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Friday, February 29, 2008

The Hunt Brothers' Silver Corner

The best source on the Hunt brothers' silver corner is this post on wallstraits.com. This article on gold-eagle.com is also worth reading. This post takes some information from those two sources. I don't like the academic-style of writing where you footnote every fact.

In 1971, the US completely abandoned the gold standard. The US defaulted on its promise to foreign central banks that paper dollars could be redeemed in gold. The original default on the dollar really occurred in 1913 when the Federal Reserve was created, allowing the Federal Reserve to print more Federal Reserve Notes than physical gold was in the US Treasury. Alternatively, the default occurred in 1933 when President Roosevelt said that US citizens could no longer redeem their paper dollars for gold and that US citizens were not allowed to own gold.

The Hunt brothers were the sons of a wealthy oil billionaire. They started investing in silver as a hedge against inflation. When they started buying silver, it was still illegal to own gold. They chose silver as their inflation hedge.

The Hunt brothers realized that the dollar was now worthless unbacked paper. They famously said "Any fool can run a printing press!" They decided to convert their paper wealth to physical silver. When they first started buying silver, the price was under $2/ounce. Recently, silver was quoted at $18/ounce. Over 30 years, a gain of 9x is equivalent to an annualized return of 7.6%. If the Hunt brothers were able to buy-and-hold their silver, they would have made a respectable rate of return.

The Hunt brothers realized that the Federal Reserve was subsidizing negative real interest rates. Instead of taking an unleveraged long position in silver, the Hunt brothers used margin to buy up to 20x as much silver as they actually had capital.

If the Hunt brothers merely invested a bunch of their own money in silver, they would have profited immensely. However, they got greedy *AND* they got screwed over by the Federal Reserve and the rules of the commodities exchange (CFTC).

After investing their own money in silver, driving up the price, the Hunt brothers started seeking other people to invest in silver with them. They convinced some Arabs to invest oil money in silver along with them. You're a fool to invest in an asset *AFTER* someone else has made a huge purchase, driving up the price. The Hunt brothers were seeking other silver investors to drive up the silver price even more. This made the Hunt brothers' initial silver investment even more profitable.

The Hunt brothers took physical delivery of their silver. They hired sharpshooters to protect them as they transported their silver to their warehouse.

The Hunt brothers said repeatedly, "Our goal is not to corner the silver market. Our goal is to be long-term buy-and-hold investors in silver." The problem is that the Hunt brothers were using extensive leverage. Whenever you have a leveraged investment, you risk being bankrupted during the next bust phase of the business cycle. Unfortunately for the Hunt brothers, they were *NOT* financial industry insiders. The financial industry insiders changed the rules of the game after the Hunt brothers had bought a large amount of silver.

Even though the Hunt brothers said "We are not trying to corner silver.", their actions were the same as someone attempting a corner. In a commodity market, cornering the market means buying so much of the commodity that you have a virtual monopoly. Monopolizing the supply, you can set the price at which you sell.

As you begin to corner the market in a commodity, the price naturally skyrockets. Suppose the price of silver is $18/ounce. You decide to invest $1 billion in silver, maximizing your leverage. You use 20x leverage, so you actually can buy $20 billion in silver. You have $20 billion in silver and a debt of $19 billion. HOWEVER, your purchase of silver has driven up the price. Suppose you were able to drive up the price 3x to $54/ounce. Now, you have $60 billion in silver and a debt of $19 billion. If you tried selling your silver, you would drive the price back down to $18. However, that's not the way margin rules work. Margin rules value your silver at the CURRENT PRICE. You only invested $1 billion, but your account now has $41 billion in equity ON PAPER. According to margin rules, you can use this equity to borrow more and buy even more silver! Anybody who tries to corner a commodity is taking advantage of this positive feedback cycle.

Real interest rates are negative, so this is a great deal! Your profits aren't free; they're paid by everyone else as inflation. Suppose inflation is 10% but the Fed Funds Rate is 5%. As you hold onto this position, you will benefit IMMENSELY from inflation.

