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I am no dyed in the wool gold bug. If I believed the world’s Central Banks were about to reverse their course of excessively easy monetary policy and instead normalize rates, then I would short gold with both fists. Yet when I look at the policies that governments and Central Banks are perpetuating, it makes me realize there is no other answer except to inflate our way out. The debt problem is only getting worse. As a global society, we continue to spend way more than we earn. As this debt mounts, we become more sensitive to rises in interest rates, which in turn, forces Central Banks to keep rates even lower. This increase in debt diminishes our ability to spend, so the economy sags, forcing the Central Banks to lower rates even further. This cycle continues until the Central Banks have negative rates and are in essence “pushing on a string.” We are reaching the point where the Central Banks’ ability to influence the economy is so muted, they are becoming desperate.

If you believe we will look into the abyss of this monster debt cycle, and choose to dramatically lower our spending, tighten our belts, readjust our expectations and slowly chip away by paying back the debt out of our feeble GDP growth, then short gold. In that environment, the best thing to own would be long US treasuries. Nothing else will work.

But if you are like me, and you believe that no society has ever chosen austerity over money printing, then you should think long and hard about doing the exact opposite trade (long gold short treasuries). I know right now gold is out of favour. I know that most of you have already stopped reading once you realized that I was advocating a long gold position.

I understand that feeling. Too many gold bugs seem to be bullish regardless of what is happening in the markets. If the banks are going up, then you need to buy gold. If the banks are going down, you need to buy gold. If the US dollar is rising, then you need to buy gold. If the US dollar is falling, you need to buy gold. These guys are obsessed with gold, and their position ledger only knows long, longer, and max long.

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For a couple of years after the 2008 credit crisis, the financial community swallowed the gold bugs’ story hook line and sinker. Stories about famed hedge fund manager Jim Paulson’s massive gold position filled the trader’s gossip rooms. He had nailed the real estate debacle, and now was about to nail the gold trade. The GLD ETF was the number one holding on hedge fund’s position sheet for months and months. Gold bugs like Eric Sprott became celebrities.

Then a funny thing happened. The inflationary spiral never arrived. The froth from the over owned gold bull market started to dissipate, and soon it became a full on rout. Next thing you know, instead of gold being a hedge fund darling, it became as welcome as Lindsay Lohan at a high school purity ball (for those who have never heard of a purity ball, it is a formal dance event attended by fathers and their daughters which promotes virginity until marriage. Often girls make a purity pledge to remain sexually abstinent until marriage… most people don’t realize the boys event that follows the purity ball the next night. Fathers take their sons to the local strip joint and pay for them to lose their virginity in the back seat of the family station wagon in the parking lot…)

Gold has gone from being loved to loathed. But has anything really changed? Apart from the flipping of sentiment, the fundamental story has not really being altered. The only real negative development is the gold bull market of 2008–11 encouraged too many mines to be built. From a supply side, the picture has become a little darker, but that is something that is being quickly fixed as gold companies are dropping like flies.

Central Banks keep printing like there is no tomorrow. Here is a chart of the total balance sheet for the Big 3 Central Banks:

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Does that inspire confidence? Do you really think this rise is all under control?

The problem is that in the past Central Banks might have monetized against gold, but in today’s messed up world, they are monetizing against equities. I know I harp on this way too much, yet I can’t believe more people don’t scratch their heads at the absurdity of it all. Central Banks are directly buying equities. In a big way. The Swiss National Bank is a huge holder of American equities.

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One day this will come back to bite them in the ass. And it will be difficult for them to justify the complete disaster they have made of their balance sheets.

But I don’t think the Chinese will make the same mistake…


A Chinese gold standard?

I recently stumbled upon this interesting interview on Kitco News. I know, I know… complete gold bug site. I get it. But this interview was not with the gold bug Jim Cramer equivalent (BUY! BUY! BUY!). It was with Ken Hoffman, the Global Head of Metals and Mining Research for Bloomberg Intelligence.

He talked about the possibility of China going on a gold standard.

“Later this year, the IMF decides if the Yuan can be become part of the currency that can be held as a currency reserve by Central Banks. If they are not allowed, they may consider something like a gold standard. Just like when they weren’t allowed to get more votes on the world bank, they started the Asian Infrastructure Bank. So they may be preparing for failing. You walk on the street in China and everyone knows about becoming part of the reserve currency. I could walk outside here on Wall Street and nobody here would know it. It is a big deal for China, and if they are not allowed in, and the US has a veto vote… And if the US says ‘nope – you’re not allowed in – wait five years’, the Chinese might turn around and say we have a currency we want to float and guess what? We want to be the only currency on earth backed by a metal, being gold.”

He went on to discuss how China was putting in place the needed infrastructure to have a gold backed Yuan. It was an extremely interesting interview and it certainly got me thinking.

I have always believed the gold end game is when the Chinese come for it. So far that demand has proved elusive. But I wonder if they aren’t a little smarter than all the hedge funds who thought they were front running the Chinese in 2008–11. What if they are quietly accumulating gold? What if the gold bugs are right about the possibility of the Chinese or Russian creating a gold backed currency? If they were planning something like this, it wouldn’t make sense for them to advertise it ahead of time. It would be in their interest to keep the price as low as possible for as long as possible.

