17 January 2011

An Interpretation of the China Silver Short Theory and Fractional Reserve Bullion

I have had quite a few readers ask for clarifications on this story, Is JPM Covering Up a Naked Silver Short Held by China as a Claim Against the Yanks? The story offers one possible explanation for the overly large and quite possibly undeliverable short position at the Comex.

This is my interpretation of the China silver short theory as expressed by others, but especially the respected analyst Harvey Organ. As you may recall, Harvey was the trader who helped to identify the notable lack of actual bullion in the vaults of Scotia Mocatta, causing a minor scandal.   There have also been other claims of a significant leverage or 'fractional reserve selling' in the physical bullion markets, with a circumstantial evidence of a potential 100 to 1 leverage involving unallocated bars and claims of cross ownership of bullion held by some of the large ETFs.

Several other well known analysts and academics have pointed to China as the source of the oversized silver short position, including Ted Butler and Professor Antal Fekete. However to my knowledge they have not fleshed it out in the same way that Harvey has done. If they have done so and I have not seen it I apologize in advance.

I have not been researching this aspect of the story before now. I have merely been watching the US markets train wreck unfolding without necessarily understanding the root causes. I still prefer to think of this as a rogue trading operation involving JPM, HSBC, and quite possibly a Chinese sovereign producer or wealth investment entity. There is some precedent for this.
Imagine you are China.

At some point, probably shortly after the year 2000, a large US bank comes to you via the US Treasury discreetly and asks to borrow 300 million ounces of silver. The deal is that the Treasury/Fed will provide you with US Treasury bills as collateral. The US sweetens the deal by granting the unrelated negotiating point of most favored nation trading status, and explicitly but verbally guarantees the deal with its full faith and credit. The Bank, with explicit US backing, promises to return your silver on demand after four years.

Some six years later you come back and ask the Bank for your $300 million ounces of silver. They say that the silver is gone, having been sold into the physical bullion market.

So you ask, well, what did you do with it?

And the Treasury answers, we lent it to the bullion banks and JPM, who sold it in the markets as a part of our plan to keep the prices of gold and silver from rising, in order to sound a warning about our monetization of the reserve currency using Treasuries.

So you approach the US Treasury and complain, asking them to honor the agreement. The Administration says, "we are sorry, but we no longer have the silver and we do not have any in our reserves. So you can keep our paper IOUs we offered as collateral instead."

You are very angry as you do not wish to own more paper, but instead the bullion which is a legacy asset.  You, as China, consider the situation, and start selling silver short on the Comex, using HSBC and JPM as your agents. They sell the entire 300 million ounces of silver short. On the side and through other sources, you are using other agents to buy this same silver in the form of physical bullion for your own reserves. You consider this an equitable return of your bullion at a relatively neutral price compared to that at which you lent it.

When JPM and HSBC need the silver to cover the pledges on the short sale as more people demand delivery and existing supplies become tighter, you as China offer the pledge of the US for your 300 million ounces of silver as collateral and says "collect it from your colleagues at the US government."

Technically the short sale is 'hedged' because the US offers little counter-party risk, and it is their IOU that is the basis of the short sale. The problem is that the collateral is in dispute between two sovereign nations.

But in point of fact the US does not have and cannot obtain this quantity of silver without severely disrupting the silver market, or demanding the output of its own silver mines which is unconstitutional. They do have the power to force a 'cash settlement' for the short positions, but this would be viewed as precipitating a major default on the Comex and with the Fed's "house bank" JPM. Not exactly a trust builder in already shaky markets tainted by scandals of fraudulently valued paper.

And so the market remains at an impasse with a tremendous undeliverable short in silver with the US and JPM in a very embarrassing position of being entrapped in what China considers their own scheme by one of the few entities capable of standing up to them - their major creditor China.

As I say in my piece, I find this to be a bit convoluted. It is possible I do not understand it correctly and if this is the case I apologize. It does sound like the plot of a novel, and I keep waiting for the sharks with frickin' laser beam helmets to appear. But all kidding aside, it is plausible.

However, it is easier to just explain it as a silver shorting scheme that got out of seriously out of hand with JPM and HSBC holding a short position that will ultimately be blamed on a rogue trader, but likely involves a price manipulation scheme involving the ESF, the Treasury, and perhaps the Fed.

This includes the scenario in which JPM and HSBC had borrowed or leased silver bullion from China or others and sold it in the market. But in this case it is NOT China that is holding the short sale, but it is owed some bullion that is not involved in the short sale. I do believe this scenario is possibly prevalent in the gold market wherein central banks had been broadly leasing their gold reserves to the bullion banks, and it is no longer available and is accounted for in a rather dodgy manner on their books. Hence all the stone-walling regarding independent audits.

For those who doubt that bullion banks tend to borrow bullion from governments for a fee and then sell it in the market, here is some knowledge about such arrangements involving J.Aron/Goldman Sachs. See especially the paper hedge arrangement on page 258.

This is how leverage builds up, and how the same bullion can be sold many times. It is particularly easy if you can start obtaining custodial ownership of large amounts of unallocated bullion which you can also sell and move around to satisfy short term demands. As long as the music keeps playing one can make it all work and very profitably so. But when the music stops, it all comes crashing down and rather quickly. Just ask Bernie Madoff's investors.

And so there it is. To my mind it always comes down to a lack of transparency in markets inviting corruption and the inevitable cover-ups for the sake of 'market confidence' that ultimately end up distorting and sometimes destroying the very institutions that they purport to protect.

Postscript: Here is the greatly oversimplified explanation of the China silver short theory which I used on a friend who called in between weekend poker tournaments to ask the same question.

I am China. My friend is JPM/Treasury. Let's call him Jamie.

His wife Joan is the American public.

Jamie calls and borrows $1000 dollars from me. He promises to pay it back in four years and gives me an IOU.

Four years later I call Jamie back and ask for the return of my loan. Jamies says sorry he doesn't have it. Too bad. So sad.

I then in turn borrow $1000 from his wife Joan. When she asks for return of her money I hand her Jamie's $1000 IOU and tell her to get her money back from her husband Jamie.

I now have my money back, and perhaps a little personal satisfaction to boot, depending on how Jamie had spent my $1000 in the first place, and what if anything he had told his wife about it.