Over the last few weeks I have been trying to elucidate my understanding of counter-party risk. This is my analysis, and I am interested the thoughts of others on this issue, as I pursue a path of risk management.
Physical Assets
Assets held in physical form, which may include those assets that we currently have not intention of selling (part of the total asset class) which are therefore not held for $FRN value, but for other characteristics we find desirable.
Physical assets have a problem as a store of value to the extent that they have one or more of the following qualities:
- Lack of widespread demand
- A high rate of decay (spoilage, rusting)
- A high maintenance cost
- Vulnerability to loss of value through market saturation
- Lack of liquidity
Real Estate assets in general have been performing poorly as a store of value for the last few years, particularly when compared to other physical assets.
Physical Tokens of Monetary Exchange Units
Also in physical form is a small cache of printed $FRN which should probably be enlarged to arbitrage any condition in which printed $FRN purchases more real goods than electronic exchange credit. I am also hoarding (rather than dishoarding) physical UST coins that are currently illegal to melt, but whose physicality may have value.
Physical tokens of monetary exchange units perform only nominally under current conditions, and like the smaller-scale physical assets generally, carry a small risk of failure (through loss or theft).
Equity Positions Not Held on Account
An equity position in a business held in one’s own name (sole proprietorship, partnership, whatever) is an exchange of savings (capital) for an expectation of cash flow (dividends, profit sharing, etc.). The investment is a liability of the company, and as such carries no guarantee of performance, either actual or nominal, and the major risk is the actual success or failure of the business in question.
Equity Positions in a business are not a store of value, but an effort to use capital to increase human productivity in exchange for an ongoing cash reward.
Bank Accounts (FDIC Insured)
The Treasury’s intentions to print to support the government’s insatiable appetite can be taken as a given; keeping the FDIC solvent is a relatively cheap process of buying voters through nominal performance on the occasion of bank default, although there may be some time, paperwork and general bureaucracy involved. These accounts are credited in $USD increments and currently insured with no limit for non-interest-bearing accounts.
$USD held “on account” with a bank is stored in a convenient form for exchange, which is the main selling point. However, there are still counterparty-created constraints on access to those theoretical $USD (they are theoretical, as the bank uses fractional reserve processes to generate profit). These constraints may include (depending on account and bank) time and location access (e.g. passbooks accounts), daily limits on certain transactions (e.g. ATM use), and structural limitations based on local conditions (my local branch does not keep much in the way of physical $FRN, and there is therefore a limit on my ability to obtain physical $FRN from them under currently circumstances). There is also the issue of reports to the USG that are generated when transactions meet certain bureaucratic criteria.
Bank accounts perform nominally, and are expected to continue to do so, but are subject to counterparty gating problems to a degree that may limit their usefulness as a store of value; in addition, nominal performance may not be sufficient in conditions declining $USD purchasing power, such as when the USG decides to weaken the $USD through monetization.
Brokerage Accounts
Brokerage accounts, regardless of where they are held, are not FDIC insured. Their performance is not guaranteed, even nominally. Performance of these accounts is driven by the intentions of the company involved to retain and attract customers, both retail and corporate. The measuring stick these companies use is nominal ($USG) and thresholds for performance are generally mean-driven (e.g. “versus the Lipper Average”) and usually not particularly sensitive to small deviations.
Shares or units held “on account” with brokerage houses are theoretical, on the books of the brokerage house as a liability of the corporation. The brokerage house buys shares or units in bulk, and essentially assigns them to holder’s account merely as a bookkeeping formality.
Brokerage accounts are not guaranteed to perform AT ALL, and even under normal conditions are not expected to perform nominally. $USD held on account with a brokerage house is explicitly “at risk” in the pursuit of the returns that accrue with investing in a successful enterprise. Unfortunately for today’s investors, mal-investment has been accruing in the $USD financial universe for such a long time that the near-term chances of making a success of such an investment in real terms is catastrophically low, and the market for financial instruments looks more rickety by the day.
To make matters worse, for those who had some funds on account prior to the run up in stocks over the last 30 years of credibility inflation, there is a kicker to liquidating brokerage accounts in the form of capital gains tax owed on the nominal gains. This up-front pain in additional taxes owed makes liquidating brokerage accounts psychologically daunting. In addition, liquidating a brokerage account involves talking to people whose employment depends on trying to keep funds under management, and that can undermine all but the most firm intentions.
In addition, delays in access to funds are routine, and routes “out” for $USD credits are few. Generally EFT to a bank is preferred, although old-fashioned wire transfer is occasionally available; certainly “cashing out” in $FRN is out of the question.; essentially, funds held in a brokerage account are essentially bank account funds lent out to pursue gains remittable back to a bank, without the nominal performance guarantee: the more counterparties involved, the higher the default risk, and all the time/space/medium constraints of bank credits are involved, only more so.
My Take on Risk
I realize that these descriptions may be overly broad and simplistic, but the exercise has helped me understand why I have made some of the decisions I have made with respect to storing the “excess productivity” that I have been given control over as the financial head of my household. My preference is for physical assets for store of value, and the others only on as as-necessary basis for a variety of reasons, with the exception of Brokerage Accounts. I have no idea why anyone would have that kind of trust after MF Global.
