Exciting Frontiers in Insurance Pricing

(November 2, 2009) Gold prices just completed a full month (October 2009) trading above the $1,000 mark for the first time in history, and on Monday, November 2nd, gold’s PM London fix of $1,062 was an all-time high in dollar terms.

Gold’s price rise in dollars over the past year has exceeded 35%. Gold first reached the $1,000 mark, albeit only briefly, in March of 2008. By the fall of 2008, our recent financial crisis was in full swing, and gold bottomed out at $712 on November 13th of that year, during a period of panic in which the world’s financial behemoths sold what they could, including gold, in a mad scramble for the dollars needed to plug gaps in their balance sheets.



From that $712 mark, gold’s price rise in dollar terms has been steady as she goes, without a lot of volatility. Gold has traded above $900 for the past six months or so, during a time in which it has slowly crept toward the $1,000 level. We are now in the fifth week of gold prices over $1,000.



Physical off-take of gold bullion has been steady, but not quite at the rate of unexpected panic that we saw last fall. More and more people are buying gold in much larger amounts than we saw earlier this decade, and often for the first time. The alternatives - stocks, real estate, or parking your money at today’s miserable interest rates - are simply not very appealing. So, for many, for the first time, gold holds an attraction that it never had before.



E. S. Browning’s “Stocks and Gold Along for the Same Ride,” an article in the 10/26/09 edition of the Wall Street Journal is pretty much on point: “When governments and investors lose faith in currencies, and fear economic trouble, they turn to gold.”



Browning surveys money managers who now include gold among their holdings. Michael Avery of Waddell & Reed’s Asset Strategy Fund, is quoted by Browning:,br>


“In 5,000 years of human history, gold has been the currency of choice, the store of value, when humans have called into question their government’s efforts to solve problems by running printing presses.”



Mr. Avery’s timeline appears a little confused, since gold coinage began around 600 BC, and money from ‘printing presses’ made its appearance nearly 2,000 years after that. Probably he was misquoted, and actually said “500 years of human history,” but either way, his heart seems in the right place.



Browning finds support for gold among those who see its value both as an inflation hedge, and as an alternative, not just to the dollar, but to all fiat currencies. David Einhorn of Greenlight Capital, a $6 billion hedge fund, is quoted by Browning:



“My instinct is to want to short the dollar. But then I look at the other major currencies. The euro, the yen, and the British pound might be worse. So, I conclude that picking one of these currencies is like choosing my favorite dental procedure. And I decide holding gold is better than holding cash.”



The beauty of gold, however, is that it is not just for Wall Street types – anybody with some excess dollars can own some. Gold in its basic bullion forms is easy to understand. Gold requires no maintenance, it won’t go bankrupt or out of style, and it literally lasts forever. In your possession, gold is the most astoundingly basic form of wealth imaginable.



But gold has certainly attracted the attention of Wall Street types. On Tuesday, November 3rd, a book about John Paulson entitled The Greatest Trade Ever, and written by Gregory Zuckerman, is to be published by Broadway Business.



Mr. Paulson was a hedge-fund manager who launched his first fund in 1994. He was not a giant of the financial industry, but in the year 2006 he came to a conclusion that would make him incredibly rich: the US residential housing market was overvalued, by his reckoning, by about 40%.



After several false starts during which he was turned down by many money managers who told him that his idea would take him nowhere, he finally managed to ‘place his bet’ against housing by purchasing then-cheap residential mortgage insurance through the use of derivative CDOs. Paulson found a way to trade against the cult of residential real estate, and took advantage of the market’s blind complacency about ever-rising housing prices. His firm went on to make $15 billion in 2007 alone. His cut of that: about $10 million per day for the year.



By the middle of this year, everything that Mr. Paulson had bet on, came too pass. US housing prices had fallen, on average, 30% from their peak. So what next? Mr. Zuckerman, in the Wall Steet Journal, writes:



“As Mr. Paulson and others at his office discussed how much was being spent by the United States and other nations to rescue areas of the economy crippled by the financial collapse, he discovered his next targets, certain they were as doomed to collapse as subprime mortgages once had been: the U.S. dollar and other major currencies.”



“Mr. Paulson made a calculation: the supply of dollars had expanded by 120% over several months. That surely would lead to a drop in its value, and an eventual surge in inflation.”



Mr. Paulson’s firm purchased billions of dollars of gold investments. “What’s the only asset that will hold value? It’s got to be gold,” Zuckerman quotes Paulson as saying, “Three or four years from now, people will ask why they didn’t buy gold early.”



We should insert the warning here that “Past performance is no indicator of future results.” But gold, which has rather placidly traded on both sides of the $1,000 level for seventeen months now, certainly has the potential to surprise. Or, should we say, the value of the dollar certainly has the potential to disappoint.



In the twelve years starting in 1968, when gold had an official world price of $35/ounce, through January 1980, when it peaked at $850/ounce, gold increased in value some 2400%. Gold prices then spent the next twenty years going nowhere but down in dollar price terms, finally touching the $255/ounce level in 1999 and again in 2001.



If the assertion is true that the US dollar is going through the inflationary 1970s all over again, then a similar 24-fold increase from its 30-year low of $255 would put gold at $6,120.



We are now approaching the 40th anniversary of the dollar having no gold backing whatsoever. Forty years is a significant longevity milestone for any purely fiat currency. Dollar creation, particularly in the past two years, has been accelerating at a pace no one previously could have imagined.



The more obvious the need is for a particular kind of insurance, the more expensive that insurance becomes. John Paulson made himself and his clients several fortunes by understanding that simple concept as it applied to the housing market.



Today, we are in the 8th year of this bull market in gold, and dollar gold prices in four figures are certainly a new frontier that takes some getting used to at first. And until or unless political realities allow the dollar to return to a position of strength, today’s market price for physical gold insurance does not seem a bit unreasonable.