Friday, December 19, 2008

Goldman, Morgan Stanley, & Commodity Prices

Before Goldman Sachs and Morgan Stanley chose to become commercial banks, their leverage ratios were allowed to be up to 33 times capital. Now that they are in the process of transforming into boring old commercial banks, they will have a ratio closer to 10:1. The two companies are the leaders in the commodities markets, so I do not find it surprising that commodity prices have fallen by nearly 70% when their leverage ratios have fallen by that amount. As these banks deleverage we will probably see prices fall a bit more. Rallies in commodities will be sold to allow the banks to recoup their money until they reach their desired ratios. As of the end of August, GS had an Asset/Equity ratio of 24 compared to JPM which had a ratio of 15. GS has been selling all types of assets to deleverage, but because of the liquidity and price run in commodities over the past few years it makes sense that they would sell commodities.

Once GS & MS are done deleveraging, the pricing mechanism called the market will realize the value of the lifeblood of our economy; commodities. I expect that gold will probably make a huge run to catch up with the expansion in the money supply. Other productive and agricultural commodities in the short term are not attractive to buy because resources are going to be diverted by the to the bailed out auto companies and their workers.

My long term opinion is that of dollar destruction. The government will have to print money to keep up with the unfunded liabilities in the future. I'm going to be keeping a close eye on Treasuries because the printed money will devalue the coupons on bonds. Buy gold, sell bonds is the trade so the tough part is the timing. Selling bonds that are on a moonshot is silly so I will wait for them to correct a bit, and sell them as they come off the top, while limiting my risk to 2% of capital.

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