The Scarlet Absence Of A Letter Of Credit

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If there’s one thing we all know about banks and bankers: they love to tell tales in public of how much they value their customers. However, what you’ll never hear them profess in private: is how much they trust them. Although one may think that’s unseemly, believe it or not there is another entity banks hold at an even lower tier. Other banks.

One of the known facts people remember about the melt down in 2008 (as opposed to general public) was when the banks no longer trusted each other, and what they earlier claimed was “collateral” wasn’t actually worth what it was stated to be.

Credit default spreads (CDS) were supposedly the insurance to negate valuation concerns. But when the banks felt CDS weren’t worth the paper they were written on, not only did they operate in a fashion reminiscent of cutting their noses off to spite their faces, but rather they began cutting visible ties (and/or appendages) to other banks.

The blinding issue with all that took place during that period is the speed in which it all took place. 0426-assholeOnce it seemed one bank (regardless of size) was not going to be able to make good on a promise of clearing, near overnight the banks regarded any and all collateral at a discount. This fed on itself to where even once valued pristine collateral such as hard materials let alone paper began to be not only discounted, but prices slashed at such discounts that would make a blue light special at K-Mart™ blush.

So when I read the following article on Zero Hedge™: How China’s Commodity-Financing Bubble Becomes Globally Contagious.  My blood ran cold. The implications of this development and the consequences it portends just might make it the proverbial “canary in a coal mine.”

The underlying issue that makes this far more dangerous or different from times past is three-fold. First: The idea of the need to send a perishable product overseas to another country that operates in a differing court system without the only document that gives one a chance of a “guarantee of payment” is not something to be taken lightly. As a matter of fact, it should be looked upon as a move of desperation.

Second: If that commodity is both a readily needed or used product, the immediate resale by the receiving party (especially if they themselves are in trouble) may sell it off at a steep discount. And yes, I’m implying less than what they are being billed for.

For if the receiving party needs cash, and you don’t have anything backing payment, i.e., Letter of credit (LOC.) Than it’s free money to do with as they please until you can get them into court – if you can at all.

Why would one pay full price (or even think they should) when pennies on the dollar will now be the opening settlement offer in any negotiations?

Third: The commodity itself is well-known, and has been publicly reported as being used as a collateral for cash strapped real estate developers in China. This last point is probably the most troubling of them all, and where the real issues might come about.

Here’s a scenario many are missing yet, is highly plausible. If bankers once again (for any reason) don’t believe they’ll get paid, while also concluding what they have on their books once again as collateral (since housing is a sunk line item now) can possibly deteriorate in value faster than a foreclosed building in Detroit. All bets are off.

A vicious cycle begins something akin to this… (Yes this example is an oversimplification, but the implications are not.)

The commodity producer is leveraged up and is either fully, or has over expanded needing to produce X at a rate consistent with structures and costs. The banks (markets, etc.) base their loans for operating expenses on sales, and value of on hand inventory. All rudimentary stuff.

If the collateral backing the loans for operating expenses are mostly the refined product itself, and that product is a commodity, then both the product along with its value are at the mercy of a perishable overhang. e.g., The product can spoil, or the price can plummet via oversupply, etc. But the one thing it can’t do that’s possibly worse: is sit on a producers site, books, or more, indefinitely.

The only way to turn that product into useable cash is to sell it. And here is where things get a little tricky. For what a sale “is” as to open or allow funds to be allocated to the producer for operating expenses, can sometimes have more in common with that other famous distinction of what exactly, “is” – is.

If you’re a company and producing X where LOC’s are the requisite detail of paperwork that can not be overlooked or forgone, and is standard operating procedure for the industry, and you deviate from these expected practices: it sends signals that not only something may be wrong, but quite possibly something far worse. i.e., An act of desperation.

Imagine yourself as if you owned the commodity and it were beginning to either pile up in excess inventory. Or, you had tentative sales yet, they were unable to come to fruition for lack of a LOC. What would you do?

Well, if you hold onto the product and let it sit it begins to lose value via market forces. Second, your lender values you product as collateral less and less via those same market forces squeezing you even more. So do you sit idle and let the chips fall where they may? Or, do you send it off in hopes of getting paid?

If you send it off it’s entirely plausible on your own books it will still remain as a “sale” and it keeps the demand narrative intact, reduces inventory, and helps in keeping production quotas all in check – for the time being. Keeping the spigots of operating revenues flowing. (Hopefully giving breathing room so fallacy can turn back into reality)

However, at issue is also the recipient of the product, For either A:  They didn’t want or need it. Or B: (which is far worse) Need it, but can’t pay for it.

