That WAS a good laugh.
I am only speculating here as I have no first hand information on the intended meaning trying to be conveyed by McGuire, GATA, etc… regarding the 100:1 "leverage" on the LBMA (London market).
The way I received that information is through the lens of my understanding of Exeter’s pyramid - an inverted pyramid showing the various classes of "assets" with gold at the bottom of the pyramid and each successive level above gold being less secure and "leveraged" upon the "base" - i.e. gold. The thinking being that in a flight to safety - the asset classes at the top of the pyramid are liquidated as people rush to the lower lying levels of asset - and ultimately gold at the bottom.
Taking that thought further, if and when the music stops and there is a rush for chairs (safety) all those paper based positions might sell their paper holdings and try to convert their assets into physical. So - in that perspective, the 100:1 "leverage" would imply that for every 100 ounces of paper gold, there was only 1 physical ounce available at the then current prices and if/when the other 99 decided they want physical - they would all have to try to run through the door at the same time.
I cant say definitely that my explanation is an accurate depiction of the concept they were trying to convey - I can only say that what I have written above is how I interpreted their comments then and now.
When the music really stops - and all hell breaks loose, what I am describing above may very well be exactly what happens - i.e. a mad rush into physical where untold numbers of people are desperating trying to convert literally trillions and trillions of paper dollar (digital) assets into physical gold.
PS - I sent an email to Ranting Andy Hoffman from Miles Franklin inviting him to join in the discussion here. I am particularly interested in his comments related to the numbers that Bron has provided showing the distribution of outcomes of price increases/decreases since the inception of this bull market. I thoroughly enjoy reading his daily rants although I do so with the full understanding that he is employed by a company that makes its revenue through the sale of physical metal - i.e. I have no doubt he is "talking his book". Hopefully he jumps in and joins the discussion.
Strawboss,
the ratio you should be looking at is the (inverse) reserve ratio of the bullion market, i.e. the total ounces of gold credit created (unallocated balances) divided by the physical gold reserve held by the banks.
Perhaps Jeff Chritian is still reading here and can tell us his estimate. Before he corrects me, let me put out my estimate: it is 20:1 and I get a total credit volume (aggregate unallocated balance) of 1500…5000 metric tons (very rough estimate) which implies a physical reserve of the banks of 75…275 tons. I am posting these guesstimates here, hoping that Jeff Christian is going to jump in with better figures.
FOFOA has argued that one problem with the gold market is that it is dominated by ‘paper gold’. Although there are strong hands who accumulate physical gold or even still holders of unallocated balances for political reasons (the oil states in the 1990s), most of the trading may be by speculators who are in it for a quick gain and perhaps even on margin.
If there is another credit crunch and stock market crash, these people may just sell all assets for cash, or even have to because their bank or broker cuts the credit lines. This may cause the gold price to drop just as in 2008 because the longs are selling. Yes! Because the longs are selling!
Then the problem is that
-
the strong hands who exchange their dollars for gold, get more weight per dollar which drains reserves from the market
-
if at the same time nominal interest rates turn negative (because everyone wants out of risky assets and into T-bills, bidding up their price beyond par), gold would be in backwardation. As a consequence, it is no longer profitable to lend your gold for dollars which you can invest, and this might remove further supply from the market.
I don’t know how close the market got to failure in 2008. It was probably a lot less severe than in September 1999.
There are some further remarks in the comments at
http://screwtapefiles.blogspot.ca/2012/05/study-in-gold.html
Victor
[quote=Strawboss]I sent an email to Ranting Andy Hoffman from Miles Franklin inviting him to join in the discussion here.[/quote]Thanks for doing that, Steve. I encourage you and others to invite Turd, GATA, or anyone else to come join this discussion. I’ve made some pretty strong accusations that these people’s primary arguments are nonsense, yet nobody seems willing to come defend their position. I find that rather telling. Ted Butler’s stated excuse is that he doesn’t have time, and Harvey Organ’s excuse is that if Jeff Christian is here, he refuses to participate on that basis. In deference to site policy, I won’t elaborate on my opinion as to what that says about Harvey.
