The Scarlet Absence Of A Letter Of Credit

Tyler Durden's picture

Submitted by Mark St.Cyr,

If there’s one thing we all know about banks and bankers: they love to tell tales in public of how much they value their customers. However, what you’ll never hear them profess in private: is how much they trust them. Although one may think that’s unseemly, believe it or not there is another entity banks hold at an even lower tier. Other banks.

One of the known facts people remember about the melt down in 2008 (as opposed to general public) was when the banks no longer trusted each other, and what they earlier claimed was “collateral” wasn’t actually worth what it was stated to be.

Credit default spreads (CDS) were supposedly the insurance to negate valuation concerns. But when the banks felt CDS weren’t worth the paper they were written on, not only did they operate in a fashion reminiscent of cutting their noses off to spite their faces, but rather they began cutting visible ties (and/or appendages) to other banks.

The blinding issue with all that took place during that period is the speed in which it all took place. Once it seemed one bank (regardless of size) was not going to be able to make good on a promise of clearing, near overnight the banks regarded any and all collateral at a discount. This fed on itself to where even once valued pristine collateral such as hard materials let alone paper began to be not only discounted, but prices slashed at such discounts that would make a blue light special at K-Mart™ blush.

So when I read the following article on Zero Hedge™: How China’s Commodity-Financing Bubble Becomes Globally Contagious.  My blood ran cold. The implications of this development and the consequences it portends just might make it the proverbial “canary in a coal mine.”

The underlying issue that makes this far more dangerous or different from times past is three-fold.

First: The idea of the need to send a perishable product overseas to another country that operates in a differing court system without the only document that gives one a chance of a “guarantee of payment” is not something to be taken lightly. As a matter of fact, it should be looked upon as a move of desperation.

Second: If that commodity is both a readily needed or used product, the immediate resale by the receiving party (especially if they themselves are in trouble) may sell it off at a steep discount. And yes, I’m implying less than what they are being billed for.

For if the receiving party needs cash, and you don’t have anything backing payment, i.e., Letter of credit (LOC.) Than it’s free money to do with as they please until you can get them into court – if you can at all.

Why would one pay full price (or even think they should) when pennies on the dollar will now be the opening settlement offer in any negotiations?

Third: The commodity itself is well-known, and has been publicly reported as being used as a collateral for cash strapped real estate developers in China. This last point is probably the most troubling of them all, and where the real issues might come about.

Here’s a scenario many are missing yet, is highly plausible. If bankers once again (for any reason) don’t believe they’ll get paid, while also concluding what they have on their books once again as collateral (since housing is a sunk line item now) can possibly deteriorate in value faster than a foreclosed building in Detroit. All bets are off.

A vicious cycle begins something akin to this… (Yes this example is an oversimplification, but the implications are not.)

The commodity producer is leveraged up and is either fully, or has over expanded needing to produce X at a rate consistent with structures and costs. The banks (markets, etc.) base their loans for operating expenses on sales, and value of on hand inventory. All rudimentary stuff.

If the collateral backing the loans for operating expenses are mostly the refined product itself, and that product is a commodity, then both the product along with its value are at the mercy of a perishable overhang. e.g., The product can spoil, or the price can plummet via oversupply, etc. But the one thing it can’t do that’s possibly worse: is sit on a producers site, books, or more, indefinitely.

The only way to turn that product into useable cash is to sell it. And here is where things get a little tricky. For what a sale “is” as to open or allow funds to be allocated to the producer for operating expenses, can sometimes have more in common with that other famous distinction of what exactly, “is” – is.

If you’re a company and producing X where LOC’s are the requisite detail of paperwork that can not be overlooked or forgone, and is standard operating procedure for the industry, and you deviate from these expected practices: it sends signals that not only something may be wrong, but quite possibly something far worse. i.e., An act of desperation.

Imagine yourself as if you owned the commodity and it were beginning to either pile up in excess inventory. Or, you had tentative sales yet, they were unable to come to fruition for lack of a LOC. What would you do?

Well, if you hold onto the product and let it sit it begins to lose value via market forces. Second, your lender values you product as collateral less and less via those same market forces squeezing you even more. So do you sit idle and let the chips fall where they may? Or, do you send it off in hopes of getting paid?

If you send it off it’s entirely plausible on your own books it will still remain as a “sale” and it keeps the demand narrative intact, reduces inventory, and helps in keeping production quotas all in check – for the time being. Keeping the spigots of operating revenues flowing. (Hopefully giving breathing room so fallacy can turn back into reality)

However, at issue is also the recipient of the product, For either A:  They didn’t want or need it. Or B: (which is far worse) Need it, but can’t pay for it.

