What Happens in Russia Doesn't Stay in Russia

Revisiting the collapse of Long-Term Capital Management... A must-watch interview with Jim Rickards... What happens in Russia doesn't stay in Russia... A burgeoning food crisis and economic 'nuclear war'... What's immune from a liquidity crisis...

They nearly shut down markets all over the world...

It was September 23, 1998. Market historians and geeks, and anyone who worked on Wall Street the last several decades for that matter, likely know the story, or were involved themselves...

I (Corey McLaughlin) am talking about the collapse of Long-Term Capital Management ("LTCM"). While it happened nearly 25 years ago, things started to go bad partly because of Russia's economic troubles... so the story has some new relevance, which is why we are talking about it in today's Digest.

When you look back at a timeline of "major financial crises that could have been avoided if not for greed and bad decisions," the demise of LTCM is one of the bold-face inclusions...

Just a few years after it opened with great promise on Wall Street, by September 1998, the firm needed a nearly $4 billion cash injection from the Federal Reserve to avoid failing completely and possibly taking down global markets with it...

Back then, LTCM was a sexy hedge fund that did business with the biggest players on Wall Street... It offered a highly leveraged portfolio built around a darling quantitative (data-driven) strategy that sought big returns and a lower tax bill.

Things were great for a little while. The fund, founded in 1994 by former Salomon Brothers Head of Bond Trading John Meriwether, returned roughly 21% in its first year, 43% in the second, and 41% in the third...

Then things started to fall apart...

It happened slowly and without many people realizing it...

First, other Wall Street firms began copying LTCM's process of seeking "arbitrage" opportunities in U.S. government bonds by essentially betting that historic interest-rate patterns could continue as they had been...

In other words, the market was becoming crowded with more competition, and LTCM's first-mover advantage was dwindling, so the firm started using its models to fish different ponds to seek big profits...

One was emerging markets, which the firm didn't know much about... Yet the folks leading the firm kept trading as if they did. Others within LTCM warned that they should stick to the markets their models were designed for.

LTCM eventually had $1.4 trillion tied up in derivatives contracts, which paid massively when things went as planned... But would suffer crippling losses if they didn't.

Long story short... with exposure to the Asian financial crisis in 1997, the firm started losing capital, and by June 1998, LTCM had racked up a 10% monthly loss, its biggest one-month deficit to date. Still, not backbreaking...

But then, came "the biggest shock of all," as senior editor Stephen Slivinski chronicled in a 2009 article for the Richmond Fed. It was in one of those new fishing ponds, Russia, that was embroiled in its own financial (and political) crisis with inflation at 84%...

That is a whole other story, but as Slivinski wrote, ultimately it led to major unexpected event that, among other things, crushed the portfolio of Long-Term Capital Management...

On Monday, August 17, the Russian government defaulted on its debt and let its currency plummet. This triggered a flight to more stable assets, like U.S. Treasury bonds. This created problems for LTCM's balance sheet, and not just because the fund held a large number of Russian bonds outright.

The events also threw off the well-defined and predictable pattern of interest rate spreads upon which the firm's derivative investments in domestic and foreign bonds relied. Now, instead of interest rates converging, the massive rush to more secure bonds — an anomalous occurrence in the assumptions of LTCM models — were driving the rates further apart.

In other words, it was all going wrong. Because LTCM was addicted to leverage – placing bad bets on top of mounting losses – by the end of August it quickly lost $1.85 billion in capital. A few weeks later, in mid-September 1998, its cash on hand dropped to $400 million, still with $100 billion in liabilities.

Worse, because the hedge fund was connected to so many other Wall Street firms (who were connected to so many other things), and it couldn't pay its debts, the Fed feared the situation would trigger an even greater crisis than the one already happening...

So the central bank organized a $3.6 billion loan to "save" LTCM... In the massive deal, basically every major Wall Street firm – like Goldman Sachs (GS), Merrill Lynch, and Morgan Stanley (MS), who were among 11 banks to put up $300 million – took a combined 90% share of LTCM's debts.

It was enough to prevent "who knows what"...

We know one guy who can explain "what"...

Jim Rickards had 'better' than a front-row seat to all of this...

He was the lead negotiator and general counsel for LTCM on the $3.6 billion Fed-backed bailout... who brokered the deal that he says avoided much worse. As he says...

We came within hours of shutting every market in the world.

A Renaissance man of sorts, who has worked as a lawyer, economist, and investment banker, Rickards is now a bestselling author of six books and a sharp commentator on the financial markets.

