Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Friday, September 23, 2011

Commodity money: It's back! (and it sucks)

You may recall hearing that earlier this year, J.P. Morgan began to accept gold as collateral for some types of loans. The story can be found here. Here is an excerpt:
Gold hasn't reinvented itself as a currency yet. But it is getting closer. 
J.P. Morgan Chase & Co. said it will allow clients to use the metal as collateral in some transactions. For example, a hedge fund wanting to borrow money for a short period can put up gold as collateral and use the borrowings to invest elsewhere, betting on making a better return. Typically, banks accept only Treasury bonds and stocks in such agreements. 
By making the announcement, J.P. Morgan is effectively saying gold is as rock solid an investment as triple-A rated Treasuries, adding to a movement that places gold at the top tier of asset classes. It also is trying to capitalize on all the gold now owned by hedge funds and private investors that is sitting idle in warehouses.
O.K., so gold is not quite "money" (in the sense that it circulates widely as a medium of exchange). That is, if gold was money, one would not need to use it a collateral for a money loan, right? (You could use the gold to buy the stuff you wanted directly.)

But the use of gold as collateral in short-term lending arrangements nevertheless has the effect of increasing the liquidity of gold.

It is interesting too, to observe that the practice appears to be extending to other commodities, including copper and soybeans. Where is this happening? Apparently, in China; see China's copper collateral -- and covert credit and China and the magic financing (soy) beanstalk.

Evidently, the use of commodities as collateral constitutes an attempt by the private sector to get around China's highly regulated credit market. It is China's "shadow banking" system. Short term financing (at low rates) supported by "high-grade" collateral (like the private-label AAA MBS securities used as collateral in the U.S. repo market prior to 2008).

The problem, of course, is what happens to the shadow-banking sector when the value of the collateral plummets. (In case you haven't been paying attention, gold and copper prices have recently declined rather dramatically.) What happens is that creditors no longer want to roll over their short-term financing--they want their money back (and hey, you can keep the copper). Debtors, in a desperate attempt to acquire the cash to repay their loan, begin to dump copper on the market--the effect of which is to make matters worse.

And this is what is happening now; see: China Copper Prices Drop as More Bonded Copper Reaches Domestic Market.

I think that this experience gives us some hint as to why commodity money systems are not the panacea that some like to make them out to be. Sometimes, it even appears that the private sector prefers government money. Look, for example, at the way private-label MBS products were driven out of the U.S. repo market by U.S. treasuries in the recent financial crisis. It's a tricky business, trying to figure all this out. See also this discussion by Steve Williamson: Commodities and Money.

33 comments:

  1. Good post. However - ever thought about the fact that a mortagage (and I mean the kind 'created out of thin air') has a house as collateral... and at least in Europe (I didn't check the Fed data for the USA) mortgages (well, to be more precise: the sums of money provided to households backed by a mortgage) are about the most important kind of money which prevents the stock of M3 money from actually declining. Much more of our money stock has goods as its collateral as commonly perceived. Think also of loans used to buy cars and commercial credit from one company to another.

    Merijn Knibbe

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  2. Merijn,

    Have I thought about that? Yes; please take a look at my post of a few days ago on fractional reserve banking.

    One question of interest would be whether gold or copper have better safety/store-of-value properties over senior tranches of securitized products (backed by income-generating assets, like mortgages).

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  3. David:

    Using gold as collateral is not fundamentally different from using land as collateral. In either case, if the collateral drops in value relative to the loan, then the lender gets stuck for the difference between the money he lent and the collateral he is able to seize. That's life, or rather, that's banking. Even when a 'fire sale' happens, we should assume that both borrower and lender saw that possibility when they signed on the dotted line.

    But the fact that land or gold is used as backing for money does not mean that land and gold are now commodity moneys. The money is denominated in dollars, while the collateral is denominated in oz. or acres. And one of the best ways to keep the value of the dollar stable is to back it with a diversified bundle of various kinds of collateral.

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  4. Mike,

    You are correct--it is not fundamentally different. But it is different, and in an important way.

    People do not just use land for collateral. They use the senior tranches of debt backed by a diversified portfolio of income generating properties.

    This is potentially important because I think (am not sure) that the price of the latter is much more stable than the price of the former.

    And that matters. Thoughts?

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  5. David:

    True, a senior tranche would normally be more stable. A lender might therefore lend $.90 on the dollar of senior tranches, but only $.50 on the dollar of land. This is still not a case of fundamental differences.