Consider that this thread is approaching 20,000 reads and 200 comments, and has attracted interest from serious professionals like Bron and Jeff. Considering that the gold bugs depend on newsletter subscriptions and donations for their existence and need to market themselves… and that a huge audience is now following this thread, it’s hard to give much credibility to the "I don’t have time" excuse. One would think that GATA, Turd, Ted, Harvey, Andrew, etc. would be chomping at the bit to come put me to shame by explaining why their "set vs. discover the price" or "100:1 leverage" arguments really do make sense, and why I am mistaken in my conclusion that they are apparently so naive as not to comprehend what leverage really is or to be familliar with basic Econ 101 vocabulary (i.e. price discovery). Yet so far, they seem afraid to participate. I agree that Turd’s piece (linked by Jim H) was quite humorous, but if this guy were serious I would expect him to respond not only with comedic sarcasm, but by coming and being the expert he perports himself to be, by showing me up in this thread for why I’m wrong. But so far it would seem that all the most prominent gold bugs are each making up their own respective excuses for not participating. Telling to say the very least.
Victor, please elaborate on why you think that ratio is relevant. Most of the notional exposure in the futures market is heavily leveraged, and the people holding both sides of most of those contracts don’t have anything close to sufficient capital to stand for or make delivery. So the gold bugs’ argument that some day all the longs will recognize the system is broken and demand physical delivery is just plain silly. Also, by calling this the reserve ratio of the bullion market, you seem to be implying that the physical metal that is there somehow collateralizes the paper transactions, which simply isn’t the case. Did you intend to say that the physical bullion in the system serves as a reserve to secure or collateralize paper transactions? If so, please explain.
Thanks,
Erik
Dear Jeff, Bron, Erik, Victor,
Thanks very much guys for this rich thread. Special thanks to you Jeff, as your commentary is hard to come by. The only place where the average guy can receive your great insight is Jim Puplava’s Financial Sense, and I always love to hear what you have to say. I’m fairly new to precious metals, however, my bullsh*t detector is quite well developed, also being skilled in sifting facts from emotional outbursts, and its clear that yourself and Bron, are to be counted amongst the very few in the world, who are rational voices in the precious metals sector. Erik, I’ve thought of more an an oil guy, and Victor, a smart enigmatic fellow.
PS: Jeff, some of the things you’ve said, I have had Bron clarify for me, in questions on his blog. So I guess I’m a fan.
Thanks again guys.
From an average guy.
There’s no need for them to come over here. Yes, you’ve made some accusations but provided very little evidence in support… You also disqualified yourself by admitting that you were not an expert. You’re claiming that this thread “has attracted interest from serious professionals like Bron and Jeff.” Yet Jeff (Christian) has not reappeared since he was challenged by Strawboss (see post # 156 on page 16 of this thread) to present some credible evidence that his business was actually adding some value to his clients (Mining Companies Shareholders) something which certainly doesn’t appear to be reflected in current Miner-valuations. Once again you’re calling certain individuals by name “GATA, Turd, Ted, Harvey, Andrew, etc.” yet when I challenged you to call other individuals who are proponents of the same ideas (David Morgan, Jim Sinclair, Eric Sprott, James Turk, Keith Neumayer and Chris Martenson) the same way, you have ignored my request at least on 2 occasions… So if you have any intellectual honesty, this is what you should do: (a) You should tell everybody here that the above are all a bunch of charlatans (your chosen word) for promoting the same ideas as the other individuals whom you’ve labeled this way. (b) You should write each one of them an email, telling them to come over here immediately to defend your public accusations against them. Once you do that and Jeff reappears with some credible evidence of success stories that he has created in the mining industry there might be a point in continuing this thread… Otherwise, I think it speaks for itself.