To that point, our editor-at-large Daniela Cambone recently recorded a terrific interview with Jim, which first got us reminiscing about the Long-Term Capital Management collapse... and all the lessons it can teach investors ‒ No. 1: Be careful with leverage...

But the second and more timely point I want to share in today's Digest is that, given Jim's experience dealing directly with a financial crisis that accelerated because of Russian economic troubles, he made us think hard about the present day...

Like how the ongoing war in Ukraine – and the ensuing sanctions by the U.S. and the West on Russian banks and other industries – could influence the global economy, slowly without most people noticing... and then quickly to a spectacular, in-your-face blowup...

Rickards, who noted the awful human cost of the war first and foremost, told Daniela that the U.S. slapping sanctions on Russia will have unrealized second- and third-order effects...

What happens in Russia doesn't stay in Russia. Russia may be the first victim of U.S. sanctions. But the entire world will pay the final price.

Without hyperbole, he said escalations stemming from what he calls the first full-scale economic war, between the U.S. and Russia, could lead to the "economic equivalent of a nuclear war" and a global liquidity crisis.

First, there's the inflation story...

In the conversation with Daniela, Jim outlined how he sees the war unfolding – and noted Russia's obvious plans to control the eastern side of the country, which means likely blocking trade out of Ukraine...

Ukraine and Russia (essentially now cut off from the West) provide about a quarter of the world's grain exports. So considering that many African nations and countries like Lebanon rely heavily on wheat from Ukraine, this is a big deal. Jim said...

You take 25% of the world's grain exports off the market, tell me what that does to the price of wheat. And by the way, wheat's not just a loaf of bread. Most grain is used to feed livestock, so it goes straight through to the price of pork, chicken, beef, et cetera.

You're looking at things doubling or more. That's if you could get it, and behind that are shortages. We had a supply-chain breakdown before any of this started... Now you put the Ukraine war on top of that, and economic sanctions on top of that, it's going to get a lot worse.

Keep an eye on this part of the story... rising commodity prices.

Second, read the 'fine print' on those sanctions...

We've written previously that Russia and its largest banks have been booted from SWIFT (the Society for Worldwide Interbank Financial Telecommunication), the international payments system that makes sending funds back and forth among nations fairly easy...

That one is quite straightforward...

But let's get into the "fine print" on the sanctions, as Jim did with Daniela after reading through hundreds of pages of documents.

Last month, for example, the Russian central bank claimed it paid $117 million to investors in dollar-denominated government bonds. What? How?

Turns out, there was anywhere from a 30- to 90-day delay on most of the sanctions... plus the U.S. Treasury Department had been allowing the Russian government to pay off debt in dollar bonds on a case-by-case basis, which made sense because you want your debtors to pay off their loans.

This was the approach... until today.

The 'currency war' just went up another notch...

As international-news service Reuters reported, the U.S. is now denying the Russian central bank access to funds at U.S. institutions to make good on any dollar-denominated bonds payments it owes...

The United States stopped the Russian government on Monday from paying holders of its sovereign debt more than $600 million from reserves held at U.S. banks, in a move meant to ratchet up pressure on Moscow and eat into its holdings of dollars.

According to Reuters, the Treasury Department stopped JPMorgan Chase (JPM) from processing a Russian payment, which it would normally do before sending the appropriate funds to bondholders. More from Reuters...

The move was meant to force Moscow to make the difficult decision of whether it would use dollars that it has access to for payments on its debt or for other purposes, including supporting its war effort, the spokesperson said.

Russia faces a historic default if it chooses to not do so.

"Russia must choose between draining remaining valuable dollar reserves or new revenue coming in, or default," the spokesperson said.

So basically, the U.S. is pushing Russia toward a default, meaning it'll owe creditors somewhere a lot of money...

This might sound like a hardball, appropriate stance on the surface given the horrors of the war in Ukraine, but cutting Russia out of the dollar system will have knock-on effects...

As Jim told Daniela last week, before this news broke earlier today, be careful what you wish for...

If we tell Russia they can't pay their debt, who loses from that? They keep the money and its American bondholders who lose money... It's the creditor that loses out when the debtor can't pay.

Where are those bonds? Well, you'd be surprised. A lot of them are in BlackRock. They could be in someone's 401(k)... Did you buy an emerging-market exchange-traded fund from Morgan Stanley? Because there could be some Russian bonds in there...

When you tell the Russians that they can't pay their debt, debt starts defaulting all over the world [and] you don't know where it's going to pop up.

