April 26, 1999 – In the last letter I laid out the case that Gold in recent years was being increasingly mobilized. It is being borrowed today in weights never before imaginable, and by implication, it is also being loaned today more frequently than ever before.
The desire by mining companies to sell today a portion of what they plan to produce in the future (or in the case of some Australian companies, to sell all of what they expect to produce) has created a new demand for borrowed Gold. Similarly, by choice many banks and hedge funds are now using Gold and the low interest rate it has to offer to finance a variety of assets denominated in higher interest rate national currencies. Together these uses have created an abnormal demand for this precious metal.
This abnormal demand in turn has found a ready supply. Many central banks that own Gold have seemed intent to try turning this reserve asset on their balance sheets into a revenue asset, apparently regardless of the risk and in disregard of the reason they hold the Gold in the first place. Accordingly, they have been lending Gold in increasing weights to any institution willing to borrow it, namely the banks and the hedge funds.
The result of this abnormal activity in recent years has been an abnormal Gold price. By any measure Gold is cheap, and never before has one ounce of Gold offered so little purchasing power. While today’s $285 per ounce price may seem expensive when compared to the $35 per ounce price that prevailed until the 1960’s, when adjusted for inflation and Dollar debasement Gold today has less purchasing power than ever before. But an abnormal Gold price is not the only result from all of this borrowing and lending of Gold.
Significant risk has been added to the balance sheet of the banks and hedge funds that have borrowed and now owe all of this Gold. Normally, I wouldn’t shed a tear for any hedge fund that goes belly-up because it took a risk that in time turned out to be a bad bet. But things don’t work that way anymore. If they did, Long Term Capital Management would have filed for bankruptcy last September. So I use the terms banks and hedge funds interchangeably, because what’s bad for the hedge funds is also bad for the banks.
I also use these terms interchangeably for another reason. The banks and the hedge funds are on the same side of the equation. They are borrowing what the central banks are lending.
The banks borrow Gold to on-lend to those mining companies that want to sell today the Gold they hope to produce in the future. The banks also borrow Gold they don’t on-lend, to fund with Gold’s low cost of borrowing their high yielding assets denominated in national currencies. Hedge funds borrow Gold for the same reason, even though this practice exposes the banks and hedge funds to the risks stemming from a rising Gold price.
And this reality brings us to the crux of today’s abnormal Gold market. The banks have a problem. A BIG problem.
By my reckoning, banks and hedge funds worldwide have borrowed about 10,000 tonnes of Gold. Some 4000 tonnes have been loaned to mining companies, most of which will probably be repaid because the operating risks of producing this Gold are more or less limited. So let’s ignore this weight of Gold from the equation, but 6000 tonnes still remain. Where is this Gold?
Well, it’s on loan, but there’s a big difference between who is borrowing the Gold and how it will be repaid. In contrast to the mining companies, which are going to repay their loans by digging Gold out of the ground and sending it to the banks from whom Gold was borrowed, how will the 6000 tonnes be repaid?
Long Term Capital, Chase Manhattan and the other banks and hedge funds that have borrowed this Gold from the central banks are not in the mining business. They have only one option to obtain the Gold needed to repay their debts – they have to buy it in the market, but this answer is not really an answer. The reason is that 6000 tonnes of Gold is not available, at least at $285 per ounce.
Each year about 2500 tonnes of Gold is mined. If we assume 900 tonnes would be used by mining companies to repay their loans in a rising Gold price environment, then 1600 tonnes is available to the market, only about one-fourth of what the banks and hedge funds owe. What’s worse for them though is that they have to compete for that Gold with the many thousands, probably millions, of people worldwide who also want to buy that Gold.
The demand for Gold has been at or near record levels for years. Consequently, the banks and hedge funds would have to bid up the price of Gold, with a twofold result. A higher price will both (1) reduce demand and (2) increase supply (by dislodging Gold from someone’s vault at higher prices), but what price would be required before the 6000 tonnes has been purchased?
No one knows the precise answer to that question, but it can be answered in a general way. In the last letter I used my Fear Index, which is at record lows, to show how depressed the Gold price is at the moment. I also indicated that just to get Gold back to 2.60%, a level which historically marked Gold as good value, a price of $608 is required. Therefore, it is not unreasonable to guess that demand will not fall off substantially until a price over $608 is reached, even though the nature of that demand may change on the way up as jewelry demand falls and investment demand rises. In fact, given that markets overshoot the equilibrium point on both the upside and downside, it would probably take a price as far above $608 as $285 is below, or in other words, $931 per ounce, which is a difference of $323. We can now measure the size of the problem.
If the banks and hedge funds started buying back the Gold they need in order to repay what they have borrowed, and they covered their position at $608 on average, the loss from current levels on the 6000 tonnes they have borrowed would be $63 billion. No self-respecting (and politically well connected) bank is going to take that kind of loss, so the banks naturally will do what banks have done ever since the Bank of England was formed in 1694. They get the government to help.
Back in the old days, that help came in the form of suspending the Gold Standard. The Dollars or Pounds one held were for a time no longer redeemable into Gold. In short, the governments helped out the banks by saying that the banks no longer had to meet their promise to redeem for Gold the paper currency they created.
Governments still help the banks, but now their help is different. They do two things.;
First, governments continue lending Gold into the market. The result is that banks are not exposed to any jump in the Gold price, which could be very costly. A $100 rally in the Gold price would mean almost $20 billion of trading losses for the banks. As harmful as this practice is for the freemarket, it gets worse.
The second way governments help is to never ask the banks to repay the Gold they have borrowed. In fact, aside from the fact that the amount of Gold loans just keep getting bigger, if one borrower fails to repay its loan, then all of the banks step in and bail it out, with the government’s tacit approval. And sometimes not so tacit government help. After all, when Long Term Capital Management was bailed out its creditors did not meet in LTCM’s Greenwich office, nor did they meet in any one of the creditor’s offices. They met at the offices of the Federal Reserve Bank in New York City. And here’s where GATA enters the scene. GATA stands for Gold Anti-Trust Action, and as its name implies, GATA intends to sue under anti-trust laws the different banks and the big security houses that it alleges and that I believe are manipulating the Gold price. As GATA puts it, if the world’s big auto-makers had been meeting in the offices of the Federal Reserve last September to bail-out one of their failed brethren in an effort to prevent the freemarket from purging itself of that failed firm’s bad management, then those auto-makers would already be knee deep in anti-trust law suits. Are the big banks and brokerage houses above the law?
Don’t answer that question. We all know the way things have operated so far, but past experience doesn’t mean that this injustice has to continue. Through donations from many, many people and some Gold mining firms, GATA has collected over $50,000 so far. Importantly, they have retained Berger & Montague, one of the nation’s premier law firms, to help GATA launch an investigation into those that it believes have colluded to hold down the Gold price. As plaintiffs’ counsel Berger & Montague has recovered billions of dollars in damages in the Drexel Burnham/Michael Milken junk bond case, the Exxon Valdez case, and many others.
For more information, and/or to make a donation to GATA to help fund its legal costs, contact John D. Meyer, Vice Chairman and Treasurer, GATA, P.O. Box 885, Great Barrington, Massachusetts 01230, or send an email to him at: [email protected] Also, be sure to check GATA’s website at www.gata.org.
I think GATA is on to something, and I am hopeful that they are about to level the playing field. And a level playing field means the Gold price will skyrocket.