[quote=victorthecleaner]Perhaps Jeff Chritian is still reading here and can tell us his estimate. Before he corrects me, let me put out my estimate: it is 20:1 and I get a total credit volume (aggregate unallocated balance) of 1500…5000 metric tons (very rough estimate) which implies a physical reserve of the banks of 75…275 tons. I am posting these guesstimates here, hoping that Jeff Christian is going to jump in with better figures.[/quote]Victor, you are way off. It is more like 1500…5000 tonnes of physical. With 33,000t estimated as investor stocks (http://www.gold.org/investment/why_how_and_where/why_invest/demand_and_supply/) you’d have to think a fair bit of that was held by the bullion banks. I don’t know what they have but 275t of physical is just crazy, I mean if that was the case why have they been opening new vaults all round the world?
As to the fractional ratio, Jeff said in an interview it was circa 8:1 to 12:1 (http://goldchat.blogspot.com.au/2010/04/london-unallocated-fractional-fubar-or.html).
Thanks Jim.
Victor, you are way off. It is more like 1500…5000 tonnes of physical. With 33,000t estimated as investor stocks (http://www.gold.org/investment/why_how_and_where/why_invest/demand_and_supply/) you’d have to think a fair bit of that was held by the bullion banks. I don’t know what they have but 275t of physical is just crazy, I mean if that was the case why have they been opening new vaults all round the world?
As to the fractional ratio, Jeff said in an interview it was circa 8:1 to 12:1 (http://goldchat.blogspot.com.au/2010/04/london-unallocated-fractional-fubar-or.html).[/quote]
Bron, are you saying that the bullion banks hold 1500…5000 tonnes as custodian for their customers? This I find entirely plausible. Or are you saying they own that much and have it on their own balance sheet? That would be $80bn…$265bn in bank assets that is sitting in the vault as physical gold. Doesn’t this sound way too high? Where are you getting the range 1500…5000 tonnes from?
Finally on the question of 10:1 or 20:1, the page you have linked cites Jeff, "meaning that they will loan or sell 5 to 10 times as much metal as they have either purchased or committed to buy.". I wonder whether the ‘committed to buy’ still leaves the possibility that the reserve ratio can be higher than 10:1 if you count only the physical gold actually in the vault at that moment.
The way I am getting the 20:1 is by looking at the COMEX data and by rewriting all the open futures positions synthetically as gold credit or debt (part of a swap), and a spot transaction. This way, I view the COMEX as a fractionally reserved gold bank. If you are long the future on margin, this is equivalent to buying at spot and then lending the gold to the bank and borrowing dollars until you close the futiure or take delievery. Taking delivery is withdrawing cash. Closing the futures contract is a foreign exchange. If you are short the future, it is the opposite. So the total open interest tells you something about the credit volume in this market relative to the reserve held by the market maker which is represented by the registered inventory. This yields an estimate of 19:1 as of earlier this year.
Erik,
So the gold bugs’ argument that some day all the longs will recognize the system is broken and demand physical delivery is just plain silly.
Yes. This is why I said I can imagine the price to crash as the longs sell. But then, with a much lower gold price, you also need to think what happens to the physical reserve of the bullion banks if some players (perhaps a minority of today’s long position) keep accumulating physical gold. So the question of how big the reserve is, is not entirely pointless. You can plot GOFO if you want to see when the banks were running out of reserve and had to borrow gold in the market in order to satisfy the allocation requests.
Victor
Bron,
I don’t know what they have but 275t of physical is just crazy, I mean if that was the case why have they been opening new vaults all round the world?
How about for the gold that they are custodian of rather than the gold that they own themselves?
Victor
if the currecncy issued is un-backed and unredeemable.
Hi. Erik you wrote:: "Telling to say the very least… [that no-one from tfmetals was here]".I’m happy to spend some time here, having just discovered the conversation through a link there, though I represent no-one but myself.
I think you are right to ask for elaboration from Victor, I found his arguments on Turd’s site to be quite hard to follow. You could follow links here if you wanted to see my thoughts. But I think you might miss a subtle point when you write: "So the gold bugs’ argument that some day all the longs will recognize the system is broken and demand physical delivery is just plain silly." I don’t know who exactly proposed this argument, but I do think it is worth pointing out that it does not require "all the longs" to stand for delivery in a leveraged market to cause disruption.
