Sharp selloff in gold!

Thanks for the ping, John. Your Greenspan quote bears (constant, drumbeat) repeating:

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation .... The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves .... Deficit spending is simply a scheme for the 'hidden' confiscation of wealth. Gold stands in the way of this insidious process .... Alan Greenspan, July, 1966

What has happened to this man in the last thirty-five years? Apparently, he once was an economist in practice, rather than simply in title. Is he a glaring example of the concept that power corrupts?

Are there any markets (stock/precious metals, etc.) that are actually free moving, as regards the laws of economics, anymore? Are there any markets in which the individual investor can anymore feel confident investing, without wondering what the manipulators are doing behind the scenes in order to cause his well-researched investment to defy the laws of economics, leaving him scratching his head in frustration and disbelief? I’m really beginning to wonder. The term free market is fast becoming a fond memory.

Two essays which will answer at least a part of the question posed here:

Gold, Dollars, and Federal Reserve Mischief, by the venerable Ron Paul (R-TX)

Excerpts from an essay entitled ‘Gold or Dross? Political Derivatives in Campaign 2000’, by Reginald H. Howe:

Special Risks of Gold Derivatives

Although comprising what is by far the smallest discrete sector of the global derivatives business, gold derivatives seem to have created the worst problems. This result is testimony to gold's unique quality as the commodity that is also permanent, natural money.

The rocket fuel propelling gold derivatives is gold from central banks that is deposited with or loaned to bullion banks at normally very low rates of interest (typically 2% or less depending upon maturity) called lease rates. This so-called "leased" gold is immediately sold into the market and the currency proceeds delivered for investment or other use by the bullion bank and/or its customer. When the gold deposit is called or the gold loan comes due, the physical gold required for repayment must be repurchased in the market. But during the term of the deposit or loan, the central bank retains the leased gold as an asset on its books and as part of its official gold reserves notwithstanding that the buyer of the leased gold owns it free and clear.

In other words, although sold into the market, the leased gold remains on paper an asset of the central bank. The obligation to repay this gold to the central bank puts the bullion bank and/or its customer in a short physical position, i.e., they owe physical gold that they do not have. While benefiting from the low lease rates, they bear the risk of higher gold prices at the time of repayment. To cover or reduce this risk, gold borrowers ordinarily purchase forward contracts or call options, which in turn are usually delta-hedged by their purveyors. Bullion banks, acting for themselves or their customers, are usually on both sides of these transactions. The bullion banks' customers include gold mining companies, fabricators of gold products, investors, traders and speculators. Among the last three groups are many trying to take advantage of gold's low lease rates to fund higher-yielding investments, or the so-called gold carry trade. For a very interesting article about the gold and other carry trades, see Mervin Yeung, Carry Trade: Short Term Heaven Long Term Hell, at Sky Blue Monthly.

Borrowers in the gold carry trade ordinarily have only the market as a source of metal for repayment. Another large group of gold borrowers are the producers, who borrow gold through their bullion banks and sell it forward in order to earn the contango (the difference between the dollar interest rate and the lease rate) on a portion of their future production. Forward contracts also offer gold mining companies a measure of protection against falling prices. Typically written with maturities extending as far as ten years forward, they add future gold production to the spot market. However, almost entirely funded by gold deposits or other short-term loans mostly by central banks, they are also a classic example of borrowing short to lend long.

Given the popularity of the gold carry trade as a means for funding speculative investments in the period prior to LTCM's failure, not to mention the enormous leverage that it is known to have used, the absence of a large short gold position would have been more surprising than its presence. Any major financial failure with international implications is likely to put upward pressure on gold, but the collapse of an entity with a large short position is likely to turn that pressure into a booster rocket, creating a central banker's nightmare: an international financial crisis accompanied by sharply accelerating gold prices. Saving a single hedge fund with a short position of 300 to 400 tonnes is one thing. Rescuing one or more bullion banks with short positions running into the thousands of tonnes is quite another.

Gold leasing today is essentially traditional gold banking under a new moniker. The chief difference is that now the principal depositors are the world's central banks rather than private entities and individuals. However, gold derivatives are treated today not as gold banking but rather as ordinary commodity contracts. Prudential rules developed over centuries of experience with gold banking, such as provision for adequate bullion reserves, are largely ignored. As discussed in two prior commentaries, Gold: Can't Bank with It; Can't Bank without It! and Central Banks vs. Gold: Winning Battles but Losing the War?, the result is a huge inverted pyramid of interconnected paper instruments representing various types of claims and obligations denominated in gold but built upon a very small amount of bullion at the base. Making the structure even more shaky, most of the gold at the base is leased, and much of that has been sold into Indian and other Asian and Middle Eastern markets.

No commodity except gold is held by central banks as an international monetary asset. No other commodity (with the possible exception of silver) presents the danger that quantities equal to several years of new supply may be quickly called upon for immediate physical delivery, particularly under conditions of monetary stress or uncertainty. Gold derivatives hold the same two basic dangers for bullion banks that imprudent banking did a century ago: (1) bank runs by depositors or others to whom the banks owe gold, including today the counterparties on the long side of their gold derivatives contracts; and (2) impairment of their gold assets, which today are mostly derivatives subject to both counterparty and market risk.

