If the natural resources giant Glencore collapses, it could pull the whole commodities sector with it. The consequences would be similar to those inflicted on the financial system by the collapse of Lehman Brothers. This is more than just scaremongering; financial experts are also making parallels with UBS in 2008.

The worldwide financial community is watching market developments around Glencore like a hawk as the Swiss commodities giant finds itself in an existential crisis carrying far too much debt – 30 billion dollars.

Why a Lehman moment? If the massive commodities group with some 200 billion dollars turnover does collapse, it could release a shock wave into the mining industry and the natural resources markets similar to the one seen in the financial markets after the collapse of Lehman brothers under Richard Fuld (pictured).

Numerous parallels

The parallels are clear. Just like Lehman Brothers used to, Glencore works with a very high proportion of borrowed capital to increase profitability. Also like Lehman Brothers, Glencore carries out many counterparty transactions because of its extensive trading activities.
If Glencore collapses, this could have a domino effect, a fear expressed by Frank Holmes, for example, head of US Global Investors on CNBC. Nigel Wilson, CEO of the Legal & General Group, also made the comparison on Bloomberg TV.

CDS spreads exploding

The fears are echoed in the financial markets. Along with the Glencore share price, the raw materials indices are also tumbling. Shares of mining giants such as Rio Tinto and BHP Billiton are rapidly losing value. Zambia’s currency, the Kwacha, lost close to 50 per cent against the dollar after Glencore temporarily closed copper mines in the country.

In the finance community, the price of Credit Default Swaps (CDS) for Glencore, which has gone through the roof in recent days, is alarming and reminiscent of the Lehman circumstances.

Echoes of Lehman: Everything is under control

This all triggers bad memories. A rule of thumb established during the financial crisis was that CDS spreads higher than 400 basis points spelled danger. In recent days five-year CDS for Glencore have gone above 1,000 points. The risk of bankruptcy within the next five years is in this case 1 to 4, or 1 to 10.

Glencore has been behaving in this crisis like Lehman Brothers did up to the last moment. Everything is under control, Glencore said in a brief statement on Tuesday. The problems are being solved.

Borrowed capital like LTCM

The very high reliance on borrowed capital, i.e. leveraging, is also leading market commentators to look for parallels in the more distant past. They can be found in the collapse of the hedge fund Long Term Capital Management (LTCM).

The Glencore trading departments are leveraged to a similar high degree as LCTM was in the 1990s, according to Private Eye magazine.

Poor financial strength

The hedgefund achived global infamy because the US Federal Reserve had to intervene when it collapsed. UBS was one of the banks that LTCM pulled into the mire. The Swiss bank had to write off around one billion dollars.

Swiss asset management group CEAMS has drawn another parallel, this time to UBS. Glencore’s financial strength was far below average long before the commodities crisis, comparable to UBS before its existential crisis in 2008, CEAMS co-founder Philipp Weckherlin wrote in a client commentary.

Rather than blaming a particular crisis, like the one now being seen in the commodities markets or back then in the financial markets, for the failure of these big names, Weckherlin says it is down to financial weaknesses in the companies, to which he adds the cases of Enron, Parmalat and AIG.

Crisis not surprising

The main cause for disaster is poor financial quality, in other words the extremely high reliance on borrowed capital. This should have been warning sign to investors long before the crisis stuck. The unpopular truth, according to Weckherlin, is that the Glencore’s troubles are really no surprise.