If there are additional downgrades of European or American banks ahead, or if the cost of credit default swaps continue to rise, thus making new financing prohibitively expensive, the banks trading derivatives will have to post additional marginable collateral.
In plain English, this means the firms trading in derivatives will have to come up with huge amounts of cash they don’t have. So they will sell everything but the kitchen sink as a means of raising it.
Consider what happened the last time around.
Merrill Lynch said in a quarterly report in 2008 that a one-notch downgrade of its credit rating would require the firm to post an additional $3.2 billion of collateral on over-the-counter derivative trades. Around that same time, Morgan Stanley (NYSE:MS) estimated in a regulatory filing that a single-level downgrade would mean posting an extra $973 million. And Lehman Bros, before it collapsed, said a one-level downgrade would require about $200 million of additional collateral.
This is what was behind the massive drops in gold, silver, and the broader markets in late 2008. Credit locked up, the cost of capital rose and margin calls ensued. So banks and trading houses sold everything they could as quickly as they could to raise the necessary capital. The selling began in the metals markets because they are most liquid. Then it moved rapidly into the broader equity markets, causing a downdraft that most investors would like to forget.
We experienced a similar thing earlier this summer as a result of more downgrades and prohibitive CDS costs. Not surprisingly, the S&P 500 fell 18% and gold tumbled 15% as the banks’ trading arms raised capital to cover their bets.
And it will happen again when the latest plan fails.
If you’re tempted to believe that the likes of JPMorgan Chase & Co. (NYSE:JPM), Goldman Sachs Group Inc. (NYSE:GS) and others care about anything other than their own hides when the downdraft starts, think again.
Not only will institutions like these begin selling at the first hint of a margin call or more ratings downgrades, but they will actively use their own proprietary funds to book more gains in the process — even if it means trading directly against their own clients.
Four Ways to Protect Yourself
So enjoy the rally while it lasts and do these four things in the meantime:
- Sell into strength using trailing stops. That way you can capture the rally if it continues and move your money to the sidelines if it doesn’t. Nobody knows how long the fairy tale will last so you might as well let the markets show you the way instead of trying to second guess them and risk being wrong.
- Buy commodities. Holding energy and agricultural commodities as well as precious metals like gold and silver will help you preserve your wealth. Even after large pullbacks that may result from capital raising activities, the long-term direction for these is up. To minimize risks, buy in chunks or dollar cost average in over several months.
- Go Global. Put new money to work in “glocal” stocks . These are companies with fortress-like balance sheets, globally diversified revenue and experienced management. Average in here, too. Things may get rocky but over time, but dividends are the best defensive measure available.
- Short financials. If you’re an aggressive trader, you can short individual banks or the entire financial sector. After all, “they” took us for a ride — why not get even when the tables eventually turn?