That is the real reason "cornering the market" in a commodity is considered illegal/immoral. The real culprit is Federal Reserve negative real interest rates, combined with margin usage. As your attempted corner drives up the price, the margin rules mean that you can borrow more and buy more! Negative real interest rates mean that you profit immensely from using leverage. Money supply inflation is greater than the interest rate you are charged, and you will profit if you can hold onto your position long enough.

The Hunt brothers were exploiting the defect of negative real interest rates combined with margin rules. If real interest rates were not negative, but instead market-determined, this would not have been a profitable trade. If margin rules were based on liquidation price instead of current price, they would not have been able to drive up the price of silver so much.

At one point, the Hunt brothers had 77% of the world silver supply, either physically held or in the form of futures contracts. The Hunt brothers had substantially driven up the silver price.

The Hunt brothers were making a HUGE bet that the price of silver would continue to rise. At the same time, financial industry insiders started making a HUGE bet that the price of silver would crash. Guess who won the conflict?

The Hunt brothers were buying all the silver futures contracts they could, using leverage. Financial industry insiders were naked short selling all the silver futures contracts they could. There was no way all this silver could be physically delivered. There was a real risk that there would be a default on the silver futures contract.

Suppose you owned futures contracts for 1 billion ounces of silver while the world silver supply was only 200 million ounces. The futures exchange would be forced to default on its promise to deliver silver. As a commodity exchange, a failure to deliver is the most serious disaster you can have. The commodity exchange would collapse in default/bankruptcy. Large financial companies assume liability for the trades. They would be also forced into bankruptcy, because they would also be responsible for the commodity clearing default.

The large banks were smart to take a huge bet against the Hunt brothers. They knew the government and Federal Reserve would bail them out! There was *NO CHOICE* but to bail out the banks and screw over the Hunt brothers, because otherwise the financial system could have collapsed! There was no way that much silver could have been physically delivered! The Hunt brothers had practically bought more silver than existed!

Besides, nobody other than financial industry insiders is allowed to exploit the defects in the monetary system. Whenever someone else tries, an example must be made of them!

In a futures market or options market, there are two types of transactions. You can have an "opening transaction" or a "closing transaction". Suppose A, B, and C have no position in silver futures. Suppose A buys one contract from B. A now has a position of +1 and B has a position of -1. A new futures contract was created by B. Both A and B report their transaction as an "opening transaction", which means the total "open interest" has increased by 1. Suppose B now buys 1 contract from C. B's position changed from -1 to 0, so he reports a closing transaction. C's position changed from 0 to -1, so he reports an opening transaction. This is a closing transaction from B's point of view and an opening transaction from C's point of view. The total number of futures contracts is unchanged. Suppose C now buys 1 contract from A. A's position changes from +1 to 0 and C's position changes from -1 to 0. They both report a closing transaction. The number of outstanding contracts has decreased by one.

The "open interest" is the total number of outstanding contracts. An opening transaction is whenever a new contract is created, by one person increasing their long position and another person increasing the size of their short position. A closing transaction is whenever a contract is destroyed. In a closing transaction, someone who is long sells a contract they own, and someone who is short covers their short.

One quick way to calculate the "open interest" is you sum up the absolute value of everyone's position and divide by 2.

Due to the Hunt brothers' huge silver purchases, there was concern that the open interest was greater than the amount of physical silver available.

The Hunt brothers were screwed over by the government and the Federal Reserve. The CFTC/COMEX/CBOT are the regulators that set the rules for the commodities exchanges. The people sitting on the regulatory body are all financial industry insiders, EACH OF WHICH HAD A HUGE SHORT POSITION IN SILVER! First, they set position limits. The number of silver contracts each person could own was restricted, although the Hunt brothers' existing position was partially grandfathered. Second, THEY BANNED OPENING TRANSACTIONS. ONLY CLOSING TRANSACTIONS WERE ALLOWED. Third, they raised margin requirements for long speculators BUT NOT SHORT SPECULATORS! This forced the Hunt brothers into margin calls, while the short speculators could wait to buy and cover!

