15 September 2009

Protecting yourself from World War III: Debtors vs Creditors

Steve Keen is an Australian Post-Keynesian economist credited as having "seen it coming" in this survey of research by economists or financial market commentators. Keen was one of only eleven researchers who qualified, which included Schiff, Roubini, and Shiller.

Steve Keen is a follower of Hyman Minsky’s “Financial Instability Hypothesis”, which he summarises as:

1) Capitalist economies periodically experience financial crises;
2) These are caused by debt-financed speculation on asset prices leading to bubbles in asset prices;
3) These bubbles must eventually burst because they add nothing to productive capacity while increasing the debt-servicing burden;
4) When they burst, asset prices collapse but the debt remains;
5) The attempts by both borrowers and lenders to reduce leverage reduces demand and causes a recession;
6) If the economy survives such a crisis it goes through the same process again, with another boom driving debt up even higher, followed by yet another crash; but
7) This leads to a level of debt that is so great that another revival becomes impossible since no-one is willing to take on any more debt;
8) Then a Depression ensues.

A plausible but dismal explanation. Consider this comment on Steve's latest blog post:

"This is one of the great questions for all of history, how to get out of this. For one thing, one persons debt is another persons asset or in many cases their money. ... It is clear that everyone that has something is going to take a haircut on it. Either by a systematic bankruptcy or by a natural one."

As Steve Keen says:

Some form of price chaos has to be expected though, whatever is done. One side-effect of the bubble has been an enormous dislocation in prices, not just with overvalued financial assets, but also with drastically overinflated incomes for the financial class, and concomitant price distortions all the way through commodities.

How do you protect yourself from this economic World War III? Simply swallow the red pill and step outside the Financial Matrix: bail out of your "has something"s into precious metals and sit by and watch the annihilation as everyone else takes "a haircut".

14 September 2009

Scotiabank Certificates

The article Scotiabank and the Real Silver prompted me to have a closer look at their 2008 Annual Report. Two interesting quotes (note all dollars are Canadian):

“In Scotia Capital, revenue declined by 25%, due mainly to charges relating to the Lehman Brothers bankruptcy, valuation adjustments and generally weak capital markets. These were partially offset by record foreign exchange and precious metals trading revenues, and strong growth in corporate lending.” (p28)
“Precious metals trading revenue was a record $160 million, an increase of $44 million or 38% over last year, with higher revenues recorded in each of our major centres.” (p30).

Not surprising to see strong precious metal results from Oct 2007 to Oct 2008 (Scotiabank's reporting year). What I did find interesting is the observation by ispeakofpeak that Scotia's gold and silver certificates declined from $5,986m to $5,619m (p122), a 6.1% drop. This drop would reflect both changes in precious metal prices as well as changes in ounces held.

Unforunately, Scotia do not provide a breakdown of how many gold or silver ounces made up the certificate dollar total. But we do know that Canadian dollar gold prices were up 18% from 1 Nov 07 to 31 Oct 08 and that silver was down 14%.

If you think about it, assuming all the certificates were gold, then if the price was up 18% but Scotia's value dropped 6.1%, they must have lost a lot of ounces. On the other hand, if it was all silver, then as the silver price dropped 14% yet Scotia's value dropped only 6.1%, then they must have had an increase in ounces of silver.

Either of these would not be correct - there must be a mix of gold and silver. For sake of example and to put some numbers to it, lets assume for every $1000, $500 was gold and the other $500 silver. This is not unreasonable, I have seen many clients make this sort of "portfolio allocation" when buying precious metals. A 50:50 split by value works out as:

Gold Oz 2007: 3,996,336
Gold Oz 2008: 3,179,160
Change: -817,176

Silver Oz 2007: 220,173,903
Silver Oz 2008: 240,380,913
Change: 20,207,010

First off, some pretty impressive ounce totals, that would put them up there in my gold and silver league tables, if they were prepared to publish their actual ounce numbers.

What I do find interesting is that they lost gold at a time when everyone else (ETFs, GoldMoney, etc) were gaining. And it does not matter what you assume the split at. If you chose 75:25 gold:silver, or 25:75 it may change the amounts of gold and silver, but it still results in a loss of gold and a gain of silver.

Another interesting observation is that on their balance sheet they list Precious Metals at only $2,426m ($4,046m for 2007, p106). So dollar value precious metal liabilities only down $365m, but precious metal assets down $1,620m. This means that in 2007 they had 68% of their liabilities covered by physical but in 2008 only 43% cover.

