Investment and Insurance: Prospective Risk and Return in Various Precious Metal Investments

To buy, or not to buy? Allocated, unallocated, or exchange-traded, derivative, or nothing? That is the question.

"Simply, antifragility is defined as a convex response to a stressor or source of harm (for some range of variation), leading to a positive sensitivity to increase in volatility (or variability, stress, dispersion of outcomes, or uncertainty, what is grouped under the designation "disorder cluster").

Likewise fragility is defined as a concave sensitivity to stressors, leading a negative sensitivity to increase in volatility. The relation between fragility, convexity, and sensitivity to disorder is mathematical, obtained by theorem, not derived from empirical data mining or some historical narrative. It is a priori".

Nassim Taleb, Mathematical Definition, Mapping, and Detection of (Anti)Fragility

Yes, there is a certain fiendish humour as Taleb introduces this quotation with 'simply' and then goes on to use enough jargon to make the layperson's eye glaze over.

But what Taleb is describing here is a fundamental that many have forgotten. It is the corollary to his more famous observation about 'black swans' and 'tail risks.'

What Taleb is basically saying is that a system or investment that is designed to accommodate infrequent but outsized and somewhat unpredictable risks performs one way he calls anti-fragile. And other systems and investments are designed so that they perform well under 'normal conditions' but tend to underperform, and often badly, during the unexpected.

Here is my own picture of Taleb's concept of how investments react.  It might not be exactly what Taleb himself has in mind, but it something that fits certain other types of information systems in a prior occupation, and how I remember it for my own purposes:

If you want to grossly oversimplify this principle, and remember it as a saying, pick the right tool for the right job, and remember that nothing comes for free. I used this in describing tradeoffs in very complex products and networks, and while it may sound tritely obvious, it worked with a lot of upper level executives.

But what is the job itself? Well, the application defines it of course. But one must also take performance criteria into account, and with performance there are environmental conditions and variabilities. Would you like to have a network that can function for your casual use in your home, or a high performance network that can survive arctic cold and desert heat?

Don't laugh. we used to drop networks into some of the more out of the way and volatile places around the world, put electronic equipment in explosive environments, and met application criteria that had many other product groups running out of the room screaming for momma. It was our particular competitive edge. It only comes with experience, confidence, and a fanatical understanding of the odds and how they can mount against you.

But you don't want to waste money and over engineer something either. That is a good way to go broke. One needs to understand expected performance, and the risk profiles for just about anything that is not merely incidental.

And if there is anything that I wish you to remember from this blog, after all these years, it is the deadly trap of undisclosed risks and the tendency of some to understate those risks for their own short term advantages. And how other people will go along with them for the sake of position, power, and prestige. In a nutshell, this is the story of our recent financial crises.

It is far too complicated to get into this afternoon, but lets just say that a number of mathematicians and industry analysts, among them Taleb, Mandelbrot, Tavakoli, William Black, Yves Smith et al., saw that there was significant undisclosed risk in the system because models (Black-Scholes for example) greatly simplified the risks, and assumed distributions of variability that were not real world realistic.And even worse, in many cases the risks were actively hidden, and even more despicable in the worst of them, purposeful.

There was a movement in finance to force normal distributions onto data that did not really justify it. In order to achieve this, the risk models made certain assumptions, and thereby 'flattened' reality in order to fit the model. What one ended up with was a mis-estimation of the risk probabilities. And so we saw 'once in a hundred year events' happening with alarming frequency, despite the best efforts of the financial planners to smooth them over with piles of bailout money.

Here is a picture of what such a discrepancy might look like:

So the financial system designer likes the normal distribution and makes their operational plans based on that. But why is this? Are they diabolical fiends? Do they enjoy screwing up?

No, they are ordinary people for the most part, but following orders. And the orders are sometimes to take the faux normal approach because it costs less to implement, allows for greater leverage, and fattens profits, at least in the short term. Watering the cattle, cutting a corner,  putting lipstick on a pig. 