Is it not the case that in an N:1 leveraged market, whether through derivatives or fractional reserve, that any concerted action by greater than 1/Nth the market is sufficient to cause disruption? A 10:1 fractional reserve bank can’t suffer more than 10% of its deposits being withdrawn else it must begin to call loans. The LBMA or COMEX (if they actually enforced delivery, that is) are in a similar situation, though likely leveraged more highly than 10:1, should that small fraction of longs choose in concert to stand. I believe the COMEX has fiat-settlement provisions, not sure about details at LBMA, I’d be happy to get informed here, but if so, it makes the point somewhat moot, though market disruption is certainly possible.
I’ll go catch up on the argument here. Thanks for something interesting to read.
bbacq
Erik, thank you for updating the link. It is a reasoned analysis and makes worthwhile points. I think we can now accept the Maguire emails are authentic (in that they were presented to the CFTC) and we all await the CFTC report.
With respect to leverage in the OTC/LBMA my interest is unallocated accounts and I thank Victor for addressing this.
According to the London Precious Metals Clearing Ltd website " Unallocated accounts are the most convenient and commonly used method of holding gold and silver"…
The ratio I am seeking to establish is the ratio of latent claims on unallocated accounts. Given the LPMC Ltd statement above, and London’s reputation for re-hypothecation, I feel the answer would be similar to Tim Geithner’s response when pressed to put a number on how high the US debt ceiling would have to be raised if he could only raise it one more time…"It would be a lot, it would make you uncomfortable", he answered after much prevarication.
First I’d like to make a public apology here for words used elsewhere, as here and at screwtape I see a bunch of facts and sense from Victor. I’d still like to get to the bottom of USD vs Euro vs gold valuation-under-stress discussions, Victor.
Has anyone taken the time to focus this thread with a summary of what the board-borg has determined are the points at issue?
On the name-calling and my-resume/credibility/hero-is-bigger-than-yours I have no opinion. But I read above:
"So the gold bugs’ argument that some day all the longs will recognize the system is broken and demand physical delivery is just plain silly.
Yes. This is why I said I can imagine the price to crash as the longs sell."
I first ask if the conversants agree on the scenario that precipitates the longs’ decision, and therefore also what happens next. I think it matters. A credit lock-up, some straw on a hyperinflationary camel, a cascade of derivative-default-induced bankrupticies, some international currency or bond-market event, war…?
But I also ask Victor, especially since we both used the frac-banking analogy, do you not agree that "all the longs" is not the correct measure, as the bank’s solvency limit is hit at 1/Nth customer asset withdrawl for a leverage ratio of N?
S Roche,
I think it is much easier to agree on the estimate for the technical numbers such as the ratio of unallocated balances divided by physical gold owned by the banks, rather than on the interpretation of what this means for the future.
Many of the usual goldbug sources from Turk, Butler to Embry, Sprott claim there will be a big short squeeze that will drive the price up because one day the longs would overwhelm the shorts. I urge you to be very careful with such a statement.
The vast majority of the longs seem to operate on margin and not to be interested in allocation. Under normal conditions, most of them don’t have the cash in order to stand for delivery on their futures contract (COMEX), they are a hedge fund trading unallocated on margin (OTC), or they are in a product (some commercial bank issued gold savings scheme for retail customers) in which they cannot request allocation at all. The experience of 2008 and of several occasions since then shows that many of these longs are either forced to sell when liquidity gets scarce and banks and brokers cut credit lines, or they dump their paper gold because they prefer cash in such a situation, or they operate with a stop/loss and get out as soon as the price drops.
This explains why the paper gold price often drops when there is a crisis or some panic. I know this is counterintuitive unless you think about who the typical longs are, but it may explain a good part of the price action without invoking the manipulation meme.
In turn this tells you what’s the real danger for the bullion market. It is not a short squeeze because the longs overwhelm the market. No, the majority of the longs don’t have the cash for this. The danger is rather that the paper price collapses in a crisis and then, at the lower price, the banks lose too much physical to the minority of strong hands. But without the price rising.
So I am generally open to the idea that the present bullion market will collapse one day, simply because of the change in the role of the dollar. But I don’t think you are guaranteed a short squeeze with a steep price rise. What’s more likely is that the paper price collapses, and the market runs out of reserves when the price is low, i.e. that the market dies when it is down.
