We’ve all followed the cascade of financial and economic sanctions the US and its allies have piled upon Russia in the past two weeks. The assets of the Central Bank of Russia (about US$600 billion) have been frozen. Major Russian banks have all been kicked out of the global financial telecommunications system SWIFT. High-tech and luxury exports to Russia have been banned.
Western banks aren’t allowed to trade or underwrite securities of Russian issuers. The assets of Russian oligarchs, from super yachts to multimillion-dollar townhouses in London, are being seized. The list goes on.
But all of these banks and borrowers were doing business with investors in the West. When you freeze Russian payments, some Western bondholder isn’t getting paid, and some investor will end up taking the loss. That investor could even be you.
If you look inside your superannuation fund, you might find an emerging market’s ETF or a fund that just happens to hold some Russian debt.
The point is that it’s easy to slap on sanctions, but it’s almost impossible to ascertain exactly where the loss will fall.
This phenomenon is called ‘contagion’. It works exactly like a virus. One creditor loses money, and that causes him to default to another creditor, and so on. It’s exactly the way a virus spreads from one victim to another.
The most famous case of this also involved a Russian default. That was in 1998. That financial crisis started in Thailand in 1997, then spread to Indonesia, Malaysia, and South Korea before hitting Russia. From there, the next victim wasn’t another country but a hedge fund in Greenwich, Connecticut, called Long-Term Capital Management.
The Fed had to organise a US$4 billion bailout to save world markets. I negotiated that bailout on behalf of LTCM, as I explain in this interview with Fox Business.
Now it’s happening again. Russia is on the brink of defaulting on its debt, as described in this article. The initial losses could be as high as US$150 billion. That’s based on the outstanding debt. But then contagion takes over.
There will be some initial losers, but those losses could cascade out of control as they did in 1998. Banks, brokers, and hedge funds are all at risk. Individual investors could be at risk too as panic sets in and investors sell everything to raise cash. You can get ahead of that by reducing equity exposure and increasing allocations to cash now.
If Russia pays its debt in rubles, is it still a default?
Among the many economic sanctions imposed on Russia by the US is a ban on dollar payments through the global payments system and a freeze on the assets of the Central Bank of Russia. That sounds draconian (it is) and possibly even effective (it isn’t), but it begs the question of who bears the loss.
If I’m a debtor and you tell me I’m not allowed to pay my debts, I might say, ‘Thank you, that’s a relief’. In those circumstances, the loser is not the debtor. It’s the creditor who was expecting to be paid and now finds that’s impossible.
Russia has about US$100–150 billion of dollar-denominated debt, about half of which is owned by investors outside of Russia. If only part of that defaults, it could be US$50 billion or more in direct financial losses to ETFs, mutual funds, and even small holders in retirement funds who may not know what’s inside the products that Wall Street cooks up.
Mega asset manager BlackRock has already lost US$17 billion of its investors’ money with bad Russian stock and bond bets, as explained in this article.
Still, Russia is trying to pay. The head of the Central Bank of Russia is Elvira Nabiullina, who is one of the smartest central bankers in the world and perhaps the only one who understands how to do her job. As reported in the article, she’s trying to pay the debt in rubles, even if she isn’t allowed to pay in dollars.
Despite the sanctions, she still controls Russia’s ruble printing press and could create enough money to pay the debt. Still, if this ruble workaround doesn’t work, we’re looking at massive losses for Western investors.
The damage doesn’t stop there. In addition to outright bond holders, there are billions of dollars of derivatives that track the bonds, as well as credit default swaps that pay the holder if the bonds default. This means that actual losses can be many times the losses on the bonds themselves.
This is exactly what happened in the subprime mortgage crisis in 2008. There were about US$1 trillion in subprime mortgages at the time. A 20% default rate, which is sky-high compared to usual default rates of less than 5%, implied US$200 billion in losses. That’s a huge loss, but it’s manageable in the financial system.
What most analysts missed is that there were US$6 trillion of derivatives written on the US$1 trillion of subprime mortgages. This meant that actual losses were more on the order of US$1.2 trillion than US$200 billion once derivatives were taken into account.
Something similar is at play regarding Russian bonds. There is some ambiguity about whether a ruble payment on a dollar-denominated bond is a default (probably yes). The exact identifiers of the holders and the scope of derivatives are almost completely opaque. No one really knows how far the financial distress may spread. The best advice is to expect the unexpected.
All the best,
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Jim Rickards,
For The Daily Reckoning Australia Weekend