I can’t help but think about how much sense it makes. Right now the Central Banks are monetizing against bonds and equities. Whoever has the guts to go first with gold will have a huge advantage. Why would a foreign Central Bank want to put money into Tim Cook’s wallet by purchasing his stock? How much sense does it make for a foreign government to own a whole pile of equities? But gold – that decision has thousands of years of precedent.

The global financial system is hanging together by a thread. It is amazingly unbalanced, yet market participants have never seemed surer of its stability. So far, the Central Banks have pushed up financial assets in their attempt to keep things afloat, but that might not last for too much longer.

If one of these days gold all of a sudden gets mysteriously strong, do not fade it. A change of policy of a Central Bank will move prices first. You will see it in the market long before you hear about it. I could easily envision a $100 up day out of the blue. It would be tempting to give it to them on this sort of rally, but this will actually be a buy signal – not the other way round. Until then, just sit back and watch the Central Banks hoover up all the equities.


Something a little different

Usually I stick to writing about macro events, but this next part is something a little different. It will be a little inside baseball for everyone except Canadian equity traders, but I thought I would throw it in anyway.


North American Palladium – A balance sheet arbitrage opportunity?

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Everyone wants to invest like Warren Buffett, but his unique position often gives him access to deals that regular investors can’t buy. Think back to the credit crisis of 2008. In the depths of the panic, Warren invested in a few different financial companies. But instead of just wandering onto the stock exchange and purchasing stock like the rest of us, Warren was able to strike sweetheart deals. Goldman Sachs came knocking and asked for $5 billion. Warren agreed, but it came in the form of a preferred share that paid 10% with warrants to buy Goldman Sachs stock at $115. It was in essence a synthetic convertible preferred. If Goldman Sachs’ stock went nowhere for the next few years, then Warren would earn 10% (assuming Goldman was still around to pay back the preferred). If the stock rallied, then Warren would participate fully. It was a heads-I-win tails-you-lose situation for Warren. There can be no denying that having this sort of preferential deal access creates a tail wind at Warren’s portfolio’s back.

Wouldn’t it be nice to invest at the same prices as the big connected players? Usually this is a pipe dream, but I have recently stumbled across one such situation with North American Palladium.

Here is a brief summary of North American Palladium’s business according to their website:

North American Palladium’s vision is to become a low cost, mid-tier precious metals company operating in mining friendly jurisdictions. NAP is an established precious metals producer that has been operating its flagship Lac des Iles mine (LDI) located in Ontario, Canada since 1993. LDI is one of only two primary producers of palladium in the world, and is currently undergoing a major expansion to increase production and reduce cash costs per ounce. NAP’s experienced management and technical teams have a significant commitment to exploration and are dedicated to building shareholder value.

They claim to be “dedicated to building shareholder value.” I want to look like George Clooney and be as rich as Mark Zuckerberg, but saying it doesn’t make it so. North American Palladium took on too much debt, at the wrong time, and with the collapse in the price of palladium, have run their equity price into the ground.

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If you research the company on Seeking Alpha, you will find many different views on its investing merits. I am not smart enough to tell you the long term profitability of North American Palladium. I am no precious metals analyst, and even if I was, I am still not sure I would listen to myself given all the terrible calls lately in this group. But I do know a little about opportunities around restructurings, and the recent developments at North American Palladium offer a compelling chance to invest alongside a seasoned investing powerhouse.

Brookfield Capital Partners are part of the Brookfield group. Brookfield has a private equity division, a property operation, a renewable energy group, and a whole slew of other divisions. The only thing they seem to have in common is they all make money. These guys are shrewd operators, and over the years, I have watched them nail trade after trade. They might not get it right every time, but their connections, and deep understanding of financial markets, make them a player you do not want to fade.

Way back when, Brookfield lent North American Palladium some money. When the company got in trouble with cash flow, Brookfield lent them some more. Brookfield put itself at the top of the capital structure, and made sure they understood North American Palladium’s business. As the company’s performance continued to deteriorate, servicing this debt became more of an anchor around North American Palladium’s neck. Eventually management realized they could not continue without some changes, and there was some speculation the company would be sold. The stock briefly spiked to $0.40 on the hype.

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During this time I was perplexed with the prices of the various North American Palladium financial instruments. Although the stock was soaring, the listed convertible bonds were trading as if the company was going to go bankrupt.

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Along with Brookfield’s private debt, there are two listed convertible issues that trade on the Canadian stock exchange. Although the longer dated issue is small and does not trade actively, the 2017 issue has $43 million bonds outstanding.

If the company would be bought, then the bonds should not have been trading at 50 cents on the dollar. As it became clear the situation at North American Palladium would not resolve itself with a sale of the company, the equity price started to sag. As is often the case, the credit markets understood the situation better than the overly optimistic equity investors.

