Silver Dominoes, or a Tale of the Merchant of Margin.

The sharp drop in silver last week made us think of price-support in different markets and how that depends on the constitution of market participants. When a significant percentage of a market is composed of financial buyers and speculators, many of them leveraged, it is prone to sharp, steep drops. It doesn’t matter whether the underlying object is “safe as houses” or “worth their weight in gold”. When a speculator buys an asset with borrowed money, the lender (typically a bank or brokerage) will seek additional security if the asset’s market price moves in the wrong direction (a margin call), and when the speculator can’t provide additional security to hold on to the position, the lender will move to sell the asset. If a significant number of buyers are speculating with borrowed money, or on margin, small downward moves snowball as waves of margin calls  trigger liquidation, which trigger further margin calls.

This is a lesson that was dearly learned during the crash of ’29 and led to the simple and strict margin limits in the US equities markets. The lesson was unlearned over time. High loan-to-value mortgages were used by large numbers of people seduced by stories of millionaire flippers to speculate in real-estate. High levels of leverage are what trigger quick unwinds in the carry-trade as well. IN 2008-2009, all this frenzied activity triggered the recent real-estate bubble and ensuing crisis.

What a lot of US-based “investors” in commodities fail to understand is that the financial markets for commodities operate with a degree of leverage that is simply unattainable for the average investor in equities (the market people are most familiar with). To take an initial position in a 5,000 oz. silver future on the CME (worth about $187,500) requires posting $18,900 in margin. That’s 10:1 leverage, or 10% down, and this is after the exchange recently raised the margin requirement. A 10% move can wipe out the margin posted, and a 2% move can require the speculator to post additional margin. Seasoned participants in commodities know this, but we fear the vast masses who have been drawn to investment products linked to gold, silver, copper etc. do not appreciate how much borrowed money fuels the market they’ve recently entered.