04 October 2013

Currency Wars and the Ghost of Bear Stearns - The Mass Exodus of Gold Bullion

Here is one take on the gold inventory conundrum that I posted about last night.  I am not entirely comfortable with the full extent of this analogy.  Perhaps it is because I had always imagined that coat check rooms were for the most part honestly run with no leverage, lol.
“Quoted gold prices are like a coat check room at a nice hotel. Imagine that over time things develop so that there are 60-100 coat check tickets for every coat in the coat room.

If the insiders that ran the coat room suddenly realized that the value of coats was much greater than the quoted price, what should happen?   The supply of physical coats should fall & the “price” of coat check tickets should fall as well as insiders realize that with 60-100x leverage, 59-99% of the coat check tickets are actually worthless because there aren’t coats to back them.

Think about the bank run on George Bailey’s bank in ‘It’s a Wonderful Life.’ How many people get 100% of their deposit claim checks? Only one, right? Everyone else that wants immediate access to their claim check takes a BIG haircut to the ‘face value’ of that claim. What you are watching in gold markets is a slow-motion version of a classic bank run on a highly-levered depository.”
That makes some sense.  There is an informal market in coat checks where the market sets the price.  But those with asymmetric information on the true risks and valuations move the price where they wish it to be for their own advantage.

If you know that there is going to be a dislocation of inventory in the cloakroom, the first thing the average person would do is get their own coats out. And the less scrupulous might buy up all the tickets they could to redeem for other people's coats, and then sell what unfilled tickets that remain at whatever price they might get.  Those doing God's work might even short sell tickets, if such thing was possible, and take side bets against them.

My correspondent goes on to say that a strong message was contained in the valuation that was given to the Cypriot gold during their recent crisis.
"In the summer of 2007, the BSC subprime mortgage hedge fund basically went to $0, and the message to the markets should have been that 'big chunks of the subprime market are worthless.' But that message at the time was so extreme that very few traded off it.

Similarly, the Cyprus bail-in math (10 tons of Cypriot gold for $10B from ESM, IMF) would suggest that physical gold collateral is worth $31,250/oz in a crisis and that most, but not all, market participants are discounting it because it is such an extreme number.'

It probably is extreme, but some big smart people are buying gold like it is not so extreme, in much the same way that some of those same big smart people turned big sellers of subprime protection right after the BSC mortgage hedge fund blow up.”
That is possible, although one could dismiss the actual valuation as a token gesture to a weakened country. But the international organizations' desire for gold, and the extreme valuation placed to entice it, does suggest that the true valuation of a large quantity of gold in a financial crisis is significantly higher than where it is now.

As you know I tend to mark the realization that there was a serious problem with the request from the Bundesbank for the repatriation of German gold that was refused and deferred for seven years by the Fed. It still amazes me that so few are trading on that event. It was like the earth shifted when I heard about it. How Germany Disrupted the World Gold Market

My correspondent goes on to say:
"I think if something 'breaks' in gold markets, the COMEX futures, and perhaps other futures exchanges, would be settled out at the prior last trade, in cash."
I think quite a few people believe in that outcome.   We would expect a variation in premiums and valuations depending on how great the counterparty risk, and the ease which one might have to obtain any bullion for which they have a claim.  As you have seen from posting here in the chart below, the claims per ounce on some venues are quite high.

And as for what will come of the actual assets, the gold bars, that do exist after the claims may be force settled there might be some precedent for it.

In a crisis possession is nine tenths of the law, as was obvious to many unfortunate account holders in the collapse of the highly leveraged MF Global.  Even when it comes to clear title to assets and the sanctity of customer accounts,  actual physical possession and a good set of lawyers, not to mention political influence, is a powerful argument.

Do we know of any big players that have gone long gold this year, signaling perhaps a well informed change in their sentiment, even if it is not reflected in their own positions?  I suppose we might suggest a few.