If that customer is honorable, they might just receive the product as an early shipment, store it, and state never do it again or they’ll drop you. Yet, they’ll penalize you by paying for it only when they actually would have ordered it to begin with. Regardless of when that date may fall. That’s the most wishful (and probably unicorn/rainbow treatment) of an outcome one could hope for.  Yet things usually don’t happen that way do they?

Let’s use the guise that’s turned a blind eye by the so-called “smart crowd” across the financial media, and look at the recipient of that product as someone being squeezed by their centralized government in an effort to dampen a real estate bubble. Couple this with the tenacity as to not give into outside pressures as to “inject liquidity” at others promptings.

If the product is received by someone desperate of needing cash, than the first thing they’ll do with that product is whatever it takes to turn it into just that. And just like a drug sick shoplifter will sell any highly valuable stolen product for 50 cents on the dollar, so to will a credit induced financial addict with the overwhelming overhang of needing to supply a “credit fix” to their portfolio.

As devastating as the above scenario can play out there’s another just as plausible and actually more probable. This is where the ruthless play. And these players make banker on banker squabbles look like a kinder-garden recess.

To them: You shipped it without a LOC? Shame on you. Let’s start the bidding of you possibly ever see payment at a 50% discount today. If you don’t answer by the close of business today, it goes down even more.

Think they’re not serious or want to call their bluff? No problem, they begin by informing you that you can easily reload it onto your boat if you want. But, just to let you know, it’s no longer stored where it was off loaded. It’s now at X, or Y, or Z, or had been sold immediately on arrival. Oh and by the way, they were just informed the people they sold it to, don’t seem to have any money now either. Credit crunch is taking its toll your informed. (what a coincidental shame, who’da thunk it?)

Oh and by the way, it seems they’ve just instituted a new 90 day (or longer) advanced scheduling process, along with other “added expenses” that will need to be paid before you can get your product back.

They’d love to put you at the front of the line however, you’re notified there’s a lot of corruption taking place on the docks and even they can’t jump in line without paying.

By the looks of it, the farther one tries to work this out, it seems it just might cost you more to get it back than it was to ship it. Huh, funny how that happens. Well call back later they’ll say, and see what progress can be made as to rectify this for you. Click.

If you think things like this don’t happen, I have some ocean front property in Kentucky I would love to sell you.

Now take into account where the back half of the storm shows its presence throughout the commodity complex itself. (all hypothetical of course)

Suddenly the market becomes aware that company X is dumping your commodity onto the open market for say a 20% discount. That in turn spurs other producers or holders to begin offering their own discounts. As they do, the bastardized market (because without a LOC they’re in essence dumping) they begin dumping even more – for less.

That in turn pushes market forces in a downward spiral, which in turn reduces the value of everyone’s inventory leading into a black hole of who can discount faster. Which in turn begins in alerting “the lenders” to begin questioning any and all “sales” on clients books, and what they truly represents. Only to then find those “sales” were nothing but wishes and hopes. For without a LOC, what are they?

One doesn’t have to look all that far back in time to see just how fast the impact of any cuts, or implosion of credit lines by the banks can decimated businesses. Yes the 2008 crisis showed when they no longer trusted each other. However, “The Savings and Loan Crisis” of the 1980′s should remind every one of just how fast this can take place along with its consequences for Main Street.

Anyone that ran a credit line based business during that period remembers all too well the many businesses that were shuttered were not for a lack of business, but by the head spinning quickness LOC’s or lines of credit for operations were both changed as well as cancelled. This one could do the same but have far more reaching implications.

Over the last few years since the financial melt down of 2008, we have seen what many have believed are precursors that may tip the hand of markets as to show just how unhealthy this levitating act fueled by free money has become.

And yes there are always false indicators, and we all know correlation doesn’t equal causation. And even more may shrug and think, “No letter of credit, so what.” However, if there were ever a canary in a coalmine worth noting this is one not to let one’s eyes to divert from.

The issue at hand is not just the foolishness of the absence contained in a one off LOC gamble some company would take. Far from it.

It’s the desperation that could be hidden that’s a precursor one has to watch for. For the amount of desperation, or the degree that might be hidden beneath the surface to which a commodity will be sent overseas to another country, a country for all intents and purposes is using that very product as a pseudo currency to back other financial obligations without the requisite document to be paid; is mind numbingly dangerous in its implications in my view.

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Ahmeexnal's picture

Kill 'em all! Let GOLD sort them out!

0b1knob's picture

Chinese letters of credit will be honored only if the Chinese feel like it.

