IMF: Gold Leases, Loans, Swaps and the Gold Forward Rate

As you may recall we have a hypothesis that gold, the swiss franc, and the yen have all been helping to fuel the carry trade.

The yen has exploded higher, while the swiss franc has languished because of that country's heavy exposure to the financial system (16% of GDP) and the toxic debt problems throughout Europe.

As far as we know, gold does not have a similar issue with toxic bank debt, and from the numbers still looks to be heavily involved in carry trades based off leased central bank gold.

In reading this, it becomes clear that the IMF believes that once gold is lent out it becomes the property of the borrower who may in turn lend it out to third parties. What the lender holds is the 'promise' of the return of the gold at some future date.

What we find shocking however is that on the books there is no accounting for this potential liability. The gold that is lent out is still marked as 'gold reserves.'

What is the extent of this lending? How many ounces of central bank gold are really just paper promises for its return? If the dominos start falling in this carry trade it is very likely that there will be a declaration of force majeure, and the contracts will be settled in paper.

But it could be very embarrassing to the monetary authorities who have dealt away the possessions of their countries without inquiring about their ability to do so, or making their behind the scenes deals public. One way to settle this ahead of time is to promote 'gold sales' in which the paper settlement process is accelerated.

Watch this, because its sure to get interesting.

The Nature of Lease Payments on Gold Loans
BOPTEG ISSUES PAPER # 21A

IMF COMMITTEE ON BALANCE OF PAYMENTS STATISTICS
BALANCE OF PAYMENTS TECHNICAL EXPERT GROUP (BOPTEG)

Prepared by International and Financial Accounts Branch
Australian Bureau of Statistics
November 2004

Gold Loans

Gold loans or deposits are undertaken by monetary authorities to obtain a non-holding gain return on gold. The physical stock of gold is "lent to" or "deposited with" a financial institution (such as a bullion bank) or another party in the gold market (such as an intermediary for a gold dealer or gold miner with a temporary shortage of gold). In return, the borrower may provide the monetary authority with high quality collateral, but no cash, and will make a series of payments, known as lease payments.

The party who borrows the gold from a monetary authority may in turn "lend" the gold to a dealer or miner.

This ability to on-lend indicates that, while the package of transactions which makes up a gold loan is clearly very different from an outright sale of the gold, the rights and privileges associated with ownership of the gold have changed from the monetary authority to the borrower.

The loan or deposit may be placed on demand or for a fixed period. The amount of gold to be returned is based on the volume initially lent, regardless of any changes in the gold price.

The security and liquidity aspects of the monetary authority's gold loan claims on the depository corporations are regarded as a substitute for physical gold, such that the loan values are retained within the monetary authority's monetary gold reserves, leaving monetary gold stocks unchanged. If the loan is for a fixed period, it is usually available on short notice, to help meet the criteria for inclusion in reserve assets.

Gold loans or deposits share many of the characteristics of securities repurchase agreements (repos) and securities lending, the statistical treatment of which has proved intractable.

Gold Swaps

In order to analyse gold loans, it is useful to first understand gold swaps.

A gold swap involves an exchange of gold for foreign exchange deposits, with an agreement that the transaction be unwound at an agreed future date, at an agreed price. Gold swaps are usually undertaken between monetary authorities, although gold swaps sometimes involve transactions when one of the parties is not a monetary authority. In this case, the other party is usually a depository corporation. (A monetary authority is a central bank or Treasury. We wonder if J. P. Morgan is one of these swap parties since they are the major player int he global gold derivatives market - Jesse)

Gold swaps are undertaken when the cash-taking monetary authority has need of foreign
exchange but does not wish to sell outright its gold holdings. The monetary authority acquiring the foreign exchange pays an agreed rate, known as the gold forward rate. At maturity, the volume of gold returned is the same as that swapped, while the value of the foreign exchange - as determined at the time of initiation of the swap - is returned.

While, because of the limited number of players, gold swaps are unlikely to be tradable, they have all of the other characteristics of a financial derivative. The gold forward rate, which determines the payments associated with a gold swap, is set taking into account current and expected interest rates and gold prices. If gold swaps are considered financial derivatives, in statistical terms the payments associated with a gold swap are transactions in a financial derivative. Otherwise, the payments may be considered margin payments on a forward contract.

Components of a Gold Loan

A gold loan can be seen as a gold swap where the borrower of the gold provides no foreign exchange in exchange for the transfer of the gold. That is, a gold loan is a gold swap with an extra leg, whereby the gold lender lends the money received back to the gold borrower.

In order to gain an understanding of a gold loan, it is useful to separate it into three parts:

1. Change of Ownership of Gold - the monetary authority transfers the physical stock of gold to the borrower. The borrower can (and usually does) sell the gold to a third party.

