The Antidote for Subprime Woes

There are several informative reports in today's Wall Street Journal Online about the growing contagion arising from subprime loans.

The first consequence of the collapse is the scores of lenders who went out of business. The WSJ reports: "More than 80 mostly subprime mortgage lenders -- those that make home loans to the riskiest borrowers with questionable credit -- have closed shop since the end of last year as clients defaulted on payments and banks cut off the funding required to make the loans."

The second consequence of the subprime collapse is now underway. Investors who purchased subprime mortgage-backed bonds are taking losses. Two funds managed by Bear Stearns that are reportedly teetering on the brink of collapse have been well-publicized, and other funds have already gone under. The latest casualty is a London-based fund called Caliber Global Investment Ltd., so the contagion is now spreading beyond US borders, which is to be expected. There are $800 billion of subprime loans outstanding, much of which was bought by foreign investors.

At this stage, the size of the problem is unknown, but a rough estimate is possible. The following chart is from the WSJ.

This chart shows that nearly 5% of subprime mortgages are in foreclosure. That's $40 billion of assets for which cash-flow has disappeared, and for which the lenders must now rely upon liquidation value to obtain repayment. And the problem is growing, as evidenced by the trend in the chart. Also, the WSJ reports: "So far, most of the pain in the mortgage market was caused by loans made in 2006, when lending standards reached a low. Caliber [the collapsed London fund mentioned above] was hurt by loans made in 2005. Delinquencies in these older loans are also building."

A collapse in financial assets typically has a knock-on effect as fear and sometimes panic ripple through the financial scene. For example, the 1982 collapse of a little known firm called Drysdale Securities was within weeks followed by the collapse of Penn Square Bank of Oklahoma, which in turn was one of the torpedoes that eventually sunk Continental Illinois, which at the time was the nation's sixth largest bank. It succumbed to a run by depositors fearful that their money was at risk, which highlights a fundamental difference between the precious metals and national currencies.

National currencies have counterparty risk. Gold and silver do not. In other words, every national currency is dependent upon a promise, for example, the promise that the bank where you have your money deposited or the government or company whose debt instrument you purchased will repay your money to you. Gold and silver do not have counterparty risk because the realizable value of tangible assets is not dependent upon someone's promise. This observation of course assumes that you own physical gold and silver. With paper 'gold' and paper 'silver' you have counterparty risk.

Counterparty risk is often overlooked, but it should not be. Gold and silver are the bedrock assets in your portfolio, and you therefore do not want to take risks with them. You can avoid risk when you own physical metal, either in-hand or by holding title to it and having your metal safely stored for you, like the service we provide in GoldMoney. Paper substitutes for metal (e.g., futures contracts, pool accounts, gold and silver certificates, and ETFs) give you exposure to the gold or silver price, but they are not ownership of metal.

Placing wealth in tangible assets is an ideal way to avoid a financial contagion, like the one now brewing. When you own physical gold and silver, you have the peace of mind knowing that your wealth rests within a tangible asset, and not upon a promise. Physical gold and silver are the ideal antidote to avoid the subprime contagion.

What's more, the uptrend in both precious metals remains intact. Both metals are holding support, with gold above its 200-day moving average and silver above $12.

Meanwhile, the following chart of the US Dollar Index shows that the dollar continues to slip. No matter how hard US Treasury spokesmen try to talk it up, the dollar remains on a clear downward path.

Gold and silver have many advantages. While we buy and continue to own the precious metals to protect ourselves against the growing inflationary threat, the spreading financial contagion arising from subprime woes makes clear another reason to own them. Gold and silver are money that is not subject to someone's promise. When they are owned in physical form and not a paper representation, gold and silver do not have any counterparty risk, an attribute that will become increasingly important and reassuring as the subprime woes continue to mount.

Published by GoldMoney
Copyright © 2007. All rights reserved.
Edited by James Turk, alert@goldmoney.com

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