Massive oversupply of soybeans.   Deflationary you think?   And the yuan is going to replace the dollar?   Things that make you go hmmm...

Future Jim's picture

The decline leading to the great crash began when regulation forced us to go from mark-to-model to market-to-market in 11/2007 and the current bull market began when regulation forced us back to mark-to-model in 03/2009. It is almost as if regulation is being used to create bubbles and crashes. Even when we briefly had mark-to-market, that was not a move to free markets because everyone was forced to do the same thing. In a free market, some would use mark-to-market and some would not, and those who chose mark-to-market would get the trust of more customers, and failures would be spread out and fewer, and thus not serve as a pretense for new regulations, bailouts, QE, ZIRP, and lower fractional reserves.

gdogus erectus's picture

Dominos, bitchez!

(sorry - always wanted to get in on the 'bitchez' craze)

spine001's picture

For container load volumes, when you are starting to trade with a new business partner, you use irrevocable LOCs. Those you can discount and get your payment as soon as you ship. But after a few years of trading LOCs become a nuissance and you prefer to risk a few shipments in exchange for the expedience of a line of credit to your buyer. But you keep your ears on the ground and at the slightiest sign your partner may be in trouble, you switch back to asking for LOCs in a split second. That usually compounds your partners troubles who quickly runs out of collateral to maintain its LOC flow and goes belly up dragging along everybody that didnt react quickly enough. How much of this is going on in the exchanges with China, nobody knows, but it can't last for long.

For shipload volumes or very valuable commodities, it is irrevocable LOCs always.

Future Jim's picture

An LOC is something you give your customer once you trust him, and then if you smell trouble, you ask him to get his LOC elsewhere?

Winston Churchill's picture

Once you trust him it used to be revolving bills of exchange,
rather than LoC's. Things must have changed a lot in just
a few decades.

OldPhart's picture

Does this mean we'll see $300 gold and $4 silver again?

I'd better start building a fund to do a mass purchase.

Major Key Tonality's picture

The ancient relic.... that just happens to have same buying power as it did in ancient times. 

Bunga Bunga's picture

Logical consequence is using Bitcoin.

q99x2's picture

Pshaw, Just have em send those letters to the Yellen of Oz and she be printin the fiat to keep em quiet.

SmilinJoeFizzion's picture

Wake me up when the 1day repo yield is higher than the 30yr

NOZZLE's picture

I think its the obvious dirty secret at this point,  that everybody is doing this everybody is reselling or repledging the same pile of cotton over and over and over again just like they were  day trading condominiums in Florida 10 years ago.  STFU, it's the only game in town,  what else you expect us to do go, out and get a job and actually produce something for a living? 


10 years ago Americans became experts at filling out mortgage applications for condo after condo after condo, you had ramp workers, bakers at 

grocery stores buying 3 & 4 condos in Florida.

FeralSerf's picture

Who's going to buy that shit you produce? And how are they going to pay for it?

Nobody seems to realize yet that the Chinese have already supplied the world's market with just all about all the shit anyone with cash wants.

CheapBastard's picture



"Dear Valued Customer,

I am glad to report we limited your Bail-In amount to just under 40% of your total deposits held by our bank, First National American Trust Community Bank of Brooklyn, instead of the 60% we originally esimated due to banker losses.

To show our appreciation, we are rewarding you with a Brand New Batman Hand Towelette. We look forward to serving you in the future. Please do not hesittae to call us with any questions.

Best Regards,

Jamie, CEO"

DeadFred's picture

Aw Jamie, feel free to keep 60% of what I have on account at your miserable institution. hahaha

Oquities's picture

government bailout needed for LOCs!

steveo77's picture

State University Prohibits distribution of the US Constitution.

Hmmmmm...Obama grew up in Hawaii, vacations in Hawaii, requires state government to prohibit that dirty rag called the US Constitution.

kchrisc's picture

Can't have 'terrorist' propaganda riling up the sheeple can we?! Invoke NDAA and hand 'em over to the military forever. Dirty scoundrels. Land of the free and home of the brave foever!



RockyRacoon's picture

The Free Speech Zones will be areas surrounded by barbed-wire and run by the NSA -- like roach motels.

Quinvarius's picture

The CCF boogey man that doesn't actually exist.  Ignore this garbage.  There is no evidence that there is some huge hidden mystery financing industry that uses these deals beyond normal shipping.  This meme was concocted out of pure fantasy by the dumbest MKers in the room, bankers.  Even if it was a problem, commodity prices are rising, not dropping.  This stuff is pure nonsense.  You need to be worried about the same thing as ever--hyperinflation.  Copper keeps on rising despite this horseshit meme.  And I hate to blow my own horn, but that is exactly what I said was coming.  This whole annoying CCF meme is just the death rattle of commodity shorts betting against hyperinflation.  And they are dumb.  They deserve what is coming for failing at math, economics, and history.