2. Loan - as the borrower has ownership of the gold but has not paid for it, the monetary authority is deemed to have issued a loan to the borrower equal to the value of the gold. The borrower has a loan liability to the monetary authority. (Is the gold still reported in the lender's listed reserves? - Jesse)

3. Forward Contract - the borrower enters into a forward contract to deliver the original quantity of gold borrowed, to the monetary authority when the gold loan matures. At the maturity date, the monetary authority extinguishes the loan claim on the borrower in exchange for the receipt of the borrowed gold.

Analysing these components helps to understand the multiple positions and flows which are combined to make up a gold loan, and hence to understand the nature of the loan and the lease payments.

Lease Rates

In the case of a gold swap, the gold lender (cash taker) makes payments at an agreed rate, the gold forward rate, to the gold borrower.

If the above view of gold loans is correct, one component of the lease payments is the same payments as in a swap, but these are more than offset by interest on the loan going in the other direction, resulting in a net payment by the gold borrower to the gold lender (the opposite direction of the payment under a swap).

These payments are called gold lease payments and, according to the above view of gold loans, are made up of:

• interest on the loan, and
• transactions in a financial derivative or margin payments on a forward contract.

London Bullion Market Association Statistics

London Bullion Market Association Gold and Silver Fix and Forwards


To test the validity of this view, it is useful to look at how gold lease rates are determined in the market:

Gold lease rate = LIBOR - GOFO rate

LIBOR is the London Inter-Bank Offered Rate, a widely used international risk-free interest rate.

The GOFO rate is the Gold Forward Offered rate, which is the rate at which contributors (the market making members of the London Bullion Market Association) are prepared to swap gold against US dollars.

The charts below show the daily gold price and the daily one year LIBOR, GOFO, and gold lease rates over the past seven years.



The relationship of LIBOR and the GOFO rate to the lease rate is shown in Chart 2.
Comparing Chart 1 and Chart 2 shows that the gap between GOFO and LIBOR is significant in times of falling gold prices, and GOFO approaches LIBOR in times of rising gold prices.

The composition of the lease rate supports the view of the components of a gold loan outlined above. The payment of interest indicates the existence of a loan and the use of the GOFO rate indicates the existence of a gold swap.

Conclusion

The topic of this paper is the treatment of the lease payments on gold loans. The analysis of the positions and the flows has been done together as it is not possible to draw conclusions on the nature of the flows without looking at the positions to which they relate.

The description of components of a gold loan in this paper is likely to be controversial given the state of the overall debate on reverse transactions, but it is hopefully a useful contribution to that debate. The empirical support lent by the derivation of the lease rate, that is that the loan is seen by those setting the rate as a loan and a swap, may prove useful in that debate.

The conclusion on the nature of the lease payments is that they are the net of two flows, interest on a loan and transactions in a financial derivative or margin payments on a forward contract.

These should be recorded separately.

Hat tip to Steve Williams at CyclePro for bringing this paper to our attention.

I'm Proud to be an Okie Who Is Brokie..

It was a tossup this morning between this story and the one about how J.P. Morgan has virtually destroyed the New Castle school district through dodgy swaps with enormous undisclosed fees, now being investigated by the fraud unit of the FBI. New Castle is in western Pennsylvania near the Ohio border. McCain country. We'uns don't want any of that commie socialism here, unless it is for the good of the Republican party and the banks what ripped us off.

This one about Oklahoma State seems to have more pathos since at one point they were actually ahead 70%, borrowed against ti all and spent it, and then went bust on margin calls that wiped out the gains and principal, leaving them holding the debt.

And they were not really defrauded directly it appears, just recklessly foolish and badly used by an egotistical windbag.

Maybe they can get a co-signer loan from the Aggies or the Sooners.


FanIQ
Oklahoma State Is Officially Screwed

You probably heard a few years ago that T. Boone Pickens, who chairs the hedge fund BP Capital Management, gave Oklahoma State a $165 million donation to be used all for helping the school's athletic program. And the largest portion of it was going to be used to beef up the school's football stadium and football facilities.

Well, there was one problem with Boone's donation. He left the donation in the hedge fund, which initially seemed to be a good idea as oil prices soared in a post Katrina economic climate, swelling the initial gift to over $300 million. That was before things began to turn in 2007, as international demand for oil failed to meet projections, causing the fund to come to a sudden standstill, and then dropping on mistakes made by fund managers, who were managed by Pickens.

Anyway, Pickens resisted pleas by some OSU Regents to bank a good deal of the balance out of the fund when it exceeded $300 million, which was only 14 months ago. Instead Pickens decided on borrowing almost $200 million needed to expand and renovate Boone Pickens Stadium on the Stillwater campus, despite the fact that the donation was dropping in value.

Now, here's the bad news. Yesterday all indications were that OSU Regents had been told last Friday afternoon that a large portion of the Pickens donation in the BP Capital hedge fund was virtually wiped out by margin calls on the funds investments in the third quarter.

Well, that's not actually the case. It seems that ALL of the money is gone (the link provided is for a members site, but you can read the full article here).