Careerism's second law is if you are wrong with everyone else, no one can blame you. And so many financial myths have thereby obtained extended lives, because they provided a fig leaf for someone's self serving ends and moral trembling.  This is in some ways the story behind the failure of our regulatory systems, often staffed by good people but who are underpaid, overworked, and subject to extraordinary political pressure to turn a blind eye to which otherwise might provoke their action.  Especially where there is a lack of complete certainty, which is all too often the case in real life.  The rationalizations are venerable, with their roots in the Garden of Eden.

So what is the punch line?   If you are buying an investment as a safe haven, something that will perform well in a difficult and somewhat unpredictable circumstance, you may wish to take your money into something that is highly transparent, robust made to endure the unexpected, given to few assumptions, and perhaps even strongly guaranteed.

And if you are not, if you wish to invest in something with a decent return, but in your own estimation performs adequately for your time horizons and expectations, then pick the product in which you have confidence, provided it meets your needs and possesses some advantages in features and price.

These principles can be applied to the pros and cons of certain types of gold and silver investments.   And those pros and cons are ALWAYS going to be affected by how you perceive the risks, and how that investment fits into your plans.  This is a given.  And this is why I would never give anyone specific advice, because I am not a financial advisor and do not have the knowledge of their own particular situation, their goals and time horizons.

I will use myself as an example.   I tend to gravitate a portion of my portfolio into very transparent and 'safe' gold and silver investments, where I have a very high confidence in them based on audits, ownerships, and so forth.  There is not much about them I do not know and have to assume.  Yes there are the high improbable outliers like a meteor hitting the earth and bringing on Mad Max and cyclist cannibals, and so one might drop a dime or two on arms and infrastructure just for grins, but by and large I think we can ignore them for now.

But for the most part a failure in the financial system that could be adverse to one's wealth seems a little more likely.  And so a part of my portfolio is in reasonably secure investments that will benefit somewhat from disorder and provide a small premium on return or at least weather the situation well.

And other parts of my portfolio are in investments that are more fragile as Taleb would say.  But they provide a nicer short term return with less expense.  And there is nothing wrong with this.  Not at all.

By the way, and I hate to even bring it up, but gold and silver themselves suit slightly different purposes. Silver is less 'anti-fragile' than gold in dire circumstances, generally.  But it offers some juicy upside in certain circumstances in compensation. And there are always special situations to consider, and for this one might read Richard Russell or Ted Butler among others, who track imbalances and trends that could provide opportunities or risks.

I do not consider gold better than silver; they are different.   And I own both, and invest speculatively in both, at varying intensities depending on the changing context of the markets.  What is better, a hammer or a screwdriver?  It depends on what you wish to do with them.

I would certainly buy some other financial instrument or stock I consider less robust for a quick flip or outsized return.  The miners would fall into this sort of category.  I am sure some of my bank accounts would as well, depending on how high the risks,  And physical property is notoriously non-portable if you decide to take up roots and go to another place.

So, as far as unallocated gold goes, there is nothing inherently wrong with it.   It is a very nice way to own gold with a reduction in expenses.  I am sure not all providers of such a service are equally reliable, and their representatives would do well to discuss their own advantages, guarantees and superior performance as would any provider of products when faced with less reliable competitors.

I will say that deriding critics as loons and charlatans, and referring to a portion of your prospective clients and client influencer base in a generally derogatory manner with a pejorative nickname promulgated by economists who hate precious metals on principle, is probably not a high profile technique in the salesperson's handbook for success.  Answer with facts.  Once you descend to name calling you have lost.  Just a word to the wise, and enough said about that.

Know why you are buying what you are buying, and how it fits into your overall scheme, and what assumptions you are using.  And do not be afraid to have contingency plans and change them if new data comes your way. 

I know it is hard, especially in times of currency wars, because the first victim in all war is the truth.   But don't go off the deep end either, and waste your money on over complex plans or put all your eggs in an improbable basket.  It's your call, and perhaps you need a professional to help sort out exactly what your priorities are. 