In April, North American Palladium’s management struck a deal with Brookfield to restructure the debt into equity, thus eliminating the constant cash flow drain of paying the mounting interest cost. But the cost of this restructuring to existing equity holders was monstrous. As I mentioned, the Brookfield guys are sharks, and they weren’t about to take on the headaches of owning equity in a poorly performing precious metals mine without the price being right. Management agreed to a deal that severely diluted the existing equity holders, and recapitalized the balance sheet by turning the existing debt into equity. Since the deal was so advantageous to Brookfield, the company entered a formal process to sell the company before proceeding with the restructuring. That period recently ended without the company being sold, so it is now on track for the restructuring to proceed.

Brookfield has agreed to convert their $200 USD million into 92% of the new equity. The existing $43 million of convertible bonds will be converted into 6% of new equity and the current equity holders will own the remaining 2%. Brookfield has also agreed to backstop another $50 million of equity that will be issued via a rights offering once the restructuring is completed.

This deal basically wipes out the existing equity holders. There are currently 393.7 million shares outstanding, but after the reorganization, that number will 19.685 billion. Yup, you read that right, almost 20 billion. Obviously there will be the mother of all reverse splits to get the price to a more reasonable level. After it is all done, the current equity shareholders will be left with little of the new company.

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We know purchasing the equity today is obviously a terrible investment, so where is the edge? The answer lays with the other North American Palladium listed financial instrument. Let’s go through the numbers and try to make sense of the relationship between all the pieces.

We know that Brookfield is owed approximately $200 million USD (which works out to $248 MM CAD), and upon completion of the reorganization they will receive 18.11 billion shares. That works out to about 73,000 shares per $1,000 CAD face value.

Now what about the convertible bonds? What ratio will they receive? There is $43MM CAD of converts outstanding that will receive 1.181 billion shares. So that ratio of stock per $1,000 bonds is approximately 27,500.

What does all this mean? How can we put this into numbers that make sense? Let’s first start with the assumption that Brookfield is not doing this to be charitable. They don’t enter transactions with an expected return of market rates. No, their edge is being able to dictate the terms of these sorts of restructurings and receiving sweet heart deals like Warren Buffet. Look at the numbers. Brookfield is getting more than twice as many shares per notional amount of debt than the convertible bonds holders. They are also willing to backstop the entire rights offering for the additional $50 million. Brookfield has the most intimate knowledge of this company outside of management. They are the senior lenders, and have obviously been actively involved in trying to solve their cash flow problem. Brookfield has decided a level at which they are willing to buy the company, and by lending at the top of the structure, have manoeuvred their way into buying it through this reorganization.

Wouldn’t it be nice to buy alongside Brookfield? Wouldn’t it be nice to own a bond that is getting 72,000 shares of equity? Well, you can. The reason you can achieve this same price is the convertible bonds are not trading at 100 cents on the dollar. They are thinly traded, but you can buy them at 38 cents. And guess what? At that rate, it works out to the same price Brookfield is paying. 27,500 / 73,000 = ~38%.

Let’s look at it another way. If we assume at the very least Brookfield is expecting to recoup 100 cents on the dollar of their bonds, then what price are they converting their debt into equity? If they own $200MM USD and they are getting 18 billion shares, then that means they are in essence buying equity at approximately 1.3 cents per share. Right now the stock is trading at 4 cents, so Brookfield is buying equity at a considerable discount to the current market. Buying a debt free, producing precious metals company that is being backstopped by one of the preeminent financial players seems like a good risk reward. It is even better when you consider that when you buy convertible bonds for less than 38 cents on the dollar, you are getting the same deal as Brookfield. And you don’t even need to commit to all the work underwriting the rights issue along with all the legal expenses. The way I see it, if it is good enough for Brookfield at that price, then it is good enough for me.

But wait, it gets even better if you are a current equity holder that believes in the long term success of this company. Right now there is no way to directly buy equity without paying 3 times what Brookfield is paying per share. If you sell your shares, at 4 cents, and instead buy bonds at 38 cents on the dollar, then you will be arbitraging the large spread that exists. Let’s say you own 27,500 shares. You sell them at 4 cents for a total proceeds of $1,100. Then you can buy $1,000 face value of PDL bonds for 38 cents, for a net outlay of $380. After the reorganization, you will once again own 27,500 shares, but you will have picked up $720. If we were able to short the stock in size, then this arbitrage would be a real money maker. Unfortunately you can’t short multiples of the float, and there is no borrow for a 4 cent stock. But natural longs of the current PDL equity should sell their stock, and buy the bonds, locking in a great gain.

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Jim Grant is fond of saying there are no bad securities, just bad prices. At an expensive price, the safest security becomes inherently risky. At a low price, the riskiest security becomes increasingly attractive. I don’t know if North American Palladium will survive this brutal downturn in the precious metals market. I will leave that up to smarter people than me to forecast with that sort of clarity. But I know that with Brookfield spearheading this reorganization, one of the smartest, shrewdest financial players has negotiated themselves a sweetheart deal. Usually this sort of deal is for the privy of the connected few, but with the listed convertible bond trading at around 38 cents on the dollar, you can tag alongside for the same price. I will take that trade any day…

Thanks for reading – have a great wk-end,

Kevin Muir

the MacroTourist