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The Price of Gold and
CDO Structured Products
Article originally submitted to
subscribers on 24th June 2007…
A repricing of the risk inherent
in Collateralized Debt Obligations (CDO) is underway with significant
implications for the price of Gold.
Here’s the Problem!
Years and years of monetary inflation have
completely desensitized us to risk. From a national, corporate or even
individual level, the availability of cheap debt has conditioned us to borrow
And nowhere has the debt binge been more
apparent than in the housing market. Low mortgage rates have been a boon for
homebuyers and created an insatiable demand for structured products from yield
hungry investors. Eager to oblige, Wall Street has been having a feast making
loans to homebuyers then packaging them up and selling them to pension funds,
hedge funds and large insurers. The fees have been MASSIVE.
When you package up individual loans into a
product (called a CDO but with many name variations) you are able to pick and
choose the exact payout you want to achieve. Add in some AAA rated mortgages,
mix in BBB+ paper and stir in Toxic Junk bonds (bound to default) and voilà you
have an instrument with very specific yields and cash flows.
Of course there are bands as to what
constitutes for example a BBB- Investment Grade Bond. And all the structurer has
to do is use the loosest defined Bond to comply. Compliance is overseen by
ratings agencies that help banks put the products together. It’s a cozy
lucrative arrangement and its complicated stuff. One of the highest paying jobs
on Wall Street is for Correlation Traders. Quants who make sure the underlying
paper behaves according to their promise.
And then there’s the leverage. And boy is
there leverage! Payouts can be magnified by up to 10x using synthetics or
derivatives that link to even more mortgage pools.
The party was going great until interest
rates started to rise and housing began to fall.
Chart 1 - Centex homebuilder and 10 year Bonds (bottom) breaking
support - CDO reaction 1 week later
Last week the financial world was awoken by
the harsh reality that hey, maybe these mortgages are not going to perform as
originally planned. Maybe the risk of default is a lot higher than originally
thought GULP! Bear Sterns announced a $3.2Bn ‘loan’ to bail out two of its
troubled hedge funds doing exactly what I detailed above.
Based on the banking indexes sharp fall on
Friday, this problem may be a little more widespread than that.
Chart 2 - Banking index (top) reacting to CDO news; price of
gold trending lower (bottom)
Earlier this month we detailed how
higher interest rates would benefit the price of gold.
That is, in the long-term the fundamentals for Gold are incredibly bright, but
there will be short term pain. The reason is that Gold has been bid up along
with all other assets under the current wave of liquidity. A repricing of CDO
risk would likely curtail the issuance of these instruments and cause a sharp
contraction in liquidity with a commensurate drop in ALL asset classes – if last
week is an indication, the speed of this deflation would be mind blowing and
completely overwhelming. However, Gold’s Credit rating has been and always
will remain sterling. When investors realize the incredible DANGER in front
of us, they will return to Gold in droves!
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Greg Silberman CA(SA), CFA
I am an investor and newsletter writer specializing in Junior Mining and Energy
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This article is intended solely for
information purposes. The opinions are those of the author only. Please conduct
further research and consult your financial advisor before making any
investment/trading decision. No responsibility can be accepted for losses that
may result as a consequence of trading on the basis of this analysis.