"Here’s What the 'Experts' Are Missing"
by Jim Rickards
"We’ve all followed the cascade of financial and economic sanctions the U.S. and its allies have piled upon Russia in the past few weeks. The assets of the Central Bank of Russia (about $600 billion) have been frozen. Major Russian banks have all been kicked out of the global financial telecommunications system called SWIFT. High-tech and luxury exports to Russia have been banned. Meanwhile, Western banks are not allowed to trade Russian securities. The assets of Russian oligarchs from superyachts to multimillion-dollar townhouses in London are being seized.
The list goes on. That all sounds draconian (it is) and possibly even effective (it isn’t), but it begs the question of who bears the losses. If I’m a debtor and you tell me I’m not allowed to pay my debts, I might say, “Thank you, that’s a relief.” In those circumstances, the loser is not the debtor. It’s the creditor who was expecting to be paid and now he finds that’s impossible.
All of these Russian banks and borrowers were doing business with investors in the West. When you freeze Russian payments, some Western bondholder is not getting paid, and some investor will end up taking the loss. That investor could even be you. If you look inside your 401(k), you might find an emerging-markets ETF or fund that just happens to hold some Russian debt. Russia has about $100–150 billion of dollar-denominated debt, about half of which is owned by investors outside of Russia.
If only part of that defaults, it could be $50 billion or more in direct financial losses to ETFs, mutual funds and even small holders in 401(k)s who may not know what’s inside the products that Wall Street cooks up. Mega-asset manager BlackRock has already lost $17 billion of its investors’ money with bad Russian stock and bond bets.
Still, Russia is trying to pay. The head of the Central Bank of Russia is Elvira Nabiullina, who’s one of the smartest central bankers in the world and perhaps the only one who understands how to do her job. She’s trying to pay the debt in rubles even if she is not allowed to pay in dollars. Despite the sanctions, she still controls Russia’s ruble printing press and could create enough money to pay the debt. Still, if this ruble work-around does not work, we’re looking at massive losses for Western investors.
But it gets worse. In addition to outright bondholders, there are billions of dollars of derivatives linked to the bonds. This means that actual losses can be many times the losses on the bonds themselves.
This is exactly what happened in the subprime mortgage crisis in 2008. There were about $1 trillion in subprime mortgages at the time. A 20% default rate, which is sky-high compared with usual default rates of less than 5%, implied $200 billion in losses. That’s a huge loss but manageable in the financial system. What most analysts missed is that there were $6 trillion of derivatives written on the $1 trillion of subprime mortgages. This meant that actual losses were more on the order of $1.2 trillion than $200 billion once derivatives were taken into account.
Something similar is at play with regard to Russian bonds. The exact identities of the holders and the scope of derivatives are almost completely opaque. No one really knows how far the financial distress may spread. The point is that it’s easy to slap on sanctions, but it’s almost impossible to ascertain exactly where the losses will fall and how great they’ll be. This phenomenon is called “contagion.” It works exactly like a virus. One creditor loses money, and that causes him to default to another creditor, and so on. It’s exactly the way a virus spreads from one victim to another.
The most famous case of this also involved a Russian default. That was in 1998. That financial crisis started in Thailand in 1997, spread to Indonesia, Malaysia and South Korea before hitting Russia. From there, the next victim was not another country but a hedge fund in Greenwich, Connecticut, called Long Term Capital Management (LTCM). The Fed had to organize a $4 billion bailout to save world markets. I negotiated that bailout on behalf of LTCM.
Now it’s happening again. Russia is on the brink of defaulting on its debt. Then contagion takes over. There will be some initial losers, but those losses could cascade out of control as they did in 1998. Banks, brokers and hedge funds are all at risk. The best advice is to expect the unexpected. You can get ahead of that by reducing equity exposure and increasing allocations to cash and gold now."
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