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Saturday, August 11, 2007

Gold and Silver Price Manipulation

I've been reading various sites on the internet that claim central banks have been artificially suppressing the price of gold and silver. Gold and silver are unbiased benchmarks used to measure inflation. By suppressing the price of gold and silver, they cover up the weaknesses of their fiat money. This helps keep false confidence that inflation is low.

There is one thing that bothers me about people whining that central banks are artificially depressing gold and silver prices. If you believe this to be true, buy gold and silver! At some point, the central banks will have exhausted their reserves and the fair market price will be realized.

The mechanism for manipulating gold and silver prices is gold and silver leasing. Gold and silver is just sitting in the central bank's vault. Why not loan it out to earn a little extra income? The leasing rates are ridiculously low, something like 1-2% of the market value of the gold or silver. Why not lease out the gold or silver? It's extra income, right? Typically, the loans are made to mining companies, who sell the metal and promise to replace it with future production. The justification is that this lets the mining companies hedge their future production. As a justification for allowing leasing, that's kind of nebulous. After all, there already are gold and silver futures markets that can be used for hedging. The real reason for the leasing is that the central banks are using these leases to artificially depress prices.

Sometimes, the metal leases are made to bullion banks. The bullion banks sell the borrowed metal on the spot market, buy futures, and invest the cash in the meantime. Since the lease rates are only 1-2%, the bullion banks can make a risk-free profit. They borrow metal from central banks at 1-2%, and buy bonds that pay 5%. The effect is that the supply of metal is increased, driving down the price. When the loans come due, the position is rolled over rather than having the metal re-deposited at the central bank.

In a bona fide short sale, the short seller is required to deposit collateral equal to the fair market value of the thing sold short. In other words, if $1M of silver is loaned out for sale, then $1M of cash collateral should be required. The amount of collateral required is increased whenever the market price of the short sale increases. Central banks are not requiring full collateral for these short sales. In fact, there have already been instances where central banks have gotten stuck when a corporation borrowed metal for sale and later declared bankruptcy.

The central banks don't properly disclose to the public how much metal they have loaned out. They carry on their books the full amount of metal, assuming the loan will eventually be repaid even though they have no collateral. This makes it hard for traders to judge the actual amount of metal sold. Instead of demanding repayment of the loans, the central banks merely extend the loan for longer and longer. These metal leases really should be recorded as sales or, more accurately, gifts.

Of course, there's only a certain amount of physical metal. If there is substantial metal leasing abuse, it will have to end eventually. The price of metals cannot be artificially suppressed forever, and eventually there will be defaults.

There is one interesting point the websites who point out this abuse miss. If central banks really are artificially suppressing the price of gold and silver, then I would want to buy all the gold and silver I could! As long as you're not leveraged, and take delivery of physical metal, you should be able to profit eventually. However, the market could be artificially suppressed for 10 or 20 years, which might be longer than the patience some investors have. The market can't be fooled forever. If there is manipulation of the market, it has to end eventually.

The gold and silver futures markets have rules that are biased against longs and favor shorts. Shorts are not required to deposit full collateral equal to the value of the short, or proof that they own physical metal, even if it is close to delivery time. I heard a story that there once was a risk of a failure to deliver on an exchange. There were more people holding long future contracts expecting delivery than there was actual metal to deliver. The exchange changed its rules, increasing the margin requirements for the longs. This forced some longs to sell and there was no failure to deliver. (If you are a futures exchange, a failure to deliver is pretty much the biggest disaster you can have. That means that someone bought a futures contract and didn't get what they were promised.) I read that the margin requirement for longs (but not shorts) was raised to 200%, which is more than the longs would have had to pay if they accepted delivery.

For a small investor, there really aren't any practical options. The ETFs like GLD or SLV lease out their holdings for short sales, which defeats the entire purpose. The ETF shareholders would take the loss in the event of a default. If I buy futures and have the metal stored for me in a warehouse, I risk default if the corporation running the warehouse goes bankrupt. I also risk default if the government seizes the assets of the warehouse. There's no way to make an anonymous purchase with cash, so that people won't know I have gold or silver in my house. I couldn't find a dealer near where I live that sells gold or silver coins at a reasonable price. Maybe I'll stick with stock investments. Besides, stocks are also inflation hedged, plus you get the benefit of the productive value of the corporation. Metal just sits there and you have to pay storage costs. On the other hand, I think I should hedge the possibility of a global financial collapse.

Warren Buffet made a huge silver purchase recently. Rather than holding futures, he took delivery of the physical metal and stored it in a warehouse he controls. He probably concluded that the price was artificially low, perhaps due to market manipulation. I read somewhere else that he's already sold off his silver, for a nice profit.

I'm seriously considering converting 5-10% of my savings to physical gold and silver. I'm going to take physical possession and conceal them in my residence. I'm not sure that storing physical gold and silver in my residence is safe, but what alternatives are there? If nobody knows I have some gold and silver around, then it should be relatively safe! The only problem is that there aren't stores where I can conveniently buy and sell gold and silver coins. Actually, I only need to buy right now. I'll wait until the dollar collapses in hyperinflation to sell. Stock investments may not be worth anything after the upcoming global economic collapse. I think I should hold some physical gold and silver as a hedge.


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