Ref. Alarmist Theory #1: Metal Loans by CBs
Any comments on how significant (or insignificant) metal loans by major CBs might be? Any ideas on what percentage of metals "on the books" have been loaned and what percentage of the metal loaned is still actually in their vaults?
All comments welcome!
DUMB AND DUMBER
The movie was childish, zany, gross and moronically hilarious. OK, I
admit it - I loved it. There were just too many funny skits to recall all,
but the dead bird repaired with scotch tape, the snowball fight and the
scene where the bad guy finally gets the return of the suitcase with the
million dollars stand out. As the suitcase is opened, only to reveal scores
of pieces of scrap paper upon which are written amounts and notations
as IOU's for the money that was stupidly squandered by the two idiot
protagonists, one, Jim Carey, seriously explains that they're good for the
money and the chits should be handled with care - especially the one for
the car that they spent $250,000 on. The humor was in the absurdity
between the sincerity of the promise of repayment with the likelihood of
its fulfillment. Even if you haven't seen the movie, if you try to picture
the scene of the pile of worthless paper being passed off as dollar
equivalents, you will have an insight few possess in analyzing the most
bizarre financial instrument ever devised in the precious metal world -
the metal lease/forward loan. While the comparison between a slapstick
comedy and financial instruments with outstanding values measured in
the tens of billions of dollars might seem far fetched, I ask you to
reserve judgment and decide for yourself.
If you have trouble picturing important financiers, central bankers,
executives of major mining companies (along with most of their
investors), analysts and commentators of the precious metals world,
along with market regulators being compared to the nitwits in the movie,
I can understand.
Perhaps they are all not stupid, but it is my contention that the
very principle of the precious metal loan/forward sale is
dumber than dumb. For 15 years, we have witnessed two of
the world's most important markets, gold and silver, distorted
beyond reason by an idiotic premise enthusiastically embraced
by people who should know better.
What are metal loans/forward sales? While there can be variations,
simply put, they are devices intended to allow the owners of gold and
silver (mainly central banks and other government entities) the ability to
earn interest on their metal and the borrowers (mainly mining
companies, but increasingly, large speculators) the access to cheaper
money and/or better deferred prices than available from conventional
sources. On the surface, they look and work just fine. The central banks
are receiving interest (1-2% annually) on assets that never in history
before 1980 yielded any return. The mining companies have been given
such favorable terms that some have responded by selling forward years
of future production. Now even large hedge funds have responded to
these magical lease creations by borrowing and selling short thousands of
tons of gold and silver. Giant financial institutions and bullion banks
provide capital, expertise and guarantees to facilitate incredibly complex
deals. There can be no doubt that this is big business. Dumb, but big.
How did these loans/forward sales come about? About fifteen years ago,
some enterprising Wall Street commodity guys at a very prestigious
investment banking firm came upon the idea that would appear to satisfy
the desires of a good number of potential clients with what promised to
be very lucrative personal returns in the form of new fees. The idea
proved popular beyond belief because it seemed to give the two chief
principals to the transaction, central banks and mining companies, offers
they couldn't refuse. To central banks and other government entities
with large unproductive stockpiles of precious metal, the transactions
offered an interest rate and unexpected cash flow for the "lending" of
their metal. And best of all, since they were "loaning" metal, not selling
it, the central bankers didn't have to report the transactions - they could
just receive the income while carrying the metal on their books as if it
were still in their possession (since there was no question they could get
their metal back at any time). The mining companies, in turn, could
report to their shareholders high deferred prices, increased cash flow and
protection from falling prices. The investment bankers, of course, did
the best of all. This is dumb?
No, this isn't just dumb - this is the dumbest (or most crooked)
type of financial transaction ever conceived and embraced in
history (although portfolio insurance and dynamic hedging are
close). Metal loans/forward sales even overshadow Ponzi's
scheme and lasting legacy, since the participants, scope and
duration of the metal leasing scam outpace, by far, the original
stamp con or any variation since. Let me explain why.
Metal loans/forward sales are dumb because metal can't pay interest.
Gold and silver are inert materials that you can't convert to pure income
producing assets. Yes, I'm aware that you can sell options for what is
called income or arrange for a deferred sale with a built in enhanced
price that might be based on current income assumptions, but in the end,
these are just contingency sales. Metals can't pay interest because they
are not an IOU or a liability, they are elemental substances. They have
no utility value other than consumption or sale. Metals can't be "rented"
like a car or house. It does a borrower no good to simply posses metal
that is owned by another party. That's one reason why metal loans are
dumb - the borrowers don't want the metal, they want the cash that they
get when they sell the borrowed metal. And make no mistake, every
single metal loan/forward sale, with no exception, begins with the actual
sale of the borrowed metal. This indispensable first step of a central
bank's borrowed metal being sold is dumb because the owner doesn't
receive the proceeds, the borrower does. Think about that - the metal
physically leaves the central banks' vaults, is sold on the open market,
and the proceeds of the sale is not held by the central bank. This is not a
joke, trick, nor a stupid movie plot, this is what happens in every single
metal loan/forward sale. Of course, the central banks receive something
in return - an annual interest payment of 1 or 2 per cent and a paper
promise of the return of their metal. But, if you use a little common
sense, and think this through, you'll see that Jim Carey's promise of
repayment in the movie is better than the promises of metal repayment
given to the central banks.