I keep a spreadsheet, and on it there is a summary of all my assets, and it fits them into a simple risk portfolio so I can see how they are distributed by risk and by total value.  Since the prices of things change, you have to be aware of how that affects your overall portfolio. I have to say that physical bullion has taken a much larger place in my overall profile since 2000.  But that is fine, I just need to be aware of not letting it become a risk, and to balance it as required.

Would I personally buy GLD as 'insurance' against a systemic failure?  Hell no.  Maybe as a flip investment on a technical trade.  Would I buy some physical trust with strong outside auditing and redemption features that were practically available?  Probably, because it covers a bit of both insurance and investment.  But it lacks the leverage of a small cap miner just for example. But it does not nearly have the risk.

Yes it is 'that simple.'  Which is to say, it can be simple to understand but hard to implement. But you have to start somewhere, and if you start all wrong, it gets worse as you go.  Some parts of my portfolio are for insurance, and other parts are for investment.  They serve different purposes.  I had the damnedest time trying to convince a broker at a white shoe firm who was managing my stock options portfolio of this.  He thought I was schizoid.  He only thought in terms of good stocks and great stocks.  So I got rid of him, as he was too focused on his own goals, even when he feigned altruistic concern for my money.

And sad to say, for most people, their major task is just getting by day to day.  And so the pros and cons of various investment techniques is so much hoohah because their most ambitious aspiration is to stay out of debt, especially usurious and fee laden debts, while putting a little bit aside.  And this is why I spend quite a bit of time writing about these abuses, because I am not only a caterer to the elite, but to our little community which has a range of wonderful souls in it.

As always, the devil is in the details, but it helps if you know the lay of the land, and where you think you are heading, and why.  And of course, you adjust for changing circumstances as they occur.

Risk: It's Not Just a Board Game

Silver in Backwardation and the Emperor, Once Again, Nearly Naked

Growing panic in Paperville. The central banks have no silver, and the Comex is being depleted. Interesting that the SLV ETF inventories are experiencing large outflows. The patriotic miners are being called upon to hedge their deep storage inventories, that is, unrefined metal in the ground, to provide more paper.

This manipulation of silver and gold could be a John Law class debacle when it is exposed and collapses, depending on how high the leverage in paper has gone. And of course how deeply down the rabbit hole the people are willing to go in the discovery of real value and the truth.  Given what has recently transpired, I suspect not too far.

The mailbag this morning has the usual dose of overly kind words for which I am always grateful, useful information and notification of alas, typos. But also of hysteria, from those who fear the government is going to come and take their money, or who think that people like me are going to spoil their good thing by warning people about it. Thank God for spam settings.

I don't think most people realize how little their opinion matters anymore. At some point the truth is simply what it is, without regard to what we think about it, or whether we like it. Their good thing is over. It's in the end game now, and we are all in God's hands.

John Law (baptised 21 April 1671 – died 21 March 1729) was a Scottish economist who believed that money was only a means of exchange that did not constitute wealth in itself and that national wealth depended on trade. He was appointed Controller General of Finances of France under King Louis XV.

In 1716 Law established the Banque Générale in France, a private bank, but three-quarters of the capital consisted of government bills and government-accepted notes, effectively making it the first central bank of the nation. He was responsible for the Mississippi Bubble and a chaotic economic collapse in France."

I believe that "modern monetary theory" owes much to John Law, and Money and Trade Considered, with a Proposal for Supplying the Nation with Money (1st ed., 1705; 2nd ed., 1720).

“An abundance of money which would lower the interest rate to two per cent would, in reducing the financing costs of the debts and public offices etc., relieve the King.”

John Law

Here is a brief discussion of John Law and the parallels for today's crisis from Buttonwood at The Economist.

I think there is a bit of disinformation going about. The implication from some corners is that those who sell silver as a hedge borrow it from existing physical supply, drawing down physical stocks. What they do not realize, or admit, is that borrowed silver is not held as allocated and discrete collateral in any system with which I am familiar, but is at best resold again into the bullion markets, if it ever experiences any movement at all beyond some multiple ledger entries.