Contrary to Fed Chairman Greenspan's 1998 testimony to the House Banking Committee, gold derivatives are not properly analogous to interest rate or foreign exchange contracts where the underlying assets are paper instruments of virtually unlimited supply. The gold supply is large, but it is not unlimited. There can be no assurance -- even to a lender of last resort as powerful as the Fed -- that in time of crisis gold will be available in whatever amounts necessary to rescue failing bullion banks. More worrisome yet, the largest bullion banks are integral parts of very large commercial or investment banks generally considered "too big to fail," a doctrine of limited or no application in gold banking.

The most frightening aspect of gold derivatives today is the size of the aggregate short physical position. The actual figure is unknown because, except for the Swiss National Bank, the major central banks that lease gold do not report the size of these loans or deposits even to each other. At the recent Financial Times World Gold Conference in Paris, the consensus figure of the bullion banks seemed to be around 5000 tonnes. However, many outside the bullion bank fraternity believe that the short physical position is larger, and quite possibly twice as large in the opinion of one knowledgeable expert. Last April at a gold conference in Australia, Dinsa Mehta, head of global commodities trading for Chase, suggested a possible total short position of around 7000 tonnes.

Noting this range of estimates, a recent Salomon Smith Barney report states: "[T]he aggregate short position ... equates to two to three years of world mine production, which is simply too large to ever be repaid." To put this short position in further perspective, total gold reserves of the United States, which claims not to lease any gold, are about 8150 tonnes, and the combined official gold reserves of the Euro Area countries are around 14,450 tonnes.

From Gold Derivatives to Gold Price Manipulation

Explaining his 1998 congressional testimony on gold derivatives in a formal letter to Senator Joseph I. Lieberman dated January 19, 2000 (reprinted at www.egroups.com/group/gata/346.html), Fed Chairman Greenspan wrote: "This observation simply describes the limited capacity of private parties to influence the gold market by restricting the supply of gold, given the observed willingness of some foreign central banks -- not the Federal Reserve -- to lease gold in response to price increases." In other words, according to the Fed chairman himself, some central banks lease gold not to earn a return on it as they often claim, but primarily to supply this physical gold to the bullion banks during periods when strong demand is pushing up prices.

What is more, leasing is a far more effective method of putting downward pressure on gold prices than straight sales. Although the destiny of leased gold is ordinarily immediate sale, by reaching the market through the bullion banks while remaining an asset on the books of the lessor, leased gold provides certain fuel for derivatives. A sale, on the other hand, is a simple transfer. The new owner can use the gold for derivatives, but often it goes directly into the jewelry market, the vault of another central bank, or for some other purpose unrelated to derivatives.

Underlining his denial of any intervention by the Fed in the gold or gold derivatives markets, Mr. Greenspan's letter to Senator Lieberman asserts sanctimoniously: "Most importantly, the Federal Reserve is in complete agreement with the proposition that any such transactions on our part, aimed at manipulating the price of gold or otherwise interfering in the free trade of gold, would be wholly inappropriate." Why it might be "appropriate" for other central banks to lease gold for the purpose of affecting its price he did not say. Nor did he explain why the Fed apparently countenances these actions, which cannot help but affect the integrity of gold prices on the COMEX in New York.

Currently 7150 tonnes of gold belonging to foreign central banks and other foreign official monetary institutions are held at the Federal Reserve Bank of New York, down from almost 9900 tonnes in 1990. As detailed in a prior commentary, The Fed: Up to its Earmarks in Gold Price Manipulation, withdrawals of this foreign earmarked gold, especially in the 1996-1998 period, coincided remarkably with significant rallies in the gold price. What is more, the total amount of these withdrawals matched quite closely estimates of the amount of leased gold flowing into the bullion banks. Mr. Greenspan's congressional testimony on gold leasing by central banks seems to have been spoken by a man who, if he was not in on the action, at least had a ringside seat.

His testimony also began to pull the veil back on an official war against gold that likely originated in 1995-1996 as part of a coordinated G-7 effort to bail out Japan. The events and evidence supporting this thesis are described generally in a prior commentary, Two Bills: Scandal and Opportunity in Gold? It appears that following the LTCM affair in the fall of 1998 and the successful introduction of the euro in January 1999, the major central banks of continental Europe began to withdraw from lending new support to efforts to cap gold prices. In any event, the outflow of foreign gold from the New York Fed began to slow, grinding to a virtual halt in recent months.

However, for the Clinton administration in particular, rising gold prices -- considered by many a good leading indicator of inflation -- threatened unwanted consequences for interest rates and the dollar. For the bullion banks, rising gold prices jeopardized not just the profits they were earning on gold derivatives but also, and much more dangerously, their short physical positions. Any real run on gold, given the size of the short position, also posed a grave danger to the important London bullion market. And even without more leasing by European central banks, additional gold supplies were expected to come from the proposed sale of over 300 tonnes by the International Monetary Fund to fund aid to heavily indebted poor countries, an initiative strongly supported by the United States and Britain.