Yes, that's what I said - the bad guy in the movie has better statistical
odds of being repaid the squandered million dollars than the central
banks do of being repaid their gold and silver loaned out. Why? Because
the nutty characters in the movie could conceivably hit the lottery or
inherit a windfall, but the central banks don't even have that hope, there
is no possible way they can get their metal to be collectively returned.
That's because of the inherent dumbness of metal loans. You see, the
only way even a cockeyed idea like metal loans/forward sales could
have persisted for as long as it has, is because there is, and has been, a
pronounced deficit in the real supply/demand of gold and silver. If there
were not an ongoing shortfall between production and consumption in
gold and silver, metal loans/forward sales could not possibly exist. Please
think about this carefully, as it is the key to deciding the legitimacy of
these transactions. What I am saying is that the real physical release of
metal, in enormous quantities, onto the markets that metal loans
undoubtedly involve, could not possibly be absorbed in an orderly
manner unless the markets were desperately short of supply. It is the
persistent uneconomic dumping of precious metal via loans/forward
sales that has created the gold and silver deficits, satisfied the deficits,
and controlled/depressed the price for all these years. The metal flooding
the market from these loans has depressed prices, in turn discouraging
production and increasing demand, thereby escalating the deficits and
increasing the dependence of the markets for more gold and silver from
the central bank loans. It's a vicious circle. Do you think it's just a
coincidence that metal loans/forward sales have existed for precisely the
same time as the 15 year bear market in gold and silver, while the real
deficits in those markets have been exploding? How else would a
reasonable person explain, for instance, how silver could remain
comatose in price while stockpiles are evaporating and the real deficit
reaches the insane level where total consumption exceeds total
production by almost 40%?
Which leads us back to our dumb central bankers and the metal they're
never going to recover. For if these metal loans have created this
distorted current situation in gold and silver of severe shortfalls and
depressed prices, as I've tried to convince you, what's going to happen
when this stupid business ends? And make no mistake, it will end. Then
the market will be faced with accommodating a real shortage the only
legitimate way known - by price rationing. Unfortunately, there can be
no way possible that years of distortion of the laws of supply and
demand can not end violently. Can you picture a scenario where the
market struggles mightily by adjusting the price to discourage
consumption and increase production once the central banks cease their
manipulation, that could allow the repayment of the loaned metal? It
doesn't matter what their loan covenants dictate, the metal that has been
loaned for 15 years by the central banks is gone, consumed or dispersed.
And as far as future production from the mines who have pledged same
for repayment, forget it. You see, when the central banks awake from
their stupor and stop giving away their metal for free, the supply side of
the ongoing metal fundamentals will develop an immediate vacuum. If
you think on top of that (remember we're talking about the instant
removal of 30-40% of total supply), the market would permit the
remaining lion's share of supply (mine production) to bypass 6 billion
consumers and simply be returned to the central banks, it's time see the
movie again. There is no way the central banks (aside from the first few
who panic and call in their loans) can get their metal back. Maybe some
type of paper settlement, but definitely not metal.
I am not going to elaborate on the stupidity of those in the mining
community and regulatory circles, except to say that if the mining world
had not partnered with the central banks in this hare brained scheme
(apologies to all rabbits), and sold years of production forward, prices
would be nowhere near current complained about levels. And on a true
price spike, legitimate hedges could then be transacted. As it stands now,
when the markets explode, because so much future production is already
sold, there will be weeping and gnashing of teeth in the mining world,
where there should be joy. To the regulators, congratulations on blowing
another one.
I would have thought the inherent fallacy of the "leasing" of a precious
metal (or any basic commodity) would have been exposed to all with the
failure of the platinum and palladium lease market nearly two months
ago. While all the talk of default and the Dresdner Bank's pleas for US
taxpayer bailouts have disappeared from print, we still see quotes of 20
to 80% for loans where 2% was the norm (remember, metal loans are
supposed to be lower than all other rates because there is no inflation
risk - metal is replaced with metal). If the rates on bank or government
loans or debt increased 10 to 40 times the prevailing rates in a matter of
weeks, would that not alert all that something was seriously wrong? That
the central banks choose to ignore such a clear signal that things are
amiss in the world of metal lending is amazing. I guess they won't get it
until they have loaned out the last ounce of gold and silver. I might as
well end on a mixed movie metaphor
- stupid is, as stupid does.
Ted Butler
(August 16, 1997) |