The dirty little story of the metal markets is leverage and fractional ownership, not always disclosed, which some say is as high as 100 to 1. And this is in the so called physical bullion markets like the LBMA. I could not even imagine how badly mispriced the counter party risk is in the hedges. But when the music stops and the tide goes out, we may see who is naked, and there will most likely be a surfeit of some rather ugly bums.

Reuters
US silver term structure inverts as supply tightens
By Frank Tang
February 11, 2011

NEW YORK, Feb 11 (Reuters) - The tightest physical silver supplies in four years have tipped the U.S. silver futures market into backwardation this week, making near-term prices more expensive than more distant months.

Market watchers said that it has been more than 10 years since silver futures were last in backwardation, an unusual term structure, associated with shortage of physical supply. Warehouse stocks of the white metal have dropped to a four-year low on surging demand, while miners have hedged their future production.

Booming industrial demand for silver and record U.S. coin sales, combined with a surge in demand from mining companies to borrow the metal for their hedge programs have led to a squeeze in the physical silver market.

"The problem is that there is great industrial demand for a specific grade of silver, and there is not enough coming fresh from the mines," said Miguel Perez-Santalla, vice president of Heraeus Precious Metals Management.

"The stocks are being pulled for all the high grade and better materials, and that essentially put a squeeze on the physical market," he said.

Perez-Santalla said that silver futures have not been in backwardation since billionaire Warren Buffett bought 130 million ounces of silver between 1997 and 1998.

Backwardation is a condition where cash or nearby delivery prices are higher than the price for delivery dates further in the future. Usually, forward prices are higher than cash prices to reflect the costs of storage and insurance for stocks deliverable at a later date.

"The extent of the backwardation in silver is unprecedented. It suggests that retail investment and industrial demand internationally is very robust and the small silver bullion market cannot cater to the level of demand for refined coin and bar product," bullion dealer GoldCore said in a note on Friday.

Warehouse data from COMEX showed that silver stocks fell to a four-year low at 102.5 million ounces (3,188 tonnes) on Feb. 5, about 30 percent below a peak at over 141 million ounces (4,395 tonnes) in June 2007.

Strong silver coin sales have more than offset outflow from the world's largest silver-backed exchange traded fund iShares Silver Trust (SLV), which notched its biggest one-month drop in its silver holdings in January...

China and the Goldfinger Syndrome

I have had some interesting discussions recently with correspondents about the problem which China has with its very large US dollar reserves.

To summarize what I think, China is attempting to diversify their portfolio of US Treasury dollar holdings. They are obviously accumulating 'real goods' including stockpiles of basic materials, gold, silver, oil and investments in the means of production in their own region and in key regions around the world.

This is more difficult than it might appear on the surface. Real goods are often strategic, and governments are sometimes reluctant to allow them to be acquired by a government considered a potential threat. The first difficulty is the strategic importance of some assets, such as the China's offer for the purchase of Unocal.

But there is also a need for confidentiality, stealthiness if you will. If word were to leak out that 'China is dumping its Treasuries' there would be a run on the market and the Chinese could lose a portion of their reserve wealth rather quickly.

Now, would it matter. Well, yes. It would matter because US dollars are still the currency of choice for most international trade including the all important international commodity, oil. If you think that philosophically dollars have no value because they are just paper, I would be more than happy to dispose of them for you. Limited time offer, of course.

I also posited that China, while accumulating its real goods quietly against the constraint of perturbing the markets, could do short term hedges against the less catastrophic scenario of further dollar devaluation by going into the very deep and liquid financial assets markets, and hedging risk with CDS and other obvious investments including shorts of various types.

As anyone who has attempted to acquire a company or take a substantial position in or out of an asset or company, at some point you can affect the price, making other participants aware that the asset is in play, and end up selling or buying against yourself. In the case of China it could also trigger a run on the bank of the US, which is an immediate endgame.