If that customer is honorable, they might just receive the product as an early shipment, store it, and state never do it again or they’ll drop you. Yet, they’ll penalize you by paying for it only when they actually would have ordered it to begin with. Regardless of when that date may fall. That’s the most wishful (and probably unicorn/rainbow treatment) of an outcome one could hope for.  Yet things usually don’t happen that way do they?

Let’s use the guise that’s turned a blind eye by the so-called “smart crowd” across the financial media, and look at the recipient of that product as someone being squeezed by their centralized government in an effort to dampen a real estate bubble. Couple this with the tenacity as to not give into outside pressures as to “inject liquidity” at others promptings.

If the product is received by someone desperate of needing cash, than the first thing they’ll do with that product is whatever it takes to turn it into just that. And just like a drug sick shoplifter will sell any highly valuable stolen product for 50 cents on the dollar, so to will a credit induced financial addict with the overwhelming overhang of needing to supply a “credit fix” to their portfolio.

As devastating as the above scenario can play out there’s another just as plausible and actually more probable. This is where the ruthless play. And these players make banker on banker squabbles look like a kinder-garden recess.

To them: You shipped it without a LOC? Shame on you. Let’s start the bidding of you possibly ever see payment at a 50% discount today. If you don’t answer by the close of business today, it goes down even more.

Think they’re not serious or want to call their bluff? No problem, they begin by informing you that you can easily reload it onto your boat if you want. But, just to let you know, it’s no longer stored where it was off loaded. It’s now at X, or Y, or Z, or had been sold immediately on arrival. Oh and by the way, they were just informed the people they sold it to, don’t seem to have any money now either. Credit crunch is taking its toll your informed. (what a coincidental shame, who’da thunk it?)

Oh and by the way, it seems they’ve just instituted a new 90 day (or longer) advanced scheduling process, along with other “added expenses” that will need to be paid before you can get your product back.

They’d love to put you at the front of the line however, you’re notified there’s a lot of corruption taking place on the docks and even they can’t jump in line without paying.

By the looks of it, the farther one tries to work this out, it seems it just might cost you more to get it back than it was to ship it. Huh, funny how that happens. Well call back later they’ll say, and see what progress can be made as to rectify this for you. Click.

If you think things like this don’t happen, I have some ocean front property in Kentucky I would love to sell you.

Now take into account where the back half of the storm shows its presence throughout the commodity complex itself. (all hypothetical of course)

Suddenly the market becomes aware that company X is dumping your commodity onto the open market for say a 20% discount. That in turn spurs other producers or holders to begin offering their own discounts. As they do, the bastardized market (because without a LOC they’re in essence dumping) they begin dumping even more – for less.

That in turn pushes market forces in a downward spiral, which in turn reduces the value of everyone’s inventory leading into a black hole of who can discount faster. Which in turn begins in alerting “the lenders” to begin questioning any and all “sales” on clients books, and what they truly represents. Only to then find those “sales” were nothing but wishes and hopes. For without a LOC, what are they?

One doesn’t have to look all that far back in time to see just how fast the impact of any cuts, or implosion of credit lines by the banks can decimated businesses. Yes the 2008 crisis showed when they no longer trusted each other. However, “The Savings and Loan Crisis” of the 1980′s should remind every one of just how fast this can take place along with its consequences for Main Street.

Anyone that ran a credit line based business during that period remembers all too well the many businesses that were shuttered were not for a lack of business, but by the head spinning quickness LOC’s or lines of credit for operations were both changed as well as cancelled. This one could do the same but have far more reaching implications.

Over the last few years since the financial melt down of 2008, we have seen what many have believed are precursors that may tip the hand of markets as to show just how unhealthy this levitating act fueled by free money has become.

And yes there are always false indicators, and we all know correlation doesn’t equal causation. And even more may shrug and think, “No letter of credit, so what.” However, if there were ever a canary in a coalmine worth noting this is one not to let one’s eyes to divert from.

The issue at hand is not just the foolishness of the absence contained in a one off LOC gamble some company would take. Far from it.

It’s the desperation that could be hidden that’s a precursor one has to watch for. For the amount of desperation, or the degree that might be hidden beneath the surface to which a commodity will be sent overseas to another country, a country for all intents and purposes is using that very product as a pseudo currency to back other financial obligations without the requisite document to be paid. Is mind numbingly dangerous in its implications in my view.

© 2014 Mark St.Cyr