Precious Metals Investing: Expect Fireworks in Silver
3-28-11
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Leasing in precious metals grew out of the desire of central banks and bullion banks to monetize the silver and gold sitting in their vaults (in the 1980s and 1990s metals prices were falling). Since precious metals are money alternatives they do not intrinsically create cash flows or interest payments. But central banks also need to keep the metals in their vaults, meaning outright sales have to be limited.
Silver leasing solves both problems nicely. Because it is nothing more than a collateralized loan, it gets accounted for in the same way as a repurchase agreement (repo).
A central bank that enters into a lease arrangement simply transfers the physical metal out of its vault to a cash owner. The agreement states the future date that the metal will be returned to the central bank. For the privilege of borrowing the cash, the central bank agrees to pay a “rate” (SIFO) to the cash owner. While in possession of the cash, the central bank can invest any way it sees fit. Since central banks are not risky by nature (outwardly anyway) they see LIBOR as a safe, liquid place to park the cash. So the central bank receives LIBOR and if the SIFO rate is lower, the central bank earns a spread on the metal. Contrary to their barbaric nature, silver and gold are now effectively monetized.
Because the lease is accounted for as a repo, the central bank gets to keep the metal on its books. The lessee (cash owner) gets to earn interest on its cash collateralized by precious metal, meaning it has no counterparty risk. Both sides win.
Gold and silver leasing, basically, are fractional reserve banking extended to precious metals. This all works very well as long as the lessor does not need its actual, physical metal back. And it rarely gets it back since gold and silver forwards are rarely unwound, they simply get rolled over in perpetuity.
The reason is that metals, unlike T-bond or mortgage bond repos, get consumed. This is particularly true of silver since it has a lot of industrial applications. If a central bank leases some silver to a counterparty that sells the metal in the spot market to an industrial firm, then the silver is lost and the lessee has to find silver elsewhere at lease expiration.
As this process of leasing expands the ratio of paper claims to actual metal, silver mining production is the only way to keep up with paper demand. In fact, miners are the third big player in leasing.
If spot prices are high enough relative to futures prices (backwardation) miners might be enticed to sell forward production. In other words, they lease existing silver from a central bank to sell it in the spot market. At lease expiration they use the silver they have pulled out of the ground to replace what they borrowed from the central bank, earning the forward rate in the interim.
In this way extreme imbalances in futures prices pull forward future production, introducing enough supply to solve the imbalance -- as long as there is enough existing metal in the right hands.
If a supply shortage were big enough we would expect to see silver lease rates spike. In fact, lease rates did jump -- twice. On January 19, 2011, SIFO rates dropped from around 0.55% (one-month) and 0.62% (12-month) to -0.33% (one-month) and 0.03% (12-month). These negative rates persisted through January 26, with the three-month rate hitting -0.09667%.
SIFO rates continued to be slightly negative until February 16. From then until February 22 forward rates dropped significantly again, with shorter SIFO rates seeing -0.64%.
Remember what negative SIFO means in the context of silver leasing. Since lease rates are spreads, the negative SIFO is added to LIBOR, producing a wider lease rate. In physical terms it means that someone needed physical silver so bad that they were willing to pay out SIFO to the central bank instead of receive it. The central bank gets to earn both LIBOR and the negative SIFO to release some of its silver holdings.
In the wider context of this ongoing futures market turmoil, this may be confirmation that there is a shortage (the widening lease rates put the futures into backwardation since futures prices are really a function of forward rates). But shouldn’t we expect that lease rates would continue to grow as the lack of March COMEX deliveries force dealers into a more desperate position?
This is where metals investors need to be careful. Since February 22 lease rates have been falling.
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