This meant that the Hunt brothers could *NO LONGER* buy silver to keep driving up the price. The only people they could sell to were the financial industry insiders, who had huge short positions. Knowing the rules of the game had been changed to favor them, the financial industry insiders knew they were going to be able to cover their humongous short position at favorable prices.

The Federal Reserve also joined the party. The Federal Reserve jacked up interest rates. This made it hard for the Hunt brothers to meet the interest payments on their margin debt. Borrowing at 5% to buy silver is a bargain when inflation is 15%. Borrowing at 20% to buy silver is a ripoff when inflation is 15%!

The Federal Reserve also issued a special request to banks. They were to stop issuing loans for "speculative activity". The Federal Reserve didn't specifically say they were targeting the Hunt brothers, but everyone knew they were. Without this request by the Federal Reserve, if the banks colluded to stop extending the Hunt brothers credit, they would be guilty of an antitrust violation. When the Federal Reserve said "Stop lending the Hunt brothers money", the banks felt comfortable colluding to stop loaning the Hunt brothers more money, which is what they wanted to do!

With high interest rates, the Hunt brothers were unable to make the interest payments. Temporarily, interest rates were positive; interest rates were greater than the rate of money supply expansion. This ruined the Hunt brothers' profit equation, using leverage to borrow and buy silver. The Hunt brothers were hit with margin calls. They had to sell their silver. The financial industry insiders had taken a huge short position. They profited immensely as the Hunt brothers were forced to sell.

The Hunt brothers were attempting to corner silver. Instead, the financial industry insiders had created a "short corner". The Hunt brothers had a huge position they had to liquidate, and the financial industry insiders were the only legal buyers! Only someone with a preexisting short position could buy! The financial industry insiders had "cornered" the right to buy silver futures contracts, while there was a huge seller!

Of course, criminal charges were pursued against the Hunt brothers for attempting to corner the silver market. The financial industry insiders changed the rules of the game to bankrupt the Hunt brothers. Of course, what they did was perfectly legal. That aspect is amusing to me. The Hunt brothers, who lost a fortune, were criminals. The financial industry insiders, who changed the rules of the futures exchanges to bankrupt the Hunt brothers, were not accused of criminal activity at all.

The silver price crashed. Many individuals bought silver after the Hunt brothers pushed up the price of silver. The MSM said that gold and silver were discredited as an investment.

Central banks have huge reserves of gold. The world's central banks confiscated the world's gold supply in 1933. Since the default on the dollar, central banks have been slowly selling off their gold reserves to keep the price down. Central banks also own some silver, but not as much as they own gold. The price of gold and silver are used as a benchmark for the devaluation of fiat money. It is important to make a gold and silver investment look bad. This makes fiat money look good.

It was important to bankrupt the Hunt brothers. People who speculate in gold or silver are betting against fiat money. Bankrupting the Hunt brothers made the dollar look strong in comparison. When the price of silver crashed, it created the false impression that the dollar had appreciated in value.

Cornering a commodities market is only immoral/illegal in the context of negative real interest rates combined with defective margin rules that mark your position to market. In a truly free market, a corner is not profitable. Other investments would always be more attractive. Buying up the last bit of commodity to get a complete corner would be prohibitively expense. At some point, you'd be investing a lot of capital in a commodity that would just be sitting in a warehouse. It is *ONLY* state manipulation of the market that makes a commodity corner possible. Instead of fixing the defects in the monetary system, the government declares it illegal to attempt a corner.

The bottom line is that if you aren't a financial industry insider, you aren't going to profit borrowing to buy assets. If the Hunt brothers had taken an unleveraged long position in silver, they would have made a nice profit, and there's nothing the financial industry could have done to screw them over. Without using leverage, the Hunt brothers wouldn't have been able to push up the silver price that much, and they wouldn't be exploiting negative real interest rates and defects in the margin rules. The financial industry insiders will *ALWAYS* be bailed out by regulatory changes or by the Federal Reserve. In this case, the financial industry insiders had huge short positions. The insiders were bailed out regulatory changes and by the Federal Reserve jacking up interest rates, causing a temporary money supply crash.

