Thoughts Worth Thinking's  Instablog

Back in 1987, I was working retail for a company that was then a major foreign exchange and precious metals dealer.  A non-descript man entered the office with his family.  The man, who was wearing a flannel shirt one might use for garden work, asked me what our price to buy gold was.  I asked what form his metal was in, expecting one-ounce bullion or coins.  “Kilo bars,” he said.  We didn’t even have a price for a kilo bar on hand, so I asked the customer to wait for a moment while my coworkers and I scrambled behind the scenes to get a quote.  When I gave the customer the price, he dropped almost $30,000 in gold in on the counter, then enough to buy two new cars—one a BMW.

While this experience (and my speculation that the man had just unearthed the gold from his yard) forever cemented my impression of gold as a safe-haven asset, other aspects of the situation are instructive regarding the current gold market.  The man was selling his gold at a price that was probably around $450 an ounce, and history showed that he was wise to do so.   Even with gold’s recent appreciation and the financial crisis crushing the stock market, large cap equities (going from Dow 2500 to 10,332 as of market close on November 19) have outperformed gold (about $450 to $1141 an ounce) by a large margin since 1987.  And that doesn’t even take into account that stocks can earn dividends, while holding gold can incur costs in the form of storage and/or insurance expenses.  (For that reason, other than for people who want to keep a stash of gold at home to prepare for the most extreme scenarios, I suggest that people who want to invest in gold consider equity-based investments like the dividend yielding shares of one of the established gold mining companies such as Barrick Gold (ABX), Newmont Mining (NEM) and Gold Fields Limited (GFI)).

The shorter term of the current decade paints a different picture.  Gold was in the high $200’s in 1999, and now stands over $1,100 an ounce, while the Dow crossed 10,000 for the first time in 1999, to where it has just about returned.  In this decade, with the 9/11 attacks in 2001 and the financial storm beginning last year, the United States has experienced the most significant challenges to its national and economic security in generations.  Given that gold is marketed as a hedge against events that disrupt other markets, there is a strong temptation to correlate its rise to the heightened risks of the current environment.  There may be some truth to this perceived causation, as reflected by reports of investors piling money into gold and other defensive assets as unemployment persists.  (If your family or a friend has been impacted by the unemployment situation, see my post on How to Help Your Unemployed Spouse Find a New Job After a Layoff.)  But it’s also possible that the relationship between these risk factors and the gold price is exaggerated.

This leads me to the main point of this post:  while there are long-term factors that will support gold prices regardless of where the U.S. economy goes, principally consumer demand in emerging nations, there are some significant short and medium term risks.

A combined 2.5 billion people live in China and India, over eight times the population of the United States (307 million).  But China and India are already the world’s two leading gold consumers, India being first, and both already have far more demand for gold jewelry than the United States. ¹  This means that while there is still lots room for China and India to develop more gold demand as large segments of their huge populations morph into a massive middle class, temporary reductions in their demand can move gold down.

Such downward pressure is particularly likely in the case of India, where people of modest means have traditionally preferred to put their savings in gold instead of banks, and the government has long sought to discourage gold hoarding to catalyze development of the banking system. ²  Currently in India, people who have purchased gold all along are selling it to profit from the high prices. ³  While gold buying typically picks up during the Indian wedding season that runs from October through December,⁴ once that’s over the downward pressure from Indian gold selling may resume.

Also, to the degree that the current financial turbulence is driving the gold market, there is a significant risk that the party will end.  At some point, the U.S. Federal Reserve will raise interest rates, making dollar denominated bank accounts more attractive to international investors, and creating pressure for the dollar to rise against other currencies and gold.  While deficit spending in the U.S. has created a concern for coming hyperinflation and further deterioration of the dollar, I have argued in a previous post that the current fear of hyperinflation is exaggerated because U.S. tax rates are still well below those of other nations with a triple-A credit rating.  These possibilities both provide potential catalysts for the gold price to eventually experience a correction, compounded by reduced demand when the Indian wedding season ends.

In comparison, the transformation of the Chinese and Indian populations into a broad consumer group with enough wealth to further support long-term gold appreciation is likely to take place on a longer and less predictable path than the recovery from the current recession.  What this means for investors is that now is not the time to bet big on gold or gold-related assets.  It’s good to diversify and having some gold-related holdings can be a good defensive position.  For those who don’t currently have assets tied to gold and have resources to invest, given the uncertainty of the current times it’s rational to start to gradually cultivate a gold related position in conjunction with building other investments.  But in my view those who assume that they’ll turn a big short-term profit at current gold price levels risk being disappointed.  The recent statement by Barrick Gold CEO Aaron Regent that gold could fall from current highs acknowledges that risk. ⁵  Those who are prepared to accumulate gold-related assets over time are more likely in my view to be able to capitalize on future dips and long-term appreciation.

