15 Dec 2011

Shadow Banking Driving Gold Price to Xmas Present Levels

In the November monthly report, I mentioned how the MF Global collapse was a really big deal because it further shattered the one major commodity that holds financial markets together – trust. When investors lose trust in a 'system' meant to safeguard their wealth, uncertainty, illiquidity and volatility ensue.

I was only half right. This is a really, really big deal. And not just because MF Global stole client money. The investigations into its downfall have revealed a system of finance so rotten and corrupt that you won't even believe it possible. Making things much, much worse, is that this system is legal.

So sit back and prepare to be shocked. The whole idea around the SMSI service is to encourage you to think differently about your wealth. Well, if you don't do so after today, I'm not sure you ever will.

What is going on in financial markets is truly momentous. By the end of this issue, you'll understand why gold and silver are getting hammered right now – and why this will prove to be one of the great buying opportunities of this historic bull market in precious metals.

You'll also see why, despite showing an apparent reluctance to do so in today's FOMC (Federal Open Market Committee) announcement, the US Federal Reserve will have to resort to another round of money printing, most likely sometime in January.

There is a lot going on in global financial markets at the moment – Europe and China are the obvious areas of focus. But the macroeconomic climate in these regions is a just a sideshow. To understand what is really going on you need to look under the hood.

And it starts with MF Global. For a brief background story, please read the November monthly. I incorrectly thought MF Global was a simple story of theft. That is, use of client money (that should have resided in segregated counts) to fund the company's speculative investments.

It turns out it is much more than that. It could well transpire that much of the $1.2 billion in missing client funds was legalised theft.

How could that happen? Let me introduce you to the arcane world of shadow banking. I'll try and keep it as simple as possible.

First, let's start with normal banking. When you deposit funds in a bank account, the bank takes that money and lends it to someone else, usually only setting aside a small portion as a reserve. These reserves are enough to satisfy a small number of people wanting their cash back at any particular time. But, if everyone loses confidence in the bank and wants their cash back at the same time, the bank will collapse. It simply doesn't have enough liquid assets (cash) to satisfy the demand from customers.

That's how the traditional banking system works.

The shadow banking system works in much the same way except it is much larger, unregulated and far more risky.

When you're dealing in amounts in the hundreds of millions, you don't usually deposit your funds in a traditional bank. The traditional banking system in the US only insures amounts up to around US$250,000. It's deposit insurance for the little guy.

So big depositors (and big borrowers) play in the shadow banking system. The interest rate is usually a little better and insurance takes the form of 'collateral', which is the simple ownership of a security, like a US treasury bond, while funds are on deposit. Instead of a guarantee that your deposit is safe, you get a treasury bond.

Shadow banking is for the financial behemoths, like sovereign wealth funds, hedge funds, large corporations, investment banks and their brokerages, governments etc. It's very complex and only a small percentage of financial market participants would know what it's about.

But I think it's very important you get the gist of how the system works (and is currently imploding) so you can understand what the market is doing and where it is going.

As a broker dealer, MF Global was part of the shadow banking system. It took money in from clients. But instead of just acting as a transactor of trades and custodian of client funds, it used those monies for itself. But the thing is, it might not have been illegal.

You might find this hard to believe, but US and UK securities law allows client funds (that are being held as security against the client's position) to be used by the holder of those funds to place new bets.

Say you have $1,000 worth of futures with MF Global, but have only put up $700 of your own money. MF Global has lent you $300. Under US rules, MF Global is allowed to use the $700 worth of securities that you think you own and post that as collateral for its own trading activity.

In the UK, there are no limits. The broker can take the whole amount and use it as collateral for its own trades. It's trading on someone else's money – and taking the profits for yourself. It's no surprise then that MF Global was operating out of London, where there were no limits on the use of client funds (as were Lehman Brothers and AIG before their bankruptcies).

The process I have just described is called hypothecation and re-hypothecation. You may have heard of it recently. It refers to the fact that when someone puts up collateral for a loan in the shadow banking system, the creditor 'hypothetically' owns that collateral. And it can then re-lend, or 're-hypothecate' the collateral onto someone else, for its own benefit

Fractional Reserve Banking on Steroids

This principle of hypothecation and re-hypothecation extends across the whole shadow banking system. Depositors' funds are taken, re-lent, and the next party in the chain does the same thing. This goes on and on until the chain of actual ownership of anything resembling a real asset is so long and tenuous a puff of wind would break it.

It's all about using other people's money to make a profit. It's like fractional reserve banking (where your local bank lends your money to someone else) on steroids. And because the system is so opaque and unregulated, no one knows where the risks are pooling.