On May 7, 1999, just as gold threatened to surge over $300 in response to new doubts that the proposed IMF gold sales would go forward, the British announced that the Bank of England on behalf of the Exchange Equalisation Account in the British Treasury would sell 415 tonnes of gold in a series of public auctions. Although this announcement came with no warning and was completely unexpected by most, the previous evening Bill Murphy of GATA reported in his Midas column at Le Metropole Cafe: "[Deutsche Bank's] bullion desk is calling their clients saying that the gold market is stopping at $290."

Various British officials have offered lame explanations of the gold auctions as an effort to diversify reserves. But British gold reserves were already low compared to those of other major European countries. British officials are also unable to agree on who made the decision. However, the timing virtually guarantees not only that it came directly from the prime minister, but also that he must have had extraordinary reasons for making it. His government was a leading supporter of the proposed IMF gold sales. The announcement clumsily put Britain in the position of front-running the IMF, ultimately a significant factor in forcing it to change tack. According to recent confidential information from a highly reliable source, the Blair government is treating certain information about its decision on gold sales as a national security matter.

The manner of the British sales -- periodic public auctions through the bullion banks rather than discreet sales through the BIS disclosed after the fact -- is so inconsistent with normal central bank practice and simple trading smarts that it has triggered an inquiry by Britain's National Audit Office. However, by limiting its examination to whether the Blair government chose a sales method likely to yield a maximum return, and by excluding any inquiry into the underlying reasons for the sales, the NAO has undertaken what appears a rather useless exercise.

Indeed, without ascertaining the true purpose of the auctions, the NAO cannot even determine whether the sales were "effective" under its own so-called "three Es" test (the other two are "economy" and "efficiency"). If the intention was to cap the gold price, which appears to be the only plausible explanation, the means chosen were if anything too effective. Within five months the gold price had collapsed to under $260, provoking severe displeasure among central banks who mark their gold reserves to market on a regular basis.

On September 26, 1999, following the IMF/World Bank annual meeting in Washington, the European Central Bank and 14 other European central banks announced an agreement to limit their total combined gold sales over the next five years to 2000 tonnes, not to exceed 400 tonnes in any one year, and not to increase their gold lending or other gold derivatives activities. The 2000 tonnes included the remaining 365 tonnes of British auctions as well as the then-planned Swiss sales of 1300 tonnes, which are now being conducted through the BIS in normal central bank fashion. The Bank of England signed the agreement on behalf of the British Treasury, but according to most reports, the British were informed about the agreement at the last minute and given a chance only to participate, not to negotiate. For references to European press commentary on the genesis of the agreement, see W. Smith, "Operation Dollar Storm," www.gold-eagle.com/editorials_99/wsmith111099.html.

Within days of the Washington Agreement, short covering caused the gold price to jump by nearly $60 to over $325 and gold lease to rates spike to over 9%. By late October, the price retreated back under $300 and a month later lease rates were nearly back to normal levels.

But as a result of the sudden sharp rally, two prominent gold mining companies, Ashanti Goldfields and Cambior, were in virtual bankruptcy due to hedge books loaded with what turned out to be imprudently chosen derivatives. Their bullion banks were threatened with large scale defaults. See, e.g., L. Barber et al., "How Goldman Sachs Helped Ruin and then Dismember Ashanti Gold," Financial Times (London), Dec. 2, 1999, reprinted at www.egroups.com/group/gata/299.html. And shareholders in gold mining companies everywhere were stunned to discover that derivatives could to turn rising gold prices into death sentences for the very enterprises expected to benefit most.

Ashanti and Cambior may not have been alone in suffering large losses in the October gold rally. Unprecedented recent trading losses by the U.S. Exchange Stabilization Fund are almost impossible to explain unless the Clinton administration, which denies making any interventions in the foreign exchange markets during the past couple of years, used the ESF to intervene in the gold market. Under the exclusive and unreviewable control of the president and the secretary of the treasury, and with around $40 billion in total resources together with an implicit call on U.S. gold reserves, the secretive ESF is well-situated to backstop gold derivatives -- particularly call options on gold -- that otherwise would be too risky for private bullion banks to write.

As detailed in a prior commentary, The ESF and Gold: Past as Prologue, and updated recently in another, the ESF's results over the past couple of years show a pattern of trading losses in quarters containing sharp or incipient rallies in gold prices and trading profits during quarters with generally weak or falling prices. This pattern was especially dramatic in 1999, when a trading loss of $1.6 billion in the last calendar quarter (the first quarter of fiscal year 2000) wiped out not just the trading profit of $1.3 billion earned in the prior quarter but the entire trading profits for the prior fiscal year. In other words, the ESF's best recent quarterly trading results coincide with the price collapse caused by the May 7 announcement of British gold sales, and its worst with the sharp rally and complete reversal of sentiment brought about by the September 26 announcement of the European central banks.

Despite numerous requests both from GATA [Gold Anti-Trust Action Committee] and from Senator Lieberman and other members of Congress on behalf of constituents, Treasury Secretary Lawrence Summers -- quite in contrast to Fed Chairman Greenspan -- has refused to provide any public clarification of the ESF's activities in the gold or gold derivatives markets.

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