“It Was Like Free Money”

I was reading a February 25 Wall Street Journal article, entitled Yuan’s Decline Triggers Fears on Leveraged Bets, when five words jumped off the screen and slapped me.

“It was like free money.”

Free money… really?!

For one, it goes against my deeply entrenched belief that there are no free lunches. Ever.

For another, it might have felt like “free money” at some point, but I guarantee that there’ll be a price to be paid soon enough.

And it looks like the time has arrived…

It was Greg Matwejev, director of foreign-exchange hedge-fund sales at Newedge Group SA, who spoke those words.

Mr. Matwejev is headquartered in Hong Kong, where Target Redemption Forwards (TRFs) are all the rage. TRFs are structured derivatives that give institutional investors the ability to place highly leveraged bets on the direction of the Chinese yuan.

These bets need the Chinese currency to continue moving higher. Should the yuan change direction, massive losses will ensue.

In the article, The Wall Street Journal offered a nice little graphic that shows what will happen to TRFs if the yuan falls lower.

Here it is…

See larger image

With the yuan crumbling recently, I’m sure all that free money doesn’t feel so free anymore.

Targeted Redemption Forwards are a close (evil) cousin of the structured derivative products that brought the global financial system to its knees in 2008. I’m talking about mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs), among other things.

As a leveraged product, very small changes in the value of the yuan create hugely magnified gains and losses for investors who bought the TRF.

The problem is, as Harry would agree, when everything is going well, people all-too-readily think it will just keep on going well. And it never does!

Current estimates show that for every decline of 0.1 yuan to the dollar, outstanding TRFs will lose about $500 million a month.

$500 million!

We saw a drop of 0.08 yuan between late January and late February. That’s about $400 million… poof… gone.

$400 MILLION!

In total, businesses and trading firms hold about $350 billion worth of these TRFs on their books. And they only expire at the end of the year. That leaves a huge amount of risk ahead of us.

But that’s not the end of it.

Here’s another part of that graphic The Wall Street Journal published….

See larger image

As you can see, it appears that the money flowing into Targeted Redemption Forwards comes from dollar-denominated company profits. And on the very surface of it, there’s some truth to that.

Companies can use TRFs as a legitimate, for-business-purposes hedge. Chinese companies that receive payment in U.S. dollars risk a rising yuan, which erodes the value of the dollar it just earned. To hedge that risk, Chinese companies can make a bullish investment in the yuan, via TRFs.

That’s all fine and well, if all $350 billion worth of TRFs were actually bought to protect dollar-denominated company profits.

In fact, many trading firms are buying TRFs to create profits… highly-leveraged trading profits… NOT to protect profits earned through business transactions, where goods or services were sold.

These trading firms are not hedging. They’re speculating.

But here’s the real kicker…

The trading firms don’t even have to put up hard cash to finance their leveraged TRF bets. They can offer up warehouses of copper as collateral, instead.

And then they use rehypothecation, which just makes the ticking yuan bomb all the more deadly.

Hypothecation is when you use an asset, like a house, as collateral for a loan. Rehypothecation is when you use an asset, like a house, as collateral for a loan… then another loan… and another loan, etc.

It’s what led to the melt down of credit markets in 2008, as U.S. banks were later estimated to have had at least $4 worth of loans outstanding for every $1 in collateral they held.

It seems the Chinese have learned nothing from that debacle. Its banks are allowing speculative trading firms to pledge copper stores as collateral for letters of credit (hypothecation). The firms use those cheaply financed dollars to buy leveraged TRFs, betting that the yuan will continue higher.

Then, a different Chinese bank will allow the same firm to pledge the same copper stores as collateral for yet another letter of credit (rehypothecation).

This is done over and over again, with the only limits on how many times one ton of copper can be used as collateral being how long it takes for the paperwork to be done… which is less than a month.

In the end, as many as 10 letters of credit have been extended for the same copper store.

So, not only are the TRFs already a leveraged bet, but rehypothecation of copper stores has added another layer of leverage to the chain.

As you can imagine, this won’t end well.

A declining yuan will trigger massive losses for TRF holders, starting a chain reaction where banks will be left holding worthless letters of credit and far too little copper collateral to escape unscathed.

While it’s difficult for the average investor to trade the yuan, you can play this pending disaster by betting against copper.

In the past year, I’ve twice recommended short selling shares of the troubled copper miner, Southern Copper. Subscribers to Boom & Bust and Cycle 9 Alert have reaped some nice profits.

You still have time to get in.

Southern’s shares have bounced higher this year, giving you favorable prices for a bearish bet against the company. If you haven’t already, I recommend short selling Southern Copper Corp. (NYSE: SCCO) at any price above $27 a share.

When China’s over-leveraged yuan bomb explodes, copper prices will spiral lower and drag Southern’s stock as low as $10 a share.

Adam

 

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Categories: Currencies

About Author

Adam O'Dell has one purpose in mind: to find and bring to subscribers investment opportunities that return the maximum profit with the minimum risk. Adam has worked as a Prop Trader for a spot Forex firm. While there, he learned the fundamentals of trading in the world’s largest market. He excelled at trading the volatile currency markets by seeking out low-risk entry points for trades with high profit potential. An MBA graduate and Affiliate Member of the Market Technicians Association, Adam is a lifelong student of the markets. He is editor of our hugely successful trading service, Cycle 9 Alert.