    So suppose a bank makes various loans on various kinds of collateral. The money created by these loans is backed by a diversified portfolio of assets, so the stability of that money is enhanced. But if some customer offers a pearl necklace as collateral, that does not mean the necklace is money. It just means that the necklace backs the money.

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  6. Mike,

    Yes, you are correct. But as I say above, the use of an object as collateral for a short-term money loan nevertheless enhances the liquidity of the collateral asset (relative to the case where it is not used in this manner).

    The AAA rated tranches of MBS became "almost as good as money" because they could easily be used to acquire short-term money (or easily disposed of for cash--i.e., they were liquid).

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  7. ..."People do not just use land for collateral."...

    Real people do use land, buildings and the crop in the ground as collateral. Not many people on Main street use Tranches for everyday business.

    I do agree with your reservations about the use of hard commodities as collateral in todays markets.

    GK

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  8. "People do not just use land for collateral. They use the senior tranches of debt backed by a diversified portfolio of income generating properties. This is potentially important because I think (am not sure) that the price of the latter is much more stable than the price of the former."

    Ok, how about senior tranches of securities backed by a diversified portfolio of various commodities? A "super-senior commodity ETF unit", so to say.

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  9. Commodity money is being used by sophisticated players on both sides of the trade. If sophisticated does not equate with smart then it's their own fault. Let the games continue.

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  10. @Anonymous,

    I never meant to suggest that the participants in these markets are not "smart."

    The way I look at it, there exist important frictions in financial markets (limited commitment and asymmetric information). These frictions lead to what some economists have called an "asset shortage" (a shortage of good collateral objects that are designed and used to overcome the aforementioned frictions).

    It is a constant struggle--no asset works perfectly. Policymakers should understand this, and then design their policies to reflect this reality (at the same time, recognizing that the private sector will react to the policy regime).

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  11. Sounds like your pushing back/carrying water on Ben B's smug answer for why the Fed holds gold. Tradition was his answer, what value do you see in those holdings? If fiat instruments(and the government control and abuse thereof) really are the answer why is someone (like you) not competent enough to make this argument empirically to validate the selling of said gold? Your disparaging commodities as collateral yet fundamentally the Fed has kept exactly that in their back pocket and paying decent storage costs to do so. Tradition is not a real answer but to abuse the concept that it is: traditionally the dynamic adjustments of fiat currency have burned holders just as much as commodities. Just look at the current multi sigma dynamics of the Swiss Franc or the ongoing abuse of savers by rate manipulation in the US. If economists were willing to add in these costs they would find much more volatility and attendant friction than they pretend to measure. The trick of course is that you denominate in fiat so the costs are not easily visible.

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  12. Anonymous,

    I'm not really sure what you are talking about. First, I was under the impression that the Fed owns no bullion (it resides at the Treasury). Take a look at this:

    http://jessescrossroadscafe.blogspot.com/2009/10/how-much-gold-does-us-have-in-its.html

    Now, I'm not sure why the Treasury owns gold. You'll have to ask Ron Paul about that, not Ben Bernanke.

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  13. Hey 'Big Guy' you might wish to have any online rags (like this one for example, http://wallstreetpit.com/84298-commodity-money-its-back ) carrying your content let the readers know you are a Federal Reserve employee to add some context to your position. Just Sayin!

    Oh, and did the Fed's "Communications Group" encourage your trash Metals post while a pricing respite is taken? You know the group reportedly with an RFP out for a Fed Big Brother monitoring undertaking http://bit.ly/pwSWwp

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  14. The idea that there can be a shortage of good collateralizable financial assets sounds fishy to me. Prices for those assets will simply rise until their price is sufficient to meet the demand for good collateral. The same with an excess demand for money - prices will simply fall to meet that demand.

    You seem to be down on commodities serving as collateral, but if this is a case of the marketplace simply engaging in the entrepreneurial search for a new and less expensive collateral, than so be it.

    Your worry about gold and copper being volatile, and therefore not ideal collateral, is something that is probably already built into the market. I'm sure that collateralization policies have been designed to take this into account.

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  15. @JP Koning:

    It may sound fishy, but I assure you that the notion can be formalized rigorously. The intuition is simple: it stems from a lack of commitment. Do you find the inability or unwillingness to honor one's promises in financial markets "fishy?" I think this is a real problem. And it leads to asset shortages.