16 comments:

gilliganscorner said...

FSK - I really enjoyed this post. You have hit the "silver" nail on the head. I always wondered about the Hunt brothers...

Anonymous said...

Thank you for this post. - An "Austrian" graduate student.

Michael Perelman said...

some students of mine were the younger siblings of some high-ranking Kuwaitis. I warned them about speculating with the Hunts. I had no real information about the particulars but explained the risks. They later expressed great gratitude for my input.

Anonymous said...

the screwed up thing is there's only like 2-3 articles ON THE INTERNET on the real details of what happened. This is nearly concrete proof the insiders in government, industry, and finance also control the media...ahem, CFR?

Anonymous said...

A system which allows the buying and selling of a commodity like Silver in quantities which do not really exist has got to be the glaringly obvious flaw in a totally crazy system. That this is everyday practice proves that the inmates are in charge of the asylum and their greed and thirst for more has no limits.

Anonymous said...

Good Article on a subject that does not get very much attention

One correction

The Federal Reserve also joined the party. The Federal Reserve jacked up interest rates. This made it hard for the Hunt brothers to meet the interest payments on their margin debt. Borrowing at 5% to buy silver is a bargain when inflation is 15%. Borrowing at 20% to buy silver is a ripoff when inflation is 15%!


FYI, They were also responsible also for the "Liquidation Only" rule the exchange instituted. The board of governors didn't come up with the rule on their own. They were....instructed.

I was at the exchange when it all started, and when it all came crashing down.

Anonymous said...

It looks like the same thing is happening now. The banks will always be bailed out.

Anonymous said...

This is such a thorough and comprehensive article explaining the Hunt Brothers' case. It's far far better than the few lines of footnotes in my textbook. Thank you so much!

Anonymous said...

you should address the fact that the central banks felt that it was necessary to destroy the Hunt brothers.

You should also tie in the demise of the IGD (islamic gold dinar) and the silver dirham that would have been used to round out the currency.

http://en.wikipedia.org/wiki/Islamic_gold_dinar#Modern_history

I think this is much more modern and interesting than the Hunt brothers episode.

pari said...

i really appreciate hunt brothers intelligence but it was injustice on the part of fed and the exchanges to change the rules of the market to bankrupt hunt brothers the real heros,,,i think the hunt brother story is going to repeat in 2011 ,,,

Richard said...

Those who don't know history are condemned to repeat it.
I'm trying to avoid getting burned by a "silver bubble" while trying to hedge against inflation and store wealth.
If the general public is now the gold and silver buyer (like Hunt) and "someone" (central banks?) is doing huge naked shorts (allegedly to support the dollar) as exposed by GATA in their manipulation lawsuit, are we "hoarders" the suckers who will see plumeting prices when the rules change like they did in your article? Remember the huge drops when margin requirements tightened in March 2008?

FSK said...

Richard:

There are some easy solutions.

If you "dollar cost average", then short-term bubbles won't hurt you much. "Dollar cost averaging" means "buy equal amounts at regular intervals".

If you're a long-term buy-and-hold investor, and you take physical delivery, short-term fluctuations won't hurt you much.

If you invest in SLV (paper silver), or you're leveraged, then you may be screwed by bubbles or fraud.

smith said...

I am learning about blogs and like what you did in yours blog.Bullionist

CWHM said...

Dear All,

I am researching this subject, The Hunt brothers and my Father, Jonathan May, can any of you help me?

please contact me via my blog, named, Jonathan May

Kind regards

Charles May

M. Wein said...

Eh, the folks at the CFTC weren't all industry insiders and the Fed raised interest rates because of inflation, not the frikkin Hunts.

Gotta love that ad for the Islamic Dinar there.

Anonymous said...

The catalyst for the crash before the Fed's action is thought to be traders from India and the Indian Government which relaxed export rules to sell a ton or more into the market. The vast quantity of silver (and gold) which is the primary form of savings there even today, was unknown to the Hunt brothers. Once the reaction got going the Fed did the rest and closed it out dramatically.

This Blog Has Moved!

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