Sovereign Suitability?

Bloomberg reports:  "Goldman Gets Ecuador Gold ...."

    Oh my gosh, this story looks familiar!  Channeling Mark Twain, History Rhymes.  This brief story has few details, so we'll need to make a few assumptions and guesses.  The deal between Ecuador, a sovereign entity that embraces the US dollar as its currency, and Goldman Sachs appears to be "gold lending" for a 3-year term in the amount of $580 million.  Just like "securities lending," Ecuador is entitled to receive cash as collateral.  The best interpretation is that Ecuador will use the cash to buy liquid USD securities from (surprise!) Goldman.

    The first alarming aspect is the statement of the Ecuadorean Central Bank that the gold "now becomes a productive asset that will generate profits."  Here we find the rhyme with the famous cases from the 1990's that created suitability laws!  The Treasury department at Procter & Gamble sought to become a profit center for the company - just like Ecuador's current Central Bank.

    A better analogy to Ecuador (a sovereign) is Hammersmith & Fulham London Borough Council (a UK municipality).  See this legal synopsis of the court judgment repudiating Hammersmith & Fulham derivative contracts as ultra vires.

    On its face, this Ecuadorean gold lending arrangement appears unsuitable for the sovereign.  We reach this view by noting that the central bank is pleased that it "will generate profits" of roughly 1% per year.  How does this happen?  It's leverage!!  It appears Ecuador will take the yield spread of the liquid securities as its profit.  But Ecuador will have, then, both the credit and market risk of the securities AND the market risk of the gold it has lent to Goldman.  Just like securities lending, this is the risk - the lender increases assets through leverage.

    For sophisticated investors with risk expertise, such leverage can be acceptable if fully disclosed.  But sovereigns don't fit this description.  How many central banks are there that gain leverage through off-balance sheet transactions?

    Good question!  Greece comes to mind!  See the February 2010 article "Wall Street Helped Greece to Mask Debt Fueling Europe's Crisis."  We don't recall anybody citing "suitability" concerns for these Greek derivative transactions, but that's how we see the story.  The Greek people were not well served by the delayed reckoning provided by the highly sophisticated Wall Street counterparties.

    Sovereigns and, really, all parties to financial transactions should keep their activities as simple as possible.  Ecuador would be better served simply by selling its gold if it needs the USD cash and near-cash instruments.  Why own gold anyway?  (The Fed itself owns essentially no gold.)  As a USD-based country, Ecuador should simply match the risks of its assets and liabilities.  Having a large, long gold position does not help such risk matching.