Vint Slugs's picture

Are you a troll or a shill or just a know-nothing blowhard?  In the USA the only commodity prices that are rising are livestock - cattle and hogs are at all-time highs.  The remaining Ags, Nfms, Softs, and Precious Metals are all well below the nominal cyclical highs that they made in either 2008 or 2012 (copper actually topped in 2011).  Those highs, incidentally, averaged out at the top of the 2-standard deviation channel that has contained real commodities prices for the past 220 years.

Quinvarius's picture

There is no evidence these deals exist.  And clearly the meme is changing due to the complete lack of evidence from huge elitist financial deals involving huge offshore warehouses and accounts to now just some shipping deals.  Maybe you have not been following the evolution of this baloney. 

There is absolutely nothing here to outsmart.  It is about trillions of new currency units being created out of thin air and no interest in the keynesian lockbox of sovereign debt.  Mouse over all the charts: 

But, you need to chase a top or sell a bottom.  You don't think that is what is going on in your mind because you look for datapoints to support something you already committed to based on fools trading momo.  There has never been a moment where the math said commodities could be held down.

And how many deviations is this chart BTW:  or this one:

And also, since you are the expert on low low copper prices and timing, this is the copper price chart since the tech implosion and the money printing explosion:

OpenThePodBayDoorHAL's picture

Excellent. There are three reasons these printers have "gotten away with it" so far: 1. Globalization (severe downward wage pressure); 2.  technology (very deflationary both for prices and wages); and 3: beggar thy neighbor (the fact that everybody's debasing at the same time). Inflation/Deflation is a tug-of-war...but tug-of-wars end suddenly with one team in a pile on the ground. I think inflation "wins".

Gold used to be the barometer but it's totally fucked, financialized, they can do whatever they want with the dollar price. Should be $10,000/oz. by now.

What are we left with: Don't laugh: Bitcoin. The only clean, clean shirt. Tons of issues still to work out, security, user experience, etc. You need to get long in the next 3-6 months at prices between $100-$500

Seasmoke's picture

Paper covers rock. Until the scissor cuts paper and rock is still there.

I Write Code's picture

Credit Default Swaps, not Spreads. 

And they never were worth the paper they weren't even written on.

I can't make heads nor tails of this post.  Were the commodities (copper, gold, not perishable) used instead of CDS?  Was their ownership hypothecated instead of an LOC?  What?

the grateful unemployed's picture

at some point the chinese have warehouses full of commodities which are owned by specs probably, who are waiting for the price to go up, (the fed pumps money into the global economy, which encourages this behavior) so they can sell the stuff back to the chinese warehouse managers for a profit. meanwhile the chinese make storage fees. who owns or doesn't own the commodity matters not to them assuming they have moved it off their balance sheet. in the end i think it works best for them, they have the product in their possession, and they aren't leveraged to it. if someone wants to ship it to another processing plant in another country, they have to pay a large transportation fee, and the chinese warehouse managers can figure out just how much premium they can attach to keep the production in house. that acts to keep the price of the commodity down. in the end the hedges are in trouble because the inflationary lift they were seeking never materializes (which is why currently the laws of supply demand are suspended, the price of something drops, the supply drops also, and the reverse) the problem is that increasing the amount of a commodity makes it worth more, only as long as the fed is willing to print an equivalent raise in the money supply in order to prevent the price of the thing from falling and supply disappearing , and a deflationary nightmare ensues. no problem as long as they is more paper and ink than anything else. when the banks stop lending the fed is stopped dead in its tracks, so the fed gives them money and pays them interest to hold it. its all simple and very perverse

Yen Cross's picture

  Is this another article about rehypothecated Chinese copper?

SAT 800's picture

More or less; but it seems to be a very silly attempt to have something to say that sounds exciting.When people start shipping Copper without a LOC; wake me up.  If someone does something terminally foolish someone else may take advantage of it ? It's all rather silly, I believe.

Youri Carma's picture

Trade firstly is build on trust so when somebody decides not honor that trust you always have a 'silly fool' but that's in the eye of the beholder and very shortsighted since the trust buster will be a victim too in the end when the whole system collapses like what is now essentially happening.