If we look to their derivatives, p150 shows that “Foreign exchange and gold contracts, futures” with 1 year or less maturity were $2,602m out of a total of $4,239m. Gap between 2008 precious metal liabilities and physical assets was $3,193m. Conclusion: remaining 57% covered by COMEX futures and/or over-the-counter forwards.

Michael Pascoe - Gold Hater

Hat tip to Justin - Gold drops 25%! by Michael Pascoe:

So much for the rampant gold bugs wetting themselves about chart levels and such, never mind the overtime being worked in the mini-industry that exists around promoting gold.

As gold sceptics know, the yellow stuff occasionally has a day in the sun when there's fear and loathing in the financial system ...

But don't try to tell hard-core bugs that – they've long been inured to Shakespeare's warning that all that glisters is not gold.

I've created a new label called "Gold Haters" so I can keep track of them for future reference.

12 September 2009

Alan Kohler - Gold Hater

One to bookmark and shove in his face when gold is $5000. From Gold fever looks incurable by Alan Kohler:

But underlying demand is weak and getting weaker, and supply is on the rise – big time.

Gold is the commodity of craziness.

... gold investors are that unique breed of incurable optimists who don’t want to be paid any income on their capital

... it is not a currency. I can’t go into JB Hi-Fi with a lump of it and buy a TV.

It’s just a commodity they [central banks] got stuck with because it used to be a currency a long time ago and will never be again.

So gold is also the commodity of confusion: is it an investment safe haven or just a commodity? Answer: it’s whatever everyone thinks it is, and right now it’s a haven.

10 September 2009

To roll or not to roll, that is the central bank's question

Yesterday I was dismissive of the recall of Hong Kong's gold as significant, but it is another bit of evidence of a shift in central bank attitudes towards gold. Far more significant indicators include (see this MineWeb article):

* China's announcement that it had moved 454 tonnes of gold into its reserves since 2003
* Central Bank Gold Agreement (CBGA) quota being reduced from 500t to 400t a year
* Russia's Prime Minister stating that it should hold 10% of its reserve assets in gold

It points to a renewed appreciation of the role of gold in turbulent times. Recalls of gold like Hong Kong may also indicate a reassessment of counterparty risk. Moves to return gold are eminently sensible, of course: what is the point of a country having its gold out of its immediate physical control if everything goes to hell. That is really the whole point of having gold reserves. In a time of war (not that I'm suggesting that is where we are heading) you ain't going to be able to buy guns or food from another country with your funny paper money.

Some have claimed that repatriation of gold by other central bankers following Hong Kong's lead will translate into higher gold prices. However, this depends on the extent to which that gold is actually sitting in a vault somewhere or has been lent out to bullion banks. If the former, then obviously there is no effect on the price – the gold is just changing location. If the latter, then it could be potentially explosive if Frank Veneroso's estimates of leased gold of between 10,000 and 16,000 tonnes are correct.

I would point out that central banks can't just recall gold mid-lease, they have to wait till it's maturity. Consider also that the leases will have been made over varying terms, from a few months to a few years, and all at different points in time. This means that all of the central bank leases will mature over a number of years. What the term to maturity of this global lease book is, is hard to say. I'll have a stab at most of it being 1 to 2 year leases, but am prepared to stand corrected.

So not all of Mr Veneroso's leases will be recalled immediately, or to be more accurate, declined to be rolled. Plus not all central banks will decline to roll their leases (although that may change depending on how bad things get).

Also, don't fall into the trap of assuming that all of this leased gold has to be bought back from the market to repay the gold loans. This sort of simplistic analysis is based on an ignorant view that “leasing = bad”. The reality is a bit more complex. To explain, I am going to have to be a hypocrite and be simplistic myself. There are three things someone can do with borrowed gold:

1) Manufacture it into jewellery, coins or bars. Sell these for cash. Use cash to buy replacement gold. Hopefully have left over cash = profit. Repeat many times.
2) Sell the gold. Use the cash to build a mine. Extract the gold from the ground. Repay your gold loan. Hopefully have left over gold. Sell this for cash = profit.
3) Sell the gold. Invest the cash to earn interest. Hopefully gold price drops. Use part of your cash to buy gold. Repay your gold loan. Left over cash = profit.

All of the above are ultimately promises