With regard to the use of financial instruments, someone raised the obvious issue of counter party risk. Well, of course it is an issue. But less so if you are merely hedging a portion of the portfolio for the devaluation scenario, and not a catastrophic default. And the choice of counter parties can be managed to some degree. It is a big world out there and the Swiss are always open for a bet.

But correctly, if there is a catastrophic failure of the dollar, they will be carrying banks and brokers around the world out on stretchers and almost all financial assets, or bets, will be in default. Those who are holding leap puts as insurance against a collapse may as well be holding food vouchers for a restaurant in Brigadoon.

China would most likely not lose the value of its reserves in the extreme case of a US default, even if every one of their remaining Treasuries and the financial hedges on those Treasuries became worthless. Why?

It's the Goldfinger Syndrome. As you may recall, Auric Goldfinger did not wish to steal the US gold supply, at that time the currency of the nation, from Fort Knox. He merely wished to eliminate it, making his own substantial gold holdings significantly more valuable. It is a form of increasing value through deflation, a concept that is much more familiar these days thanks to quite a few amateur economists patiently waiting for the US dollar to gain in value because of it.

If the US were to actually default, the value of real goods, from basic materials to gold and silver and oil, would absolutely soar in terms of dollars of course, but in most other fiat currencies of the developed world as well. The perception of the risk of a fiat currency would border on hysteria.

Returning to the deflation meme, the elimination of US financial assets from the 'world currency base' would make all the other currencies extremely valuable, and China would be flush with them. For real goods are a form of currency suitable for the exchange of wealth. They are merely less liquid, and not often used as the unit of value anymore. But real goods are a form of currency. They just cannot be printed, except perhaps on the Comex and at the LBMA it appears, and they would be absolutely discredited and out of business.

So, that is something to think about. China need do nothing but slowly and stealthily acquire real goods, and hedging their positions along with way with financial instruments, waiting for the US to play itself into some beneficial outcome for them. I think the financial hedging is important because of the relative illiquidity of some of the real goods, and the difficultly of acquiring them in sufficient supply without triggering a 'run on the dollar.' The financial markets are deeper and more discreet than the markets for real goods.

The problem facing the holders of dollars is not inflation or deflation, per se. They are merely particular manifestations of currency risk, and the uncertainty of holding substantial assets denominated in a fiat currency that is risky, meaning something abnormal or unstable in the classic sense of the term. A serious deflation or inflation are both unusual and risky.

This is not hair-splitting. Rather it is essential to understanding why gold can increase in value during periods of both a significant deflation and inflation, which on the surface seem like opposites. In fact they are similar if view in the terms of probability. They are both the opposite of currency stability, what I call currency risk. The further one gets out on the probability curve with a currency, the better gold looks in relation to it. Gold is the ultimate in stability, almost inert, and highly resistant to corrosion and decay, bordering on the timeless, comparatively uniform in its supply.

There are those who say that when the time comes, and what is happening becomes apparent, they will buy some real goods, foodstuffs, land, gold and silver. I can assure you that when that time comes, there will be little or none available at almost any price. One has to have lived through a currency crisis first hand to understand the phenomenon.

You are holding a currency in decline and there is little or no place to spend it except as a throwaway, because no one wants it anymore. Barter becomes predominant, and any hard currency is king. This is how it was in Russia in the 1990's with the old rouble before it finally imploded, at which time I was thankfully out of country. It was quieter than you might imagine, despite the headline antics of their mafia, and a sense of quiet desperation as people watched their life savings simply evaporate.

There is almost no doubt in my mind that this is how the Chinese are playing this, and certainly Russia and a few others as well, who are playing the long game. It explains some of the recent moves in price of certain forward looking assets, a phenomenon so little understood by the many, even now.

I still see the greater probability for the US as a devaluation and a stubborn stagflation for quite a few years. But the policy errors being committed by Bernanke and the Obama Administration are making the possibility of an actual collapse more likely than I would have thought even six months ago. I suppose it is never well to underestimate the self-destructive tendencies of obsessive greed.

