Glencore Collapse Could Be Even Worse Than Feared

Editor's Note: We're sharing this update on Glencore's collapse with you because it's shaping up to be even worse than Michael originally thought. Glencore still poses a "Lehman Brothers"-level risk to the global economy - but it's now clear the world's biggest commodities trader is on the hook for hundreds of billions in "shadow debt" that it simply refuses to address. This crisis is one small step away from upending our financial system, so here's what you need to know...

A lot of powerful voices have joined me in warning about the potential threat that Glencore Plc. (LON: GLEN) poses to global financial markets. Bank of America, for instance, has published a report on the true size of the fallout. As you'll see in a moment, it's staggering.

But since we talked about Glencore late last month, something insane has happened: The stock has gone up.

But not for any good reason. The company has not righted the ship. The surge is only due to short-sellers covering their positions.

SMIThe ugly truth is, the company is still a "shining" example of exactly what's wrong with these markets.

And I fear individual investors will get caught in the mess and wiped out on a stock like this or some of the others around it.

That's why I want to call out the misapprehensions and lies that are causing this "fauxcovery" and show you what's next.

Because it could end up even worse than I thought...

Glencore Is Doing Everything Possible to Calm Markets

Since hitting a low of £0.69 ($1.05) per share on Sept. 28, Glencore stock has doubled to £1.29 ($1.97) per share. Even its credit default swap spreads have recovered to 650 basis points from a panic peak of 900 basis points.

To place the last point in context, however, markets are pricing the company like a weak single B credit instead of a CCC credit. So while the major credit rating agencies still consider Glencore an investment-grade company, the actual credit markets have a much dimmer view of its prospects.

Naturally, the company is doing everything possible to calm markets.

First, last week it took the unusual step of publishing a six-page "funding factsheet" designed to dispel market concerns about its liquidity and solvency.

This factsheet shed very little light on what is really going on at the company, however. It said virtually nothing about Glencore's derivatives contracts, other than stating that its derivatives contracts were undertaken within "industry standard frameworks."

Here's the thing - "industry standard frameworks" normally require companies to post additional cash collateral upon the loss of an investment-grade rating, so the company's statement should not have made anybody feel better.

That suggests to me that the rise in the company's stock price was largely a matter of short covering, not investors suddenly deciding that everything is hunky-dory in the House of Glencore.

Second, Glencore is blaming everyone from short sellers to industry rivals for its problems.

Non-Executive Director John Mack, who led Morgan Stanley (NYSE: MS) to the brink of insolvency during the financial crisis, told Bloomberg that speculators in the company's credit default swaps were responsible for creating a false impression that the company is in trouble.

This attempt to scapegoat the credit default swap market demonstrates why Mr. Mack allowed Morgan Stanley to come close to collapse under his watch in 2009.

The truth is, there are a lot more legitimate lenders looking to protect themselves against losses on their Glencore exposures than speculators looking to make a fast buck on the company's collapse.

Then there's Chairman Ivan Glasenberg, who blamed mining rivals for oversupplying the commodity markets. This is like the Devil preaching against sin.

These modern-day Captain Ahabs would do better to stop, look within, and accept responsibility for building a company whose fate now rests with the rating agencies, capital markets, and banks.

They have lost control of their fate by borrowing too much money and failing to see that the global economy was built on an unsustainable debt bubble that inflated the prices of all commodities to levels that were inevitably going to collapse.

Glencore Ignores This Debt, but It's Critical

There is an even bigger elephant in the room that the company didn't address: the enormous amounts of undrawn bank lines and letters of credit that banks have made available to the company over the last few years.

Bank of America Corp. (NYSE: BAC) has estimated that this exposure, above and beyond the company's $30 billion of net debt and $19 trillion of derivatives, could run Glencore's total indebtedness to the global financial system to $100 billion. Furthermore, most of this debt is unsecured. The company hasn't borrowed this money yet but might have to if things get worse.

Bank of America estimates that Glencore has $50 billion of committed but undrawn bank lines against which it can draw letters of credit to finance its trading activities. While the company has an unencumbered asset base of plant, property and equipment, and inventories of as much as $90 billion, the banks would actually have to claim that property if a problem arose. And the value of those assets would decline sharply under adverse circumstances.

But while those bank lines are available today - and most banks can't reduce them until 2017 - they are likely to be reduced in the future.

The banks are well aware of these exposures and are praying that Glencore won't draw them down in the midst of the worst commodities collapse in recent memory. The moment they can reduce these credit lines, they will do so, especially with regulators breathing down their necks.

Glencore did say in its factsheet that there are no financial covenants or rating downgrade triggers in any of its committed unsecured bank lines, but it is difficult to determine whether that relates to the $50 billion of shadow debt that Bank of America is speaking about.

The recovery in Glencore's stock should not change anybody's view that the company is still a veritable house of cards - if the major credit rating agencies catch up to the markets, all hell could break loose.

But there is a larger dynamic at play here that has major ramifications not only for Glencore, but for the broader financial markets.

There's a Major Commodities Squeeze Ahead

Banks have enormous shadow exposure not only to Glencore, but also to other large commodities trading firms like Trafigura Beheer BV, Vitol Group, and Gunvor Group Ltd.

In addition, they have huge exposure to mining giants Anglo American Plc. (LON: ALL), Rio Tinto Plc. (NYSE ADR: RIO), ArcelorMittal SA (NYSE ADR: MT), and others. This is over and above their exposure to the energy industry, which is obviously a disaster.

Much of this exposure is hidden and not on the radar screen of stock market investors or the financial media. But it is in the hundreds of billions of dollars in aggregate, and repayment depends on the health of commodities.

All of this exposure to the massive commodity complex poses a potential systemic risk if commodity prices deteriorate further, which is highly likely, as I've explained.

The banks that hold this exposure are vulnerable to lower commodity prices, which is why they are going to do everything possible to cut their exposure over the next couple of years. This in turn will squeeze commodities producers even more than they are already being squeezed.

Glencore operated largely in the shadows for a long time. Now it has been brought into the light. It is an uncomfortable place to be, and investors should watch it carefully for signs of more trouble ahead in the commodities space and the rest of the financial system.

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About the Author

Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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