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Thursday, May 19, 2011

Seeking a silver lining? Bubble bursts on 'safe' assets

By Goh Eng Yeow

HAVING too much of an apparently good thing can be bad for your financial health.
The recent epic rout in the silver market may have been of no more than passing interest to the average investor here.

However, it offers a stark lesson on how the hunt for a safe asset with a higher potential return can result in unnecessary risks which undermine investments.
Investors have been left licking their wounds as the price of silver crashed by a spectacular 30 per cent in the past fortnight, after surging close to its historic highs last seen 40 years ago.

Still, some sympathy is in order for these investors over the exuberance which led to their folly. The world is awash with cash as the United States central bank prints more than US$2 trillion (S$2.5 trillion) in fresh money to try to stave off an American recession.

With the US Fed's printing press in over-drive, investors have been justifiably worried about the erosion of the value of paper money and this has led them to search for safe haven assets which can offer them a potentially higher return.
So it is hardly surprising that precious metals such as gold, platinum and others are in great demand among investors.

As the search for safety gathered pace, investors also extended their bets to other metals such as silver and copper.

But while the ordinary investor buys precious metals in a small way to try to hedge his risks against escalating prices, big-time traders such as hedge fund managers carry out the same exercise on a far bigger scale.

For them, there is an added advantage: The US Federal Reserve has slashed interest rates to almost zero in its efforts to help businesses there get back on their feet.
But its action also enables hedge fund managers to borrow huge sums at almost zero costs to make huge bets on any asset which can offer them a potentially higher return.

This means that markets in commodities such as silver can quickly become over-heated, as all sorts of participants fall over one another to get a slice of the action by bidding prices higher.

This leads to the build-up of what is known as a 'bubble', where prices reach unrealistic levels due to the huge surge of liquidity into the market.
In such cases, the bubble usually bursts when the liquidity is removed. For the silver market, that came with the decision of the Chicago Mercantile Exchange - the world's largest commodities exchange - to clamp down on the cheap loans made available for betting on the silver futures market.

It did this by raising the margin, or the amount of cash down payment, which a trader has to put up in order to finance his purchase of a silver futures contract. This action caused silver prices to tumble, as weaker players were forced to cut their positions after failing to raise the additional cash.

One consolation is that the rout in the silver market failed to produce a financial storm on the scale of the one experienced in 2008, which nearly caused the global banking system to collapse.

It is an instructive lesson on how a search for safety ended up encouraging risky investment behaviour.

But if you believe that the silver market is an isolated instance of irrational exuberance, you may be mistaken.

Take China's red-hot residential property market, for example, where Shanghai's new home average prices surged 15.3 per cent in a week, according to a Chinese property consultant, Shanghai UWin Real Estate Information Services.

What is disconcerting is that the rise in prices is not the result of a housing shortage but rather an attempt by mainlanders to buy multiple homes - which they then leave mostly vacant - as part of their efforts to guard against inflation.
What happens to those empty houses if there is a sudden shrinkage of liquidity in China's economy, leaving their owners unable to service their mortgages?

The parallels with the calamity which has overtaken the silver market may be too compelling to ignore.

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