You're now playing with a global liquidity crisis. That's how these things can evolve very quickly, as we saw in 2008 [during the financial crisis] and 1998 [during the Long-Term Capital Management collapse].

This scenario may also simply push the Russian government to seek business elsewhere, saying we've had enough of dealing with dollars, ultimately weakening demand for the greenbacks.

Here are a few important points for everyone...

First, as we often say, always know what you own...

For instance, if you're concerned that your portfolio has direct exposure to Russia, you can easily find the components of what makes up an exchange-traded fund ("ETF") on most brokerage sites... Most people never take the time to look though.

Second, remember that crises – either at LTCM or anywhere else – start under the radar, then build slowly until they escalate quickly and make headlines... after much pain has been created by usually a few people that is about to impact many more.

This is why you want to at least acknowledge the possibility of these outcomes well before most people start talking about them.

To be fair, we're talking about "Black Swan" type of events that are difficult to predict... but human nature is human nature – that's a risk worth considering in and of itself – and debt is debt.

Here's a final thought from Jim...

Everyone goes, "Oh, Long-Term Capital, you guys lost a lot of money in Russia." We didn't. We lost maybe $100 million in Russia, but we lost closer to $4 billion on everything else because in a liquidity crisis people sell everything.

It's not a question of "Do you have Russian bonds?" No, they sell everything... Not enough collateral. Margin calls. People being blown out of their positions. That's what a global financial crisis looks like...

The dominoes keep falling unless you drop a wall in, and that wall was the Fed... Each bailout gets bigger than the one before. Each crisis is more dangerous than the one before... 1998, 2008, here we are in 2022...

We're going to get to a point, and we may be there, where the crisis is actually bigger than the Fed's ability to stop it...

This may sound ominous, but let's be clear: We're not predicting a major liquidity crisis tomorrow. But they do happen... and we'll keep following the breadcrumbs that might lead to one... or even fears of one that might upend markets or prices of certain bonds or stocks.

Either way, importantly, there are actions you can take right now to protect your portfolio from a major global liquidity shock...

For one thing, Rickards suggests you own hard assets like real estate, gold, silver, and stocks of companies that make their money from natural resources, like water or oil. Stuff not attached to debt, but tangible goods.

Those things aren't going anywhere, and will have value, likely higher values over the long run – no matter how much greed (or fear), or bad decisions there may be in the world. We've seen it happen before. We'll see it happen again.

The thing is, few want to hear this kind of message when "things are good," or even "relatively OK," but that's exactly when it's the most useful. So, for even more insight, be sure to watch Daniela's entire interview with Jim right here... It's truly a must-watch.

And for more interviews, videos, and podcasts from the Stansberry Research team, if you haven't already, check out the "Media" section of the new StansberryResearch.com. All of our video and audio content for subscribers is in one place there.

New 52-week highs (as of 4/4/22): Black Stone Minerals (BSM), Formula One Group (FWONA), Kinder Morgan (KMI), Lynas Rare Earths (LYSDY), MP Materials (MP), Palo Alto Networks (PANW), Shell (SHEL), Sprott (SII), SPDR S&P Oil & Gas Exploration & Production Fund (XOP), and Zeta Global (ZETA).

In today's mailbag, feedback on the plans to tap the U.S. strategic petroleum reserve ("SPR") over the next six months, which we wrote about in yesterday's Digest... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"There are issues related to the SPR (Strategic Petroleum Reserve) release nobody seems to be talking about.

"I have read up on the SPR and the claim to be able to deliver 4.4 million barrels per day. Though the release is only for 1 million barrels per day, there are some questions nobody seems to be answering (or even asking these questions):

"1. Can they actually deliver that much oil through existing pipelines and U.S. flagged tankers (the Jones Act requires domestic shipments to be on U.S. flagged ships)?

"2. It looks like companies that take oil from the reserve must replace within two years plus provide extra oil based on the amount of time it took to replace (sort of like interest). Who would take the risk they could replace this oil with cheaper oil given the possibility of a long term supply/demand imbalance? Seems to me the risk to someone who takes this oil does is high.

"3. Could you even hedge that much oil without creating gamma squeeze risks like the ones that the almost brought down the [London Metal Exchange] recently?

"4. The 50 million barrel release announced in November 2021 has still not been completely delivered and on a daily basis this is only one-third the size.

"So is this going to be a party nobody goes to? What am I missing or have wrong? Seems to me they are just trying to talk the price down with little hope of it helping the imbalance materially." – Paid-up subscriber Lloyd M.

All the best,

Corey McLaughlin
Baltimore, Maryland
April 5, 2022