See also The Last Bubble: The Problem of Unresolved Debt in the US Financial System and Currency Wars: Selling the Rope

Most Wall Street Banks Using Lehman Style Accounting Trickery Enabled by the Fed to Hide Their Risk

"Progress is a nice word. But change is its motivator. And change has its enemies.” Robert F. Kennedy

This analysis from the Wall Street Journal indicates that most of the big US Banks are engaging in the same kind of repo accounting at the end of the quarter that Lehman Brothers was doing to hide their financial instability until deteriorating credit conditions and liquidity problems made them precipitously collapse, as all ponzi schemes and financial frauds do when the truth becomes known.

The basic exercise is to hold big leverage and dodgy debt, but swap it off your books with the Fed at the end of each quarter for a short period of time when you have to report your holdings.

This could easily be corrected by requiring banks to report four week averages of their holdings for example, rather than a snapshot when they can hide their true risk profiles so easily, compliments of that protector of consumers and investors, the Fed.

This is nothing new to us. Many of us have noted this sort of accounting trickery and market manipulation at key events especially at end of quarter.

It is facilitated by the Federal Reserve, and FASB, and the agencies.

"Their Fraud doth rarely falter, and is subsidized, instead,
for none dare call it bank fraud, if it's sanctioned by the Fed."
(apologies to Ovid)

The US is Lehman Brothers on a scale writ large. And when it is exposed by some series of events, the implosion could be more sudden than any can imagine. But in the meantime the US is still the 'superpower' of the world's financial system, through its currency, its banks, and its ratings agencies.

WSJ
Big Banks Mask Risk Levels
By KATE KELLY, TOM MCGINTY and DAN FITZPATRICK
April 9, 2010

Quarter-End Loan Figures Sit 42% Below Peak, Then Rise as New Period Progresses; SEC Review

Major banks have masked their risk levels in the past five quarters by temporarily lowering their debt just before reporting it to the public, according to data from the Federal Reserve Bank of New York.

A group of 18 banks—which includes Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of America Corp. and Citigroup Inc.—understated the debt levels used to fund securities trades by lowering them an average of 42% at the end of each of the past five quarterly periods, the data show. The banks, which publicly release debt data each quarter, then boosted the debt levels in the middle of successive quarters.

Excessive borrowing by banks was one of the major causes of the financial crisis, leading to catastrophic bank runs in 2008 at firms including Bear Stearns Cos. and Lehman Brothers. Since then, banks have become more sensitive about showing high levels of debt and risk, worried that their stocks and credit ratings could be punished.

That practice, while legal, can give investors a skewed impression of the level of risk that financial firms are taking the vast majority of the time.

You want your leverage to look better at quarter-end than it actually was during the quarter, to suggest that you're taking less risk," says William Tanona, a former Goldman analyst who now heads U.S. financials research at Collins Stewart, a U.K. investment bank.

Though some banks privately confirm that they temporarily reduce their borrowings at quarter's end, representatives at Goldman, Morgan Stanley, J.P. Morgan and Citigroup declined to comment specifically on the New York Fed data. Some noted that their firm's financial filings include language saying borrowing levels can fluctuate during the quarter.

"The efforts to manage the size of our balance sheet are appropriate and our policies are consistent with all applicable accounting and legal requirements," a Bank of America spokesman said.

The data highlight the banks' levels of short-term financing in the repurchase, or "repo," market. Financial firms use cash from the loans to buy securities, then use the purchased securities as collateral for other loans, and buy more securities. The loans boost the firms' trading power, or "leverage," allowing them to make big trades without putting up big money. This amplifies gains—and losses, which were disastrous in 2008.

According to the data, the banks' outstanding net repo borrowings at the end of each of the past five quarters were on average 42% below their peak in net borrowings in the same quarters. Though the repo market represents just a slice of banks' overall activities, it provides a window into the risks that financial institutions take to trade...

Read the rest here.

Here is an interactive visualization of the accounting deception.