Youri Carma's picture

Or gold. "The WGC revealed that China may have more than 1,000 tonnes of gold tied up in financing deals"

FROM: Will China drop gold next? - Chinese gold demand vulnerable to yuan carry-trade reversal


economicminor's picture

This scenario sounds like what the FEDs fear most... DEFLATION. Not enough income to service the existing loans AND the asset value supporting existing loans diminishes rapidly.. Wallla! A total CRASH of the entire economy and bankruptcy of any business that is heavily in debt...which is most of them.


Youri Carma's picture

And I like to add: What the 'market' likes most DEFLATION because that means more QE.

AdvancingTime's picture

Never before has mankind diverted such a large percentage of wealth into intangible products or goods.  I contend this is the primary reason that inflation has not become a major issue. The modern economy is loaded with interwoven contracts reeking of contagion. If faith drops in these intangible "promises" and  money suddenly begins to flow into tangible goods seeking a safe haven inflation could soar even as debts go unpaid and promises are left unfilled. Like many people I worry about the massive debt being accumulated by governments and the rate that central banks have expanded the money supply.

The timetable on which events unfold is often quite uneven and this supports the possibility of an inflation scenario. A key issue being one of timing. If the price of gas jumps to $8 a gallon overnight do you buy gas and not make your car payment or stop driving the twenty miles to work? Answer, it could be months before your car is repossessed so you buy gas. It is important to remember that debts can go unpaid and promises be left unfilled. More on how we have sowed the seeds for inflation to suddenly strike in the article below.

kchrisc's picture

No honor amongst thieves.

Yen Cross's picture

 pari<>passu  Bitchez

rosiescenario's picture

If it is an irrevocable, confirmed letter of credit then the onus is back on your local bank here.


If your bank will not contirm, then you shouldn't accept the foreign LOC in the first place.

Yen Cross's picture

 Speaking of triple fucked sideways asinine poli"tit"ions.  Does anyone watch VIKINGS on history channel?

  Good ideas get polluted by self interests>

AdvancingTime's picture

The more and more I study derivatives it now appears the main goal of QE may have been to hold up the underlying value of assets that feed into and support the massive derivative market more than help the economy. QE has up to now stopped an implosion of derivatives and the resulting contagion and shock that would have spread throughout the financial system.

Paul Wilmott from Oxford University estimates the derivatives market at $1.2 quadrillion, to put that in perspective it is about 20 times the size of the world economy. The point of the article below is to call attention to the insanity of derivatives as an instrument or tool to add stability to our financial system. By stacking risk upon risk and transferring it off to another party who may not be able to preform you do not increase stability.

polo007's picture

According to Tullett Prebon Group Limited:

perfect storm

energy, finance and the end of growth


The economy as we know it is facing a lethal confluence of four critical factors – the fall-out from the biggest debt bubble in history; a disastrous experiment with globalisation; the massaging of data to the point where economic trends are obscured; and, most important of all, the approach of an energy-returns cliff-edge.

Through technology, through culture and through economic and political change, society is more short-term in nature now than at any time in recorded history. Financial market participants can carry out transactions in milliseconds. With 24-hour news coverage, the media focus has shifted inexorably from the analytical to the immediate. The basis of politicians’ calculations has shortened to the point where it can seem that all that matters is the next sound-bite, the next headline and the next snapshot of public opinion. The corporate focus has moved all too often from strategic planning to immediate profitability as represented by the next quarter’s earnings.

This report explains that this acceleration towards ever-greater immediacy has blinded society to a series of fundamental economic trends which, if not anticipated and tackled well in advance, could have devastating effects. The relentless shortening of media, social and political horizons has resulted in the establishment of self-destructive economic patterns which now threaten to undermine economic viability.

We date the acceleration in short-termism to the early 1980s. Since then, there has been a relentless shift to immediate consumption as part of something that has been called a “cult of self-worship”. The pursuit of instant gratification has resulted in the accumulation of debt on an unprecedented scale. The financial crisis, which began in 2008 and has since segued into the deepest and most protracted economic slump for at least eighty years, did not result entirely from a short period of malfeasance by a tiny minority, comforting though this illusion may be. Rather, what began in 2008 was the denouement of a broadly-based process which had lasted for thirty years, and is described here as “the great credit super-cycle”.

The credit super-cycle process is exemplified by the relationship between GDP and aggregate credit market debt in the United States (see fig. 1.1). In 1945, and despite the huge costs involved in winning the Second World War, the aggregate indebtedness of American businesses, individuals and government equated to 159% of GDP. More than three decades later, in 1981, this ratio was little changed, at 168%. In real terms, total debt had increased by 214% since 1945, but the economy had grown by 197%, keeping the debt ratio remarkably static over an extended period which, incidentally, was far from shock-free (since it included two major oil crises).