Officials were told that actually, the entire $ 165 million donation, and the earnings, which once inflated the gift to over $300 million, had recently been eliminated by margin calls due to drastically falling oil prices.

As of Monday OSU's gift had flat-lined completely and was declared 'gone.'

And just so you know, the school has already made a lot of those improvements to the football field . That's because the school borrowed almost all funds used in the stadium expansion plans using the $300 million balance in BP Capital as collateral.

Yikes. So, um, Oklahoma State is now in debt of close to $300 million dollars.

I have no idea how in God's name they're going to get out of this. State schools don't exactly have an extra $300 million sitting around.

Has a college ever actually declared bankruptcy? I'm not sure, but we're probably about to find out.

It can only get better, it can't get any worse...

Escape Velocity: Take it to the Limit One More Time Like Its 1933

Escape velocity: in physics, the speed where the kinetic energy of an object is equal to the magnitude of its gravitational potential energy. It is commonly described as the speed needed to "break free" from a gravitational field without any additional impulse.

In economics, the growth rate at which the energy of monetary expansion exceeds the magnitude of deflationary forces generated by deleveraging of a prior monetary overexpansion.

In both cases, something gets put into orbit.

On 26 September 2008 Adjusted Monetary Base Rises to Record Levels we noted that the Fed was putting pedal to the metal, boosting the monetary base to levels higher than 911.

Here's an update.



When this reaches escape velocity it could be something to see. The last two times the Fed hit the afterburners we had stock market rallies leading to impressive highs.

Here is an interesting look at the history of the monetary base.



Hopefully the Fed has learned to allow the liquidity to percolate a little to trickle down to the real economy before yanking it back. We believe that this was the hypothesis of Friedman and Schwarz.

When the Fed does put on the brakes to stop the growing inflation, it might be even more impressive for those of you who were not around when Paul Volcker did his interest rate exercise in monetary restraint. Hint: zero coupons were a great buy at the top.

Europe and Asia Seek a Consensus Ahead of Washington Meeting

Sounds as though a consensus is forming, without the United States, to set the agenda for the upcoming meeting in Washington on November 15.

One step closer to a world currency, and a world government.
Tonight I am sick at heart for the damage that has been done to the world over the last eight years. We have squandered the sacrifice of a generation.

ἐδάκρυσεν ὁ Ἰησοῦς


The Economic Times
Leaders call for new rules for financial system
25 Oct, 2008, 0644 hrs IST

BEIJING: Asian and European leaders agreed that the rules guiding the global economy should be rewritten and the International Monetary Fund should be given a lead role in aiding countries hit hardest by the financial crisis.

On a day when stock markets plunged around the world, leaders from nations including China, France, Germany and Japan said Friday that they were moving toward consensus ahead of next month's meeting of the 20 largest economies in Washington.

``Europe would like Asia to support our efforts and would like to make sure that on the 15th of November we can face the world together and say that the causes of this unprecedented crisis will never be able to happen again,'' French President Nicolas Sarkozy said in remarks to the opening ceremony of the Asia-Europe Meeting in Beijing.

A draft of a meeting statement on the crisis seen by The Associated Press called on the IMF and similar institutions to act immediately to help stabilize struggling banks and staunch the flood of red ink on regional stock bourses.

``Leaders agreed that the IMF should play a critical role in assisting countries seriously affected by the crisis, upon their request,'' the draft said.

If adopted, the statement would be among the strongest calls yet for a leading role in the crisis for the Washington-based fund, long known as the international lender of last resort.

Countries as varied as Hungary, Ukraine, Iceland and Pakistan have already turned to the IMF for help bridging their liquidity crunches.

The draft statement also states that leaders agreed to ``undertake effective and comprehensive reform of the international monetary and financial systems.''

Among the first to publicly endorse the proposal was Japanese Prime Minister Taro Aso, head of the world's second-largest economy. Aso ``strongly supports'' a critical role for the IMF, Japanese Foreign Ministry spokesman Kazuo Kodama said.

The biennial gathering, known as ASEM, has no mandate to issue decisions and participants differ widely on their views toward international cooperation and intervention by global bodies. Free-trading Singapore and economic powerhouse Germany are attending, along with isolated, impoverished Myanmar and landlocked, authoritarian Laos.

Responses to the crisis have varied widely so far. Europe has already approved a plan under which the 15 euro countries and Britain put up a total of $2.3 trillion in guarantees and emergency aid to help banks.

Asian financial systems are less shaky, having had less direct exposure to the toxic sub-prime mortgages that are wreaking havoc on US and European markets. Showing a notable lack of urgency, South Korea, China, Japan and the 10-country Association of Southeast Asian Nations recommitted themselves to an $80 billion emergency fund to help those facing liquidity problems - to be established by next June.

China and other Asian economies are, however, expected to take a major hit from a drop in exports and foreign investment.

Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed,
and everywhere the ceremony of innocence is drowned...