Fool's Gold

Fool’s Gold, otherwise known as Iron Sulphide, had a reputation for attracting easily-fooled prospectors

But the use of the term Fool’s Gold has for a long time been used as a metaphor for what might appear to be an attractive investment but is in fact something really quite worthless. Usually the only people making money out of Fool’s Gold are those involved in luring in unsuspecting investors. Let’s look at a few real examples.

Collateralized Debt Obligations

On the surface, CDOs were a great idea. A lender – often of the sub-prime persuasion – has a portfolio of debts, let’s say mortgages. They don’t know how much of that debt will be repaid, and they would rather not operate with the uncertainty. So an investment bank buys the debt from the lender at an agreed rate, and then sells it in a number of “tranches”. Let’s say that the bank expects about 85-95% of the debt to be repaid. So they issue 70% of it as a AAA-rated tranche. This gets allocated repayments before any subsequent tranche. The next, say 10% is AA-rated followed by a 5% A-rated tranche. The next 5% is BBB-rated, followed by 5% BB-rated and the last 5% is assumed to be complete junk and is not rated at all. If, say 89% of the debts are repaid then the AAA, AA and A-rated holders are repaid in full. The BBB-rated holders get the remaining 4%, which equates to 80% of their nominal value. Holders of the BB-tranche get nothing.

CDOs became popular in the early 2000s as interest rates were falling and investors wanted higher yield securities. These clever little creations offered a higher yield than investors could get from government debt, and they sold by the billions. In fact by the time 2006 came along there was an estimates $1.5 trillion of CDO debts out there.

And then the sub-prime crisis came along.

Lending to the extent of many times a person’s income became commonplace and with no hope of repayment, defaults knocked out not just the BB- and BBB-rated bonds but also the A-rated bonds, eroding the value of AA-rated bonds too. In fact by 2007 even the AAA-rated bonds were looking shaky, implying that less than 70% of the loans were being repaid.

Investors lost a lot of money, especially some leveraged funds which were wiped out. And when we think about how much the CDO market provided easy finance to sub-prime lenders, the riskiness of CDOs would have been continuously increasing with time.

Should we have known this was Fool’s Gold? Well, Warren Buffett did, calling them “financial weapns of mass destruction”. But he’s brighter than most. The banks and fund managers holding these instruments should have known. but then again, it’s easy to get sucked in to something which started off harmless enough but then became unsustainable, authoring its own demise. Generally speaking, if a deal looks to good to be true, then it probably is.

Dotcom Boom and Bust

Is it really 16 years since the dotcom boom finally busted? I recall one commentator saying it will take 13 years for the market to get back to pre-2000 levels. I would argue it’s still trying. Anyway, those with long-ish memories will recall that 1999 was a crazy year for technology companies. The internet was the Next Big thing, and any company offering internet technology, service provision and content saw their share prices rise ten-fold, sometime one hundred-fold. Some of those companies are still around today: Amazon, Ebay and Cisco for example. Others, like Global Crossing, WorldCom and Nortel failed.

The boom happened because, rightly, there was “gold” to be made by exploiting internet technology. The companies emerging as global businesses will be truly massive, buying up others on the way. But the boom was indiscriminate. I recall a UK company Photo-Me share price rising sharply because a story got out that they were to put internet terminals into their photo booths. Nobody wanted to miss out. And that’s why nobody did, especially when it crashed in 2000. The tech-heavy Nasdaq 100 Index halved in value, falling further still in 2001.

Of course some companies are now world-leaders. Google, still in its infancy in 2000, now leads the world in terms of market capitalisation. Amazon, the world’s number one retailer, is still growing. And Apple, again not a major force in 2000, dominates the personal internet technology market.

Bitcoin

I suspect I will get into a bot of trouble mentioning Bitcoin here. I’ll admit it’s a clever idea, and I also suspect its faceless inventor(s) never expected it to be so popular. But what are we actually buying when we say “I have 20 Bitcoin”? Its value changes through supply and demand. Although overall supply is gradually increasing anyway, through “mining”, the liquid supply and demand relates to the extent to which people see Bitcoin as a store of value. If it were just a transaction processing system, it wouldn’t matter how many dollars one Bitcoin is worth, because the time it takes to convert dollars to Bitcoin, process the transaction, and then convert back to dollars again is minimal. To short a time to see any meaningful movement in the exchange rate. But the more that people choose to use Bitcoin as their currency of settlement, the more Bitcoin they will want to buy from existing holders, thus forcing up the price. It’s these orice movements that Bitcoin traders hope to capitalise on.

But surely the criticisms of Bitcoin equally apply to gold? Well, there are some differences. Gold can’t be destroyed but a hard disk drive with your Bitcoin records most certainly can be. And you can make some nice things out of gold. But as a store of value, are they more similar than we think?

Wouldn’t it be ironic if fool’s gold turns out to apply to gold, that very metal whose juxtaposition brought about the term in the first place. I’m not saying that Bitcoin or gold will necessarily prove to be worthless one day. Far from it. History shows that gold maintains its value when currencies lose theirs. But as for Bitcoin, I would ask: Why. Why should it ever increase in value more than gold? Why should it have any value at all? This one is a mystery, and you can be sure this site will return to Bitcoin again soon.

Is there anything we can rely on?

The trouble with assessing the riskiness of an asset is that we need to have a means of valuing it. Typically this is done in a currency, usually US dollars. But what happens if that currency becomes an unreliable store of value? Well, that’s when we need to work out what is right for us. We might use the value of our property as a reference. Or a relevant commodity, like gold. In which case anything other than what we choose as our base reference will be risky and speculative. The first two examples are where investors were wiped out simply because there was no value at all, not because relative values fell.

And this takes us back to last year’s April 1st Special. Anyone who invests is a fool. Any investment might turn out to be fool’s gold. The best we can do is to keep ourselves informed.

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