The real disappointment will be that several of the ETF may wind down and pay out cash just in this moment, i.e. when the paper price has crashed and you don’t get much cash for your ‘gold investment’, but only some weeks before trading resumes physical-only at a price that will even blow Jim Sinclair out of his socks.
Sincerely,
Victor
Yes, bbacq, that’s right, in order to make the market run out of reserves, only 5% (my estimate) or 10% (Bron’s estimate) of the longs need to request allocation. But even then, the market would run out of reserves without a price increase. And on top of this, I think, experience tells you that so many of the longs will sell in this situation that the price actually collapses.
In spite of the risk of confusing people now, let me repeat that I can imagine that the U.S. might buy paper gold in such a crash situation, just in order to protect the market and make the physical reserves last longer (the higher the price the less weight the strong hands can take out).
Victor
Victor, S Roche, bbaq
At first I thought you were suggesting/implying something very different about this "reserve" concept, but I think I see your point now. This deserves clarification, however, so I’m going to take a moment to elaborate in detail to make sure we are on the same page.
The idea some people have (and I now realize Victor was not one of them) is that the physical bullion in COMEX and LBMA vaults somehow collateralizes all the cash-settled paper contracts. This was GATA and Andrew Maguire’s very vocal misinterpretation of Jeff Christian’s 100:1 testimony. In reality, the cash-settled futures and forwards are collateralized by the "margin" (performance bond) required by the COMEX, or by whatever terms are set forth in an OTC contract. In the case of a "run on the bullion bank", the price goes up and the shorts are required to either post more collateral or close their positions (i.e. a short squeeze). If everyone suddenly wants physical, the system will automatically resolve the conflict by increasing the price until fewer people are willing to pay it or some new sellers are willing to take it. So in this matter of what happens if a whole bunch of paper longs stand for delivery and there isn’t enough metal to go around, the simple answer is the price goes up until there is enough metal to go around.
I was initially resisting Victor’s use of the term reserves because the bullion owned by the banks really has nothing to do with serving as a reserve against which the paper futures and forwards get settled.
What I now realize is that Victor wasn’t talking about the paper longs - he was talking specifically about banks that offer unallocated bullion accounts on a fractional reserve basis. Yes, you are absolutely correct that these banks have some total amount of gold credit exposure (liabilities payable in gold), and some smaller amount of bullion they actually own as fractional reserve against those liabilities. As I go back and re-read Victor’s post I realize he was actually quite clear about what he meant. I read it wrong because I am so used to (and sick of) the popular but fallacious argument that the gold in the banks’ vaults collateralizes the forwards and futures. My bad for jumping to the wrong conclusion.
I agree that this is a very interesting question, but I fear that answering it in a meaningful way is quite difficult, because we have no way of knowing all the aspects of what is probably a very complex hedging equation. I’ll throw out a few examples to illustrate what I mean.
Let’s say for sake of argument that the reserve bullion to gold-denominated liability ratio is very low. But the banks have several ways to hedge that risk, and almost certainly employ them. Problem is that some of them break down in an all-out derivative system collapse.
For example, if total gold liability exposure is X tons of gold, the bank might hold 1/20th or 1/50th of X in physical bullion, but might also be long a sufficient number of futures and forwards to hedge price risk. So if the price spikes out of control, on paper the bank is covered because they already locked in their price for enough bullion to cover all their obligations if they ever had to. If we apply accepted accounting practices, this scenario makes the bank look squaky-clean: They are fully hedged and have no price risk whatsoever. Unless, that is, the system melts down and the counterparty to their hedge trasaction doesn’t deliver, in which case you get the domino-effect that was feared if AIG had defaulted in 2008.
The situation gets even more complex if the bank is netting its exposure to include receivables denominated in gold as contingent reserve assets, or using calls to hedge risk of extreme price flutctuation. The big problem I see there is that bankers tend to think in terms of what allows them to manage perceived risk according to the accounting rules imposed on them, not true risk if the system melted down. I doubt they have any credible plan whatsoever for what they would do if the derivative system melted down. But that’s also why I always emphasize to people that when you have an unallocated account, you don’t own any gold. You are owed gold by a bank that might or might not be good for it if you ever needed it, and almost certainly won’t be good for it if you ever really needed it.
