Towards the end of last week a key event happened that will stall and possibly break the rally in oil and gold prices and dominate markets and news for the next month.
It was the SEC lawsuit against Goldman for “in-appropriate” conduct related to misstatement of facts on a CDO (Collateralized Debt Obligation) transaction linked to subprime mortgage deals brought to market by the Investment Bank. While subprime deals have no relationship or bearing on oil and gold prices, the naming of one more involved hedge fund (Hedge Fund Paulson & Co – not sued, penalized or indicted) added an additional layer of pressure since the fund named is a large player in Gold.
Both Goldman and Paulson carry significant gold and crude oil exposures and the market is correctly anticipating that the cost of financing these positions just went up. Goldman credit default swap spreads jumped by 30% to 125 bps. As a pure defensive move and a liquidity boosting measure both Goldman and Paulson are expected to cut some of their positions and release any un-anticipated liquidity pressure that may arise next week as Gold and Crude Oil both adjust to reflect the impact of this news. While this may not be a serious issue, given the vicious cycle that starts with the beginning of a “name crisis” the road map is clearly defined.
In addition to rising cost of funding, liquidity pressures are created as lines are rolled over only on posting additional margin or collateral, new lines or extension in existing lines is deferred or declined. While these pressures are manageable as part of doing business, there are a number of leveraged and structured transactions that Investment Banks carry on their books where a few basis point change in cost of funding kills the business case for the transaction. Combine this with a decline in the price of the underlying asset and you may have no option but to cut a position as loss and volatility limits are breached. The cuts further feed the downward price spiral, increasing capital pressure on the book as well as the earnings outlook of the bank.
While the crisis may not be severe or serious enough to really threaten Goldman, name crisis have a tendency of getting out of hand. Goldman runs a tight, well managed ship but the street remembers all the scores that need to be settled and a name crisis is a perfect opportunity to clear the tab with Goldman. While there is no likelihood that Goldman will fail or will even be allowed to fail, it will suffer. And no revenge is sweeter and bloodier than a forced unwind.
Monday morning opening in Australia and the rest of Asia indicate that the market is now assuming the worse. Both Gold and Oil have dipped with the oil taking the lead in heading south.
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