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Counter Party Risk

by Trace Mayer on June 25, 2008 · 21 comments

Reading time: 2 – 3 minutes

Wealth can take two forms as either a tangible or financial asset.  By extension currency can be either money or a money-substitute.  The value of financial assets is ultimately tied to some-one’s promise and their financial capacity to fulfill that promise.  Thus financial assets, such as checking, saving and sweep accounts, stocks, bonds and federal reserve notes (US$) are subject to counter-party risk.  Cash (currency) can be either a money which must be a tangible asset (gold) or a money substitute which is a financial asset (US$, Euro, Peso, etc.).

Counter-Party (Credit) risk is the risk of loss due to a debtor’s non-payment of a loan or other line of credit (either the principal or interest (coupon) or both).  For example, when a dollar is deposited into a bank account the depositor becomes an unsecured creditor of the bank and the value of that dollar is equal to one dollar minus the counter-party (credit) risk of the bank.  The price of the dollar may still be a dollar.

By contrast tangible assets have intrinsic value and can never be worthless.  If you own a tangible asset such as gold there are two ways to hold it.  Either store it yourself or work with a custodian to store it for you.  But do custodians of tangible assets held in allocated storage have counter-party risk?  The answer is no if the contract is constructed properly.  However, their customers do have performance risk. The customers accept the custodian’s promise to complete expected tasks.

So in summary, there is a big difference between counter-party risk and performance risk.  In today’s uncertain financial environment avoiding counter-party risk wherever possible is prudent.  For example, the Federal Deposit Insurance Corporation that insures most accounts held with US banks has recently increased their staff in the Division of Resolution and Receivership, the bank failure division, by 60% from 220 to 360 people.

Bear Stearns was subject to over $13.5 TRILLION of derivative liability which was added to JP Morgan’s $93 TRILLION.  Combined derivatives exceed $500 TRILLION of risk.  We can expect more Bear Stearns ‘events’ with other national or local banks such as Citigroup, Citibank, Washington Mutual, Wachovia, Lehman Brothers and only time will tell whether or not they will end in ‘soft landings’.     Why take any exposure to unnecessary risk?

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ABOUT THE AUTHOR: Trace Mayer, J.D., author of The Great Credit Contraction holds a degree in Accounting, a law degree and studies the Austrian school of economics. He works as an entrepreneur, investor, journalist and monetary scientist. Follow him on Twitter. This is merely one article of 242 by .
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