    The point of this post was not "be down" on commodities as collateral. By all means, use whatever collateral you want. I was just pointing out that commodity money/collateral is not the panacea that it is frequently made out to be. Nothing is perfect.

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  16. David, what paper would you recommend for this? I am curious.

    "Do you find the inability or unwillingness to honor one's promises in financial markets "fishy?" I think this is a real problem. And it leads to asset shortages."

    No, I don't see the concept of lack of commitment as fishy. But I can't see this as leading to a shortage in modern financial markets. The prices of more-likely-to-default assets like MBS get bid down, the price of less-likely-to-default assets like t-bonds get bid up. Other assets (like gold) get recruited into acting as collateral where before they went un-utilized. The market for collateral clears.

    If limited commitment is a major problem, gold is a great collateral asset since it has no issuer (as the gold bugs say, it is no one's liability), and while it may fall in value, it will never go into default.

    But perhaps I am not understanding the term limited commitment.

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  17. JP Koning,

    I am not sure which paper to recommend to you. Are you boned up on mathematical models? If so, I could recommend to you any one of Steve Williamson's recent papers.

    The term "asset shortage" is peculiar; it does not mean that markets do not clear.

    Gold is NOT a GREAT collateral asset. It DOES have an issuer -- the people who mine the stuff. And it's price is highly volatile, making it poor collateral material, relative to, say, US treasuries.

    The other thing that people largely ignore is that gold is not a homogeneous, easily verifiable, product. There are different grades of gold. Gold can be counterfeited (gold plated lead coins, for example). Etc., etc.

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  18. "I am not sure which paper to recommend to you. Are you boned up on mathematical models? If so, I could recommend to you any one of Steve Williamson's recent papers"

    And if not?

    I guess I don't understand what you mean by asset shortage. I've never seen a shortage in asset markets. All I've seen is prices that quickly jump.

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  19. JP, here is something that may help:

    http://econ-www.mit.edu/files/2732

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  20. Thanks. Are Caballero and Williamson saying pretty much the same thing?

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  21. JP,

    Caballero has a much broader thesis; Williamson is more concerned with theoretical details (and not so much about the global economy).

    The similarity is in the fundamental financial market friction they assume: a general lack of commmitment.

    Lack (or limited) commitment means that it is costly (perhaps prohibitively so) for people (or agencies) to honor all the promises they make. As you know, the financial market is a market of promises, so this is a serious friction.

    Institutions, like collateralized debt, emerge to mitigate these frictions. There is an eternal search, I think, for assets that serve as good collateral. Safety is paramount. Low risk. But even more subtly, people should be symmetrically informed about them (Gary Gorton's notion of "informationally insensitive."

    A good collateral asset is not one in which speculation (by informed insiders) is potentially important. That's why most equity shares make for poor collateral. This is why Treasuries make good collateral.

    Just a few ideas. Much more to it than I have time to say here. But let me know if you have any further questions after you do some reading.

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  22. "But let me know if you have any further questions after you do some reading."

    Thank you. I will do so.

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  23. Do you think it is justifiable for us taxpayers to fund the Feds initiatives to spy on us taxpayers?

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  24. Anonymous, I am not aware of any stipulation in the Federal Reserve Act that allows the Fed to engage in espionage. But perhaps you know something that I do not?

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  25. "What happens is that creditors no longer want to roll over their short-term financing--they want their money back (and hey, you can keep the copper). Debtors, in a desperate attempt to acquire the cash to repay their loan, begin to dump copper on the market--the effect of which is to make matters worse."

    I don't see the logic here - the whole idea of collateral is to be seized in case of default. If the value of collateral falls this is good for the debtor and bad for the creditor. The debtor defaults - the creditor is stuck with the worthless collateral. Why would debtors be "desperate" to repay their debt if default is actually profitable when collateral loses value?

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  26. Good point. But in reality, defaulting has costs that extend beyond losing collateral. You may be denied access to credit in the future, for example. Reputation is important too.

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  27. Well, you can't have it both ways - if reputation was really important then there'll be no need for collateral. The true answer may be that collateral is not just an instrument to alleviate limited enforcement problems but also moral hazard and adverse selection

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  28. Anonymous, I think you are wrong. Reputation can be important; and collateral can augment commitment, where reputation is lacking.

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  30. the use of commodities as collateral constitutes an attempt by the private sector to get around China's highly regulated credit market. It is China's "shadow banking" system. China Direct

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  32. So the difference between "commodity money" & "fiat money" comes down to government price fixing & redeemability?

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