the first three months of this year – a record shift that accelerates a longer-term trend away from US and western European stock markets,” reports the Financial Times.

“Equity funds suffered outflows of $98bn in the quarter ending March 28, according to Emerging Portfolio Fund Research, which tracks retail and institutional flows. The funds had inflows of $19bn during the same period last year and inflows of $49bn in the same period for 2006.”

Round and round the money goes. Where it stops…is Taiwan, Russia, the Middle East, and Africa. “Funds enjoying inflows were nearly all focused on Taiwan, Russia, the Middle East and Africa. Emerging markets funds as a group had outflows of $20bn, compared with a small outflow of $1.6bn in the same period last year.”

“Money market funds continued to see record inflows during the first quarter, adding another $140bn to reach record assets of $3,500bn. The funds are running well ahead of last year’s record $240bn in inflows.” Let’s just hope those money market fund are actually in cash and not, say, auction rate securities.

And by the way, it’s not just American capitalists that can mis-allocate capital in spectacularly stupid ways. The Saudis are building a new Tower of Babel in the desert near Jeddah. The planned tower will be 5,260 feet high, which is just under one mile (we know, hailing from near the mile-High city of Denver at 5,285 feet).

All that oil. All that waste. Will someone please invent an alternative to the internal combustion engine?

The Old Hat Factory was flooded with e-mails about Australia’s housing problems. There are way too many of them to publish here, so we’ve posted them over at our website. Blame the Reserve Bank for goosing the money supply, say some. Blame the government for bad tax laws that favor investment, say others. Blame the labour force for not producing enough tradies to build houses, say others. Read what others are saying and have your say too.

Finally, a rumination on the whole asset-based model of individual wealth creation. It’s a bit of a puzzle isn’t it? We are finding out that it only works when asset prices rise (obviously). But borrowing to invest in assets clearly doesn’t work. And in a world with wage deflation (thanks China and India) the average Aussie is left in a rather uncomfortable financial position.

If wages don’t grow, then demand for credit grows, despite rising interest rates. After all, if your wages aren’t rising but your cost of living is, how else are you going to make ends meet?

One answer-admittedly not in vogue in the last 10 years-is to reduce expenses below your income. Why is this hard to do? Big expenses like housing food and fuel have been steadily rising as a percentage of median income. If you can’t increase your income through higher wages, you increase it through borrowing.

This worked especially well when the money you borrowed led to higher asset prices (shares and housing). It worked especially well when you could post those assets as collateral for even more loans. And when the cost of borrowing money was so cheap, why would anyone put money in an ordinary savings account when you could gear up and boost your risk-free returns?

Only they weren’t risk free. Without rising asset prices, all that borrowing is for naught. It fails to make you actually wealthier. Instead, you increase your gearing to purchase financial assets that are falling in value while the liability remains. The value of the asset, as it must, falls when the supply of new credit into the system dries up.

And in case you’ve been trapped down a mineshaft for six months, the supply of new credit has indeed dried up. With an ocean of money below asset prices suddenly vaporized, the SS Credit Bubble won’t just sink, it will fall from the sky. It was so high up, though, that the fall could take quite some time before most of the passengers notice.

Dan Denning
Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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8 Comments on "Gold, Coal & Debtland in Australia"

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Excellent article. In last 7 – 8 years people seem to have forgotten that real debt needs to be paid back with real money, cheers

William Boeder
Congratulations are due to this rare but truth-telling Dan Denning. Perhaps even an Order of Australia gong. Oh how we plebians have been misled by the Barons of Banking and Business along with those noisy nothing packs of financial analysing experts whom peacock to the TV cameras, have been feeding us crocks of —-, for far too long. I refer to those television-land geeks who speak of consumer indexes, confidences, sentiments, likelihoods, of whether gold is up or down, or oil is up or down, along with their constant vaccuous ramblings and wafflings in telling us of the how and… Read more »

Buckler is wrong. He needs to refer to the definition of what a lease rate is and how it is calculated.

One thing no one seems to have cottoned on to is that we don’t actually have a housing shortage. If you look at the ABS stats housing has been growing 2-3 times the rate of the population. I.e if population growth is 12% housing has been growing 24%. So why are houses so expensive. Simple there less people per house. 20 years ago it was 2.4 people per house (dwelling to be precise). Now it is 1.6 What would it take to drop house prices by 20%-30% Credit to dry up and more and more people to share house or… Read more »

Maybe later the Indians and the Chinese can sponsor us as foster kids like we sponsor them. Oh, I forgot, most people I know in Australia were too greedy and lazy and selfish to sponsor a child overseas. Lets hope that people in thise other countries treat us better than most people treated them then hey?

Dan I think you touch on a really interesting point towards the end of your article that I suspect had a big impact in the marginal seats at the last election but which has received little attention: “If you can’t increase your income through higher wages,……” My sense is that the mortgage belt does not see itself as having pricing power in the labour marketplace and being able to command higher returns in the face of rising costs. This anxiety doubtless translated into support for Rudd’s assertions about feeling empathy with rising living costs in terms of groceries, energy and… Read more »
Diggin it!

The titans that control the vantage point of middle Earth will have little interest in helping us, they would rather irradicate us as we have with cultures of the past when we found little use for them or when we simply feared them. The nature of new empires is to see how big they can grow!

Diggin it!
Kevin, good question! Housing affordability in Australia has been reduced by many factors, two are the availability of finance which has artificially inflated values and State with local governments capitalising on this very scinario. Try and get your hands on the 4th Annual Demographia International Housing Affordability Survey 2008.In the fouth paragraph of the introduction it states, Quote; Australia is purhaps the least densely populated major country in the world, but state governments there have contrived to drive land prices in major urban areas to very high levels, with the result that in that country housing in major state capitals… Read more »
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