13 May 2010

What happens if Perth Mint becomes insolvent?

Perth Mint Depository was recently asked the question below and I thought you may find my answer of interest.

“Should Perth Mint become insolvent, for whatever reason, do clients receive gold or cash? Also, what is their seniority in terms of the Mint's liabilities?”

The usual definition of insolvency means cash flow insolvency, that is, unable to pay debts as they fall due. In that sense the Perth Mint itself can never be insolvent, because it can always borrow funds from its 100% shareholder, the Government of Western Australia. When one asks what happens if the Perth Mint is insolvent, one is really asking what happens when the Government is insolvent, which is really another question.

As Wikipedia says, “a government cannot be insolvent in the normal sense of the word. Generally, a government's debt is not secured by the assets of the government, but by its ability to levy taxes.” The question the client asked was flawed in the sense that it was trying to analyse/assess the Perth Mint as if it was a distinct corporate entity standing on its own. While it is a commercially focused entity, it is nonetheless an extension of the Government and as section 4(3) of the Gold Corporation Act 1987 says “is an agent of the Crown in right of the State and enjoys the status, immunities and privileges of the Crown, except as otherwise prescribed.”

Having dealt with the cash flow issue, there is still the case of a balance sheet insolvency, a nice way of saying the Mint has lost the gold “for whatever reason”. Now the reason is important because if it is theft, then the Mint will first go to Lloyds to claim on its insurance policy. Only if they fail to pay does the Mint have a problem.

An alternative reason is that unknown to Government, the Mint never bought gold with the money clients gave it, in other words went short the gold price. In this case we are talking about fraud as that is contra to what they say they do "The Mint purchases an ounce of precious metal from the spot market for every unallocated ounce it sells to clients. Accordingly every unallocated ounce is 100% backed". The idea the Mint would want to keep client cash and not buy gold is one I consider lacking in any commonsense, as discussed in this blog.

Anyway, lets assume a shortfall in gold to back Depository liabilities. If the loss is small, the Mint would book the loss and if larger than cash reserves, would borrow the necessary remaining money from the Government to buy the replacement gold.

However, if we were talking about a huge loss, say $500 million, then one isn't going to be able to sneak through a loan from the West Australian Treasury. In that case Clause 22(1) of the Gold Corporation Act 1987 is invoked, which states that "The payment of the cash equivalent of gold due, payable and deliverable by Gold Corporation, the Mint or GoldCorp under this Act and all moneys due and payable by Gold Corporation ... is guaranteed by the Treasurer, in the name and on behalf of the Crown in right of the State." This put the Government on the hook for any loss at the Mint.

Now the interesting wording is "cash equivalent", which gets to the rub of the client's question. This wording, I guess, was put in because a government's power to tax can only be in terms of money, therefore its obligations have to be expressed in monetary terms.

In practice what would occur is that the Mint would, as soon as it knew about the loss, work out the market value of the lost gold, request that "cash equivalent" from the Government, and immediately buy the replacement gold. The end effect is that the client would receive gold, not cash.

As to whether the Mint would be able to obtain sufficient gold, consider that it refines around 300 tonnes per year, say $13 billion. Total Depository liabilities are a bit over $2 billion (which is not all gold). Either way no problem getting hold of physical.

Ultimately, when you deal with the Perth Mint, you are taking an exposure to the Government of Western Australia. One may then ask can the Government handle a large gold loss. Again, consider the $13b worth of metal refined each year. All the Government has to do it apply a special "Perth Mint stuff up royalty" on gold production.

Consider also that it is near impossible for there to be a loss of the entire $2b, either as theft or fraud. With theft they would have to clean out the entire operation at both city and airport sites, including semi-finished product and dissolved gold in chemical solution mid-refining, for example. I can't see how even Hollywood could come up with a plausible plot for that gold heist. Plus we have to have the insurers renege as well, remember.

In the case of fraud the management simply cannot not have bought no metal with client funds, as that would mean there was not one ounce of physical gold in the mint or refinery. Just a little suspicious wouldn't you think and not what you want if you are trying to pull off a fraud.

So lets assume half of it is lost, $1b. Government could fund that with a five year 1.5% "Perth Mint stuff up royalty" on annual gold production. That isn't unrealistic considering that the current royalty is 2.5%.

I think the question is not what would happen if there was insolvency, but whether insolvency is even realistic, considering a) the likely probability of loss, b) the realistic maximum loss, and c) the capability of the Government to fund a loss.


Anonymous said...

Bron, there's no breakdown on whose debt is whose but the RBA has been actively buying state government paper for a while now.

The solvency of state governments is a real issue despite what the government will tell you. And you know what I think of the liquidity situation of the RBA!

Justin said...

Sorry, it's me