Prior to MF Global, I might have said "At least allocated account holders can rest easy knowing they have legal title to their bullion, and that it can never be expropriated to cover a bank’s fractional lending dilemma, no matter what". But we now know that the rule of law can and will be abrogated when the people who would otherwise be on the losing side of the transaction have the right political connections. The only mitigation I know for that problem is jurisdiction diversification.
It appears that Jeff is no longer following this discussion. I’ll ping him and see if he’s interested in commenting on this topic. My sense is that he’s happy to offer help on substantive questions like this, but just doesn’t have time to waste on the people here who are demanding that he justify his company’s value in the industry, etc. I’ll see if he can be persauded back to comment on the general issue of unallocated bullion bank account fractional reserve ratios, and also if he has any insight on how bullion banks hedge mass redemption risk in unallocated accounts, if they do at all.
Sorry for the confusion, Victor - at first I thought you were saying something else.
Erik
p.s. bbaq, thanks for joining us and welcome to the conversation!
Victor,
I just want to clarify what I think you meant - I see this as important because your comments could be misinterpreted as supporting some very popular misconceptions in the market. I have edited your post for clarity - please confirm you meant the following:
[quote=victorthecleaner, editied for clarity by ErikT]
Yes, bbacq, that’s right, in order to make the fractionally reserved unallocated bullion bank account system run out of reserves, only 5% (my estimate) or 10% (Bron’s estimate) of the longs who hold unallocated bullion bank accounts (but futures and forwards don’t count here) need to request allocation. But even then, the market would run out of reserves without a price increase. And on top of this, I think, experience tells you that so many of the longs will sell in this situation that the price actually collapses.[/quote]
Victor, was that your intended meaning, or am I reading more into your statement than you intended?
Thanks,
Erik
You said:
The big problem I see there is that bankers tend to think in terms of what allows them to manage perceived risk according to the accounting rules imposed on them, not true risk if the system melted down. I doubt they have any credible plan whatsoever for what they would do if the derivative system melted down.The credible plan is called freegold and is what ANOTHER started writing about 15 years ago.
All,
Sorry for the radio silence, but I was busy in the real, analog precious metals world.
Erik T. pinged me about the reserve issue.
The answer is that it depend on who you are and where you are. I actually touched on this in my 2010 CFTC testimony, but the gold conspiracy folk did not pick up on it. If I remember correctly, it was in a response to a question from Gensller.
Start with the US. If you are a bank in the US the OCC says you have to have a certain percentage of your cash deposits in reserves. I think it’s 12% or so. If you are a bank in the US and you have metals deposits, unallocated, the OCC regulation says that you have to maintain a prudent level of metals on deposit, and that you the bank gets to decide what prudent means. Most banks that take unallocated deposits seem to use reserve levels of 8% - 10%, I think.
Here is where it gets interesting: If you are not a bank, OCC rules do not apply to you. So, if you are a broker (like Bear Stearns or Lehman), or an insurance company (like AIG), or another non-bank financial institution that offers to hold gold and silver on an unallocated basis, you are not legally required by the OCC to even manage your metal reserves in a prudent fashion.
Let me stop here for a second to point out something about the mortgage debacle, and the savings and loan debacle in the late 1980s and early 1990s before it: One of the reasons the system got so screwed up and broke was that non-banking financial institutions were allowed to do things that regulated banks were not permitted. Back in the day, banks behaved more ethically and prudently in handing out home mortgages. One the home mortgage market was deregulated to allow mortgage intermediary companies to compete with banks, the system started to go haywire. The same thing happened with leveraged lending in the late 1980s when savings and loans regulations were changed in a way that allowed these institutions to behave in less prudent fashion in terms of lending out their assets.
Back to metals. Outside of the US, different rules apply to banks. And, many non-banking financial institutions skirt or are not covered by the rules by which banks live.
I hope that helps.
Jeff