Why would anyone force or risk such an outcome that would be damaging to the bullion banks, and risk the Western banking system?   It might be convenient but incorrect to attribute maliciousness to what is more easily explained as simple self-interest in the best capitalist tradition.
"Global physical trading patterns are hitting critical tipping points whereby emerging markets are becoming the lion’s share of some global goods and services demand/production and oil demand. And they have NO interest in maintaining the status quo, because they appear to be acutely aware of the fact that the Anglo-American 'exorbitant privilege' has been funded directly by their sweat equity.

Or to put it more bluntly, why would the BRICs want to settle their trades between themselves in dollars so that they can help to fund their own military encirclement that has consistently acted against their interests?”
This brings to mind the Chinese best seller Currency Wars by Song Hongbing that was the Harry Potter of the Chinese intelligentsia about 2006. I have written about it several times as a phenomenon in Asian thinking, in much the same way that some would point to Ayn Rand's influence on thought in the West.

The rise of the BRICs as an economic force is a meaningful development.
"For the 1st time we have someone big enough, in both economic size and military strength, to break the status quo, the means to do so by moving physical trade settlement amongst themselves away from USD, and the motive of satisfying intense domestic political desires to improve living standards for their people and to obtain more control over the basis for settlement of commodities, which among other things would result in lower oil prices."
It is possible that if this is true, we will see some initial indications of tension in the commodity marketplace in the manner of Lehman Brothers. 

I have the feeling that a resolution for this currency war is being crafted behind the scenes, with Russia attempting to broker a gradual currency compromise using their chairmanship of the G20 this year.  The Anglo-Americans are resisting, but primarily for terms, and for time to allow their favorite banks to square themselves up in the face of this change.

Regardless of the background and motives, the remarkable decline in Western gold inventory and the enormous buying in Asia and the Mideast is something to be considered.  To my mind the inability of the US to return Germany's gold in a reasonable timeframe was a watershed event.

There is always the opportunity to attempt to ignore an impending crisis with a flash of unrealistic bravado.   Let them eat billion dollar platinum coins.

And the difficulty of the US dollar in maintaining its status as the world's reserve currency is highlighted by current events, not only the political deadlock in Washington, but also the many bilateral agreements to settle trade in non-US dollar terms.

In summary, there are a number of odd things going on.  And the unhappiness of the BRICs with the status quo is public. 

My correspondent and I believe that there will be an 'aha' or even a 'holy shit' moment coming.  But predicting when it will and how it will arrive is not possible, at least from my seat in the house.  By the time the retail investor figures out what is happening the wave of the future is already rolling in. 

My correspondent is a little less shy of putting out a forecast but no timeframe.
"The most likely scenario is that physical gold goes up to a really, really big number in some sort of global currency system reset, thereby completely collateralizing most of the sovereign debt out there.

Gold miners go up a lot, but not as much as physical gold because the governments will effectively seize them and turn them into public utilities complete with annual dividends that are probably equal to a big percentage of current miner share prices."
Sounds plausible as anything else I suppose. We both doubt that they will 'confiscate' the gold in private hands for a number of reasons. A windfall profits tax of some sort would not surprise me, if the Democrats are in the driver's seat, although I could see a greater number of states passing gold and silver friendly laws to attract capital.

What snowflake will trigger the next avalanche, or what I call trigger event will set the tipping point in motion?  I could not even begin to say.  I am sure others have more informed opinions on this, and none of them are speaking with the likes of us, at least not in a crony capitalist culture.  They are busy doing for themselves and their friends.

Let's see what happens. China is a powerhouse now, but it may fall from the heights, as did Japan Inc. which seemed unstoppable in 1989.

But all things considered, unless I was considered TBTF at the very least I would not wish to have a significant obligation to deliver gold bullion in this market structure, even if I had hedged the risk. Sometimes risk can be remarkably hard to measure or even define.

Related: The Amazing Disappearing Gold Bullion
             Prepare for a New Gold Standard - Thanong Khanthong