Disclosure:  The author is long on Barrick Gold (ABX) as of the original publication date of this post.  The author does not hold a securities position in Newmont Mining (NEM) or Gold Fields Limited (GFI).

1. See “China’s Gold Demand Sparkles in Q2,” Chinamining.org, August 24, 2009, http://www.chinamining.org/News/2009-08-24/1251102403d28434.html. [↩]
2. R. Kannan & Sarat Dahl, Indian Journal of Economics and Business, India’s demand for gold: some issues for economic development and macroeconomic policy, June 2008,http://findarticles.com/p/articles/mi_m1TSD/is_1_7/ai_n28026379/?tag=content;col1, screens 1-3 & 8. [↩]
3. “India Buys Gold; Indians Don’t,” Goldnews, November 9, 2009,http://goldnews.bullionvault.com/india_gold_110920093. [↩]
4. “India gold demand abates after early week’s pick-up,” Reuters, October 30, 2009, in.reuters.com/article/businessNews/idIN...;“Gold hits new high on weak dollar,” BBC News, November 9, 2009, http://news.bbc.co.uk/2/hi/business/8351154.stm. [↩]
5. “UPDATE 1-Barrick chief says sell off in gold possible-FT,” Reuters, November 11, 2009,http://www.reuters.com/article/basicMaterialsSector/idUSSP46116320091112. [↩]

The first flaw in these alarmist arguments is the presumption that the budget deficit the United States is now running is inherently irresponsible.  Commentators stir up fears that the ballooning deficit puts the United States triple-A credit rating at risk.  These arguments disregard that tax rates in the United States are much lower than in other Aaa rated countries.  In evaluating the resilience of triple-A countries to expand their balance sheets, Moody’s (MCO) observes that United States tax rates average 34%, as opposed to 44% in Germany and 50% in France, so that the United States’ unused revenue raising power should be considered in reviewing its credit rating. ¹  Similarly, Standard & Poor’s (owned by McGraw-Hill (MHP)) considers already-high taxes to be a constraint on fiscal flexibility negatively affecting a sovereign’s credit rating, implying that currently low taxes are a favorable indicator of fiscal flexibility. ²

Second, inherent in the hyperinflation gloom and doom is the presumption that the expansion of public debt will not be followed by growth.  It’s true that if all that happens is that the U.S. prints more money, the rest of the world will figure this out and value of each dollar will decline, fueling inflation.  But the value of a currency is based on a range of factors far beyond whether or to what extent a government is printing money, including the value to the rest of the world of what the country is producing.

In other words, if the U.S. accelerates its development of globally desirable goods and services, buyers abroad will need dollars to purchase them, creating upward pressure on the dollar to counter the dilutive effect of printing money.  Thus, running a deficit is not inherently wrong.  The real question is whether the combination of public and private sector investment is likely to lead to growth.

Another way of looking at this is as it concerns the United States’ credit rating is that it’s not the deficit itself that puts the country’s triple-A rating at risk, it’s the shock of the crisis itself.  Rather, the deficit is byproduct of the solution currently being implemented, which could either help or hurt the credit rating depending on the quality of the result.

It’s too early to tell how much the Obama stimulus package, subsequent government efforts, and private sector activity will contribute to real growth in the United States.  But that means it’s also too early to assume hyperinflation is coming.  While it’s always a good idea to diversity and I would never discourage anyone from putting some of their holdings in defensive assets, those who bet heavily on hyperinflation right now risk being disappointed.

Disclosure: The author does not hold a securities position in Moody’s or McGraw-Hill.

1. Moody’s, “How Far Can AAA Governments Stretch Their Balance Sheets?,” February 2009, pp. 11-13,http://www.docstoc.com/docs/4808646/Moodys-How-Far-Can-Aaa-Governments-Stretch-Their-Balance-Sheets-February-2009. [↩]
2. See “Standard & Poor’s, Soverign Credit Ratings:  A Primer,” March 15, 2004, pp. 7-8, info.worldbank.org/etools/docs/library/1.... [↩]

As far as I can tell, here’s what happened. On March 31, the European Commission (EC) issued a finding temporarily clearing the Dutch government to backup ING’s portfolio of Alt-A mortgages for 6 months.¹    Then, on July 22, the EC issued a paper entitled “The return to viability and the assessment of restructuring measures in the financial sector in the current crisis under the state aid rules.”² In this paper, the Commission stated:

[Page 7] In order to limit distortions of competition and address moral hazard, aid should be limited to the minimum necessary and an appropriate own contribution to restructuring costs should be provided by the aid beneficiary. The company and its capital holders should contribute to the restructuring as much as possible with their own resources. This is necessary to ensure that rescued banks bear adequate responsibility for the consequences of their past behaviour and to create appropriate incentives for their future behavior.