This re-hypothecation of client money means the shadow banking system is far more leveraged that what official figures suggest. By how much no one knows. The IMF guessed that by the end of 2007 it could have been as high as 4 times. Even if it's only twice as large now, it's still massive. Officially, there's around US$15 trillion in the shadow banking system.

In the case of MF Global, it made a bad bet with re-hypothecated client money. That's why clients won't get their money back. It wasn't stolen in the way you normally think of a theft.

Essentially, the asset you thought you had was 'sold' and put into something else. When that 'something else' didn't pay off, your asset disappeared up, or down, the chain of other people using other people's money.

This is why the issue is so huge. It is systematic theft and when everyone realises this, confidence in the system will disintegrate.

It's already happening. The problems in the European banking system have obvious macroeconomic foundations. But the deleveraging of the shadow banking system is making these problems much worse. That's because the shadow banks are (or more accurately were) major funders of the European banks. When they pull their funding, the Euro banks will have to go to the ECB for cash... and/or sell assets.

A subscriber sent an email in today asking why the ECB's recent offer of unlimited cash to the euro banks wasn't having a negative effect on the euro and a positive effect on gold. I think it's partly to do with the fact this liquidity injection by the ECB isn't new liquidity. It's merely replacing the disappearing liquidity from the shadow banks. But the gold story is more complex and murkier than that.

What has gold got to do with it?

Indeed, just what has gold got to do with it? A lot. Much more than you would think actually. To introduce gold to our story, let's start with this recent article from the Financial Times:

It appears that the faulty plumbing connections in the euro-area banking system are now creating something I have never seen before: a crisis of confidence in a monetary system that leads to a frantic selloff in gold.

The partnership between the Federal Reserve and European Central Bank to provide hundreds of billions of relatively low-cost dollars for euro-area banks should have relieved the pressure to come up with greenbacks. Yet gold market people say European commercial banks are being driven to lend gold for dollars at negative interest rates just to raise some extra cash for a few weeks. There's not a lot of transparency about where the banks are getting the gold they are lending out, but it could be lent to them by either their national central banks or by gold exchange-traded funds.

Read that last sentence carefully. Banks don't own any gold. So they can't be selling it. But they could be selling someone else's gold. Or, using our new found lingo, they could be re-hypothecating gold held by various ETFs (exchange traded funds), which just so happen to have large banks as their trustees and/or custodians.

Gold has corrected sharply in the past week and I would put that down to two things:

1. Selling in the paper/futures markets as leveraged players dump their positions. The MF Global situation should also be waking players up to the fact the futures markets are rigged and they are closing down their positions, exacerbating the selling.

2. New supply of physical gold coming from the banks, via the ETFs, as per the article above.

Relative to the amount of 'money' in the world, the gold market is tiny. So the rise in the gold price over the past decade might seem impressive. But in absolute dollar terms, it's minimal compared to the credit created by central banks and the traditional and shadow banking systems that they oversee.

Now you could argue that gold is falling because these fragile credit markets are themselves deflating (at least the shadow banking system is), which on the surface makes sense. But when you consider that the gold market is itself a type of fractional reserve system, whereby the ounce you think you own is actually owned by a number of other parties, then you can see how gold moves with the credit system itself.

The irony of this is profound. You own gold because it is meant to protect you from all the failings of the fractional reserve banking and shadow banking system we are all caught up in. You own gold because it is no one else's liability. It is outside the 'system'.

While it might not be apparent now, the MF Global collapse will be the trigger that breaks gold away from the fractional reserve banking system. It will send a very strong signal to those who own gold in any form other than physical (i.e. you hold it yourself or store it outside the banking system) that their insurance policy is worthless. When this realisation dawns and big money demands delivery of physical metal to vaults outside of the banking system, the gold fireworks will begin in earnest.

In another irony, it will be the deleveraging of the fractional gold market that leads to its price explosion. That's because there is not enough gold (at current prices) to satisfy the demand for REAL gold. Not paper gold or re-hypothecated gold.

So do not be spooked out of your gold position at this point. If you are underweight, or want to get more exposure, this is a great time to do so. I have long advised against owning ETFs and I reiterate that advice strongly now. If you own an ETF, sell it and buy physical. There is a high likelihood that at some point the gold position you thought you had will not be yours at all. It will have been lent out to someone else who went bankrupt...and your gold will have disappeared down the chain of related counterparty failures.

As for the rest of the 'system', the Fed will have no option but to print more money. Early in the new year is my best guess. As the ramifications of the MF Global failure continue to reverberate, more money will flee the shadow banking system. At the very least, participants will make sure their funds are not re-hypothecated by signing agreements to that effect. This will continue to have a deflationary effect. Hence the Fed stepping in. The battle between inflation and deflation continues.

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