For the purposes of today’s Daily Reckoning Australia, we’ll divide all the assets in the investment world into two categories: those investments that have the potential to implode and those that don’t. The real question is whether this capacity is priced in…
But first, what is an implosion?
Well, we’ll start the story where we can all understand it: banking. Banks have a bad habit of imploding, after all. That’s why central banks were born — to prevent such banking crises from spreading.
Not many businesses have this implosive capacity in quite the same way as banks do. It stems from what banking does as a business model. Some would call it fraud, which is why banking needs so much legislation to legalise it.
Could a storage company lend out the garden furniture you deposit there? No, because it’s a deposit — you are free to come and get your garden furniture at any time, and it had better be there when you do!
But banks don’t keep the money you deposit. Not all of it, anyway. They lend some out and use it in various other ways. It isn’t there, even though you have the right to withdraw it at any point in time.
Because of this situation, if all the depositors show up at the same time and want all their money out, there isn’t enough to satisfy them all. And, at that point, the bank is bust — often worth nothing.
Of course, other companies can go to zero too. But what makes banks so interesting is their ability to do so from one day to the next on a whim. One minute they’re worth billions, the next nothing. You didn’t even get time to sell out or withdraw your money.
High-risk bonds are another example of this sudden change in fortunes. Once a default is declared, the value of a bond can plunge to near zero in a matter of seconds. Some companies don’t hold a lot of valuable assets, and so bondholders can sometimes expect to get paid back very little. The sudden change in value is the implosion.
Anything involving counterparty risk is at risk of imploding in a different way. Instead of facing market risk — the risk of prices falling — you face the risk that the business you hold accounts with, or the exchange you are trading on, goes belly up.
Many who speculated that markets would crash in 2008 discovered that their counterparty on the trade was Lehman Brothers Inc. And they therefore received mere cents on the dollar, despite being correct about the crash and betting it’d happen. The value of their positions went from soaring as markets crashed to very little.
Over in Japan, they’re encountering a bizarre problem where the household’s most valuable asset can suddenly become such a financial burden that people set it on fire. I’m talking about the family home.
You see, Japan’s demographics are so bad that many properties simply cannot be sold, whatever their supposed value on paper. The equivalent of council taxes must, however, be paid…
As a result, many children who inherit their parents’ home decided to commit arson instead of paying up. Apparently, less council tax is payable if the house is in ruins. More interestingly, insurance values often exceed the market value.
Now I’m not going to suggest this phenomenon will pop up in Australia. Although some small Aussie mining towns have seen house prices plunge for obvious reasons — the mine closes.
My point is that the financial systems of many countries — which are on the cusp of the same demographic shift as Japan was 30 years ago — are built on the presumption that houses and land retain value or go up.
What would be the value of a 30-year mortgage if you presume the house will be worthless by the end of the 30 years, as is common in Japan? What would happen to the banking system of Italy or Germany if a good chunk of their key collateral’s value declined towards zero as populations declined and property became unsellable?
China may be the next cab off the rank on this story as vast apartment blocks are felled like trees because they were unsellable. Their value went from being vast to too expensive to keep standing.
No doubt you’ve heard about these different asset value implosions before. Maybe you’ve even experienced some. You’re more or less aware of them and adjust your investment habits accordingly.
But lately, the list of investments that can suddenly evaporate seems to be growing…
The climate change bubble is an implosive one
How many ‘assets’ only hold their value based on political promises and policies, both of which have the capacity to disappear?
Diesel cars are a prime example. They went from being designated climate saviours to climate destroyers by governments, destroying their value and the value of companies producing them.
I’m getting worried that a vast asset class of similar time bombs is growing dangerously large.
Carbon credits are a figment of politicians’ imagination. And yet, vast carbon credit schemes trade on financial markets. But their value could simply disappear from one day to the next if political winds change.
Carbon offsetting is another example. What if the legislation changes and companies aren’t required to offset their carbon? Or if the regulations for what qualifies as an offset suddenly change, making many vast carbon offset programs worthless?
‘Europe’s Biggest Oil Company Quietly Shelves a Radical Plan to Shrink Its Carbon Footprint’, reports Bloomberg. A pipeline of assets backed by spending of $100 million a year in assets simply evaporated. Poof, gone.
The Australian Financial Review has pointed out that transitioning energy systems to renewable energy will require a truly vast amount of grid infrastructure to move that power:
‘In a report released on Wednesday, BCG said the scale of investment needed in electricity grids — up to $US900 billion ($1.4 trillion) a year — could be almost as much as the capital needed to actually build the solar and wind generation capacity.’
I wonder who might be collecting a rather large share of that $1.4 trillion? Next week, my co-conspirator James Cooper will tell you.
But if the energy transition cannot be done because of resource constraints, local opposition, financial constraints, time constraints or a lack of expertise, what is the value of the wind and solar installations in far-flung places?
Nada.
Another related problem is the tendency of renewable energy systems to produce either too much or not enough electricity. What is their value if they sometimes produce so much electricity that the power price goes negative, and not enough when the power price is high?
Nothing, or worse once you include the cost of having to clean up the mess in two decades’ time (well before 2050).
So far, the value of renewable energy projects has been set by political programs that effectively guarantee returns on renewable energy installations, even if they produce power when it isn’t needed. But, again, that makes their true value negative, which a change in government policy could eventually expose. And you can’t run an entire grid that way. Worse, the higher the share of renewables, the bigger the problem becomes.
Of course, it wouldn’t be a surprise if the value of climate change-related assets suddenly turned into a nightmare. It happens quite often, in fact. As in the sub-prime bubble, local councils are popular investor victims of renewable energy projects.
What is an implosive asset worth?
The fact that banking crises happen periodically, vast government programs disappear, the weather is the same across wide spaces, and demographics change just doesn’t seem to be priced into financial market asset values.
I mean, what is a bank worth today if you presume it will eventually suddenly fail at some point in the future?
What is a solar plant worth if it won’t be connected? And what is it worth if it will only sell power at negative prices because all other solar plants in the area will produce power at the same time?
If your answer is that you’ll be able to sell out before that, what does this imply about the nature of investing? It begins to resemble the game, Old Maid. And you’re playing with a politician, which means they can change the rules.
Regards,
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Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend
