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Distress Behind the Scenes in the Gold Market


The fact that metal owners are now accepting negative spreads shows just how desperate the scramble for cash within the banking system has become.


The rumor of central bank selling of gold (GLD) last week generated a lot of buzz. It took only a few days for those rumors to be refuted, at least technically. Looking at the gold forward rates confirms those refutations, but only according to the accounting rules as they exist today.

There is no doubt that gold's struggle of the past few weeks is mostly related to a surge in demand for US dollars. The global banking system is choking on its overextended position, the imminent reversal of the rehypothecation scheme that pyramided so much money on so little true value. The name of the game in global banking is, and has been for 30 years, collateral.

The crisis of 2011 ends up mirroring the crisis of 2008 simply because the banks have collectively changed their estimations and definitions of "quality." Before 2008, AAA-rated mortgage bonds fit the bill and were used and reused in repo financing arrangements far and wide. Through the ever-present eurodollar market of wholesale funding, client-owned mortgage bonds were pledged repeatedly in a bank's own funding arrangements – a process known as rehypothecation. The system and its regulators saw this as a normal course of business.

After 2008, with mortgage-bond collateral nearly fully repudiated (shipped off to the Federal Reserve in its first experiment with QE), the European banks needed a suitable replacement. Sovereign debt has always been thought of as "risk-free," having been enshrined in that bucket by the Basel rules going back to 1988, so it was a natural replacement. What should have been obvious back in 2009 was that not all sovereigns are created equal, and that risk can never really be described by a regulatory bucket.

Once again, the list of quality collateral is shrinking, and so is the ability of various banks to gain exposure to vital cash. This explains much of the counterintuitive run to "safety" of US Treasuries. It has little to do with actual safety considerations; rather, it is a funding reality within the repo market. US Treasuries remain widely accepted, at the moment, as the preferable collateral for US dollar funding.

This need for US Treasury collateral is so pronounced that it has kept the Federal Reserve on the sidelines since the summer. (See Stocks Unaware QE3 Has Been Indefinitely Postponed.) As a reminder, getting shut out of repo means bankruptcy, making the chase for collateralizing the primary consideration of every global bank in this challenged, dysfunctional marketplace.

The requirement for short-term liquidity has logically bled into precious metals (an exact repeat of 2008 for gold). The physical shortage of actual metal is still ever-present, but is no longer validated by leasing quotations. This shortage was first confirmed and "announced" to the world in the form of futures market backwardation in silver (SLV).

The futures curve takes its shape from the forward rates of leasing arrangements. These forward rates are nothing more than the terms of collateralized loans, with precious metal forward rates determining the cost of obtaining cash (which, under more operable circumstances, is then re-lent at a higher rate to someone else in the wholesale marketplace by the precious metal owner, earning the metal owner a positive spread and effectively "monetizing" precious metals).

For much of the first few months of 2011, silver forward rates were extremely low and even negative. That meant that cash owners were willing to lend out their money at a zero return (and, in the case of negative forward rates, were even willing to pay the metal owner for the privilege of borrowing money). The only reason cash owners would do something so obviously against their financial best interest was that they were desperately short of actual, physical silver. In other words, their desperation to close out short positions was more acute than the need to earn a positive interest rate on cash.

Over the course of the summer, as the banking crisis progressed into another systemic event, silver forward rates shot higher. It sent a confusing signal to silver investors since it seemed to indicate that the scarcity had been diffused. I wrote back in June (see Strange Times and Conflicting Data for Silver) that the shortage was still very real, and that the change in stance in the futures curve was really due to the disruption in the wholesale cash market, especially eurodollars.

Now that forward rates have risen to levels above LIBOR rates, it means that any lease/collateralized loan has a negative financial value to the metal owner (an exact reversal from earlier in the year when it was the cash owners that were taking on negative rates due to the physical shortage).

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