[Page 8] The banks should be able to remunerate capital, also in the form of dividends and coupons on outstanding subordinated debt, out of profits generated by their activities. However, banks should not use State aid to remunerate own funds (equity and subordinated debt) when those activities do not generate sufficient profits.Therefore, in a restructuring context, the discretionary offset of losses (for example by releasing reserves or reducing equity) by beneficiary banks in order to guarantee the payment of dividends and coupons on outstanding subordinated debt, is in principle not compatible with the objective of burden sharing.[Footnote 33] This may need to be balanced with ensuring the refinancing capability of the bank and the exit initiatives.[Footnote 34] In the interests of promoting refinancing by the beneficiary bank, the Commission may favourably regard the payment of coupons on newly issued hybrid capital instruments with greater seniority over existing subordinated debt. In any case, banks’ [sic] should not normally be allowed to purchase their own shares during the restructuring phase.

[Page 8] Footnote 33 provided: [citation to unpublished decision omitted] However, this does not prevent the bank from making coupon payments when it is under a binding obligation to do so.

[Page 8] Footnote 34 provided: See Impaired Asset Communication, point 31, and the nuanced approach to dividend restrictions in the Recapitalisation Communication, points 33, 34, and 45, reflecting that although temporary dividend or coupon bans may retain capital within the bank and increase the capital cushion and hence improve the solvency of the bank, they may equally impede the bank’s access to private finance sources, or at least increase the cost of new future financing.

Nothing in the text of the Commission’s paper itself is alarming. The idea of modifying capital structure to pay dividends while sustaining huge operating losses and receiving government aid to keep a financial institution afloat is basically a sham, and it’s no surprise that governments don’t like it. But as recognized by footnote 34, this strategy may be necessary for an institution to retain access to capital markets since once dividend or coupon payments on hybrid or debt instruments are suspended, its credit ratings crash.

As demonstrated by the CIT (CIT) experience on the eastern side of the Atlantic—where the company paid its preferred dividends after receiving $2.3 billion in TARP aid from the U.S. Government despite turning only one profitable quarter in two years—this strategy can be a disaster for investors when the company appears to lack a viable strategy to recover. But there has been no such indication that ING’s condition is anything close to CIT’s “on life support” predicament. ING recently reported a small profit of $.04 a depository share for the second quarter of 2009 following three quarters of losses concentrated in the 4^th quarter crisis epicenter. Even after the release of the EC’s communication, the prices of ING’s common and preferred shares continued to rise through early August.

What turned the tide was a decision on August 20 by credit ratings agencies Moody’s and Fitch to cut the ratings of ING’s hybrid debt. The decision was connected in particular to KBC, a Belgian bank, halting its payments of preferred dividends in response to the pressure of EC regulators, raising the possibility that ING would be forced to do the same.³

A comparison of KBC to ING may not be entirely fair. Having received its third bailout in May⁴, KBC’s case—at least form a public relations perspective—may be more akin to chronic/multiple bailout brethren Citigroup (C) and AIG (AIG). Also, ING appears to have a head start at raising capital by selling assets, as reflected by recent reports that its sale of its Swiss and Asian private banking assets is on track.⁵

I’ve argued that investors can make money by identifying an instance where Wall Street’s misunderstands public policy (see my post How to Make Money in Stock by Arbitraging Wall Street’s Misunderstanding of Public Policy), and this may be an instance of such an opportunity with a European flair. The policy standard articulated by the European Commission is rational on its face, and did not by own terms turn the market against ING’s preferred shares. Moreover, with KBC’s triple bailout status and the American experience of CIT paying preferred shareholders after receiving government aid and then begging for more fresh on regulators minds, it’s not surprising that the Commission pushed KBC to stop the payments.

With a an arguably less motley bailout history (a EUR 10 billion cash injection in October 2008 and a backup facility for Alt-A mortgages announced in January 2009),⁶  and asset sales proceeding at a respectable pace, the Commission may be reluctant to upset ING’s applecart. So there’s a good argument that the credit agencies and market have overestimated the risk that ING will suspend the payments.

But it’s not inconceivable that the credit agencies will be right, and the Royal Bank Of Scotland’s decision not to call $1.6 billion of subordinated bonds because of regulators’ objections may reflect an acceleration of this trend.⁷ If they are and the dividends are suspended, the stock price will probably go down more, though it’s possible that most of the decline from halting the dividends is already priced in.

Trying to figure out what the regulators will do is guesswork. What seems far more predictable, however, is that ING will recover, so that the share prices will eventually trend back up towards their $25 par value. Either ING will pay preferred dividends without interruption, or it will halt them if the Commission presses the issue and pay up later—including the missed payments with interest for the cumulative preferreds.⁸ If these scenarios play out, patient investors who buy now will likely make money down the line, though possibly with a short-term decline if the dividends are deferred. Another strategy is to hold out to see if they defer the dividends, but if they don’t the share price may jump and the opportunity will be lost. A middle of the road option would be to decide the maximum to invest, put half in now, and put the other half in later if the stock price goes down due to dividends being suspended.

My own sentiment is that one of the two above scenarios will happen. ING is a conglomeration of traditional European and modern mass-marketed financial services that has returned to profitability and is not likely to go under. Its on-line banking platform, ING Direct, has become a mature on-line financial services operation that is effectively marketed with a contemporary orange ball alongside ING’s venerable orange lion.⁹ ING has recently deployed its captivating “find your number” campaign to draw consumers into its retirement oriented financial services.

There are arguments that ING’s earning prospects have been abridged by deleveraging. But even if true those theories are a far cry from establishing that ING will not be a stable and profitable concern. Remember, we’re talking about preferred stocks that pay a fixed dividend—and are required to do so if any dividend is paid on common shares—not common shares that will respond to the potential for higher dividends. The idea is to establish that the business is stable for the long term to get the share price back to par and keep the dividends coming.

Interested? Investing in preferred shares is a complicated business that can depend on the terms of the individual issue, so you’ll want to take a close look. Fortunately, the prospectuses for ING preferred issues are accessible on-line on ING’s web page at http://www.ing.com/group/showdoc.jsp?docid=075252_EN&menopt=ivr%7Cfis.

Disclosure: The author is long on ING ADR’s (ING), ING 6.2 % preferred perpetual securities (ISP), CIT preferred Series A (CIT.PR.A) and Citigroup (C) Common shares as of the original publication date of this post. The author does not hold a securities position in CIT (CIT) common shares, AIG (AIG) or in any issue of KBC Group (KBCSY).

1. “State aid: Commission temporarily authorizes illiquid asset facility for ING, March 31, 2009, athttp://docs.google.com/gview?a=v&q=cache:USBKvXaGGvkJ:europa.eu/rapid/pressReleasesAction.do%3Freference%3DIP/09/514%26format%3DPDF%26aged%3D0%26language%3DEN%26guiLanguage%3Den+ing+european+commission+burden+shairing&hl=en&gl=us[↩]
2. Commission Communication: The return to viability and the assessment of restructuring measures in the financial sector in the current crisis under the State aid rules, July 22, 2009, at http://docs.google.com/gviewa=v&q=cache:pgxQ41T8Ie8J:ec.europa.eu/competition/state_aid/legislation/restructuring_paper_en.pdf+July+European+commission+bank+restrucrturing+burden+sharing&hl=en&gl=us. [↩]
3. “Fitch cuts European bank hybrid debt ratings,” Reuters UK, August 20, 2009, at http://uk.reuters.com/article/idUKN2042464020090820. [↩]
4. “Belgium Moves onto Crisis Mode on KBC Bailout,” The Wall Street Journal, May 15, 2009, http://online.wsj.com/article/SB124225248484816987.html [↩]
5. See “UPDATE: HSBC Bids for ING Private Banking Asserts-Source,” The Wall Street Journal, September 4, 2009, at http://online.wsj.com/article/BT-CO-20090904-704808.html. [↩]
6. “Transactions with Dutch State,” at http://www.ing.com/group/showdoc.jsp?docid=363620_EN&menopt=ivr|tdt&menopt=ivr|tdt [↩]
7. “RBS Told Not to Call Subordinated Bonds After Bailout,” Bloomberg.com, September 4, 2009, www.bloomberg.com/apps/news?pid=20601087...; [↩]
8. Investors should review the prospectuses to fully understand the conditions concerning the payment of cumulative interest, including extraordinary situations where cumulative interest or payments would not be made. [↩]
9. See “The history of the ING Lion,” at http://www.ing.com/group/showdoc.jsp?docid=168408_EN&menopt=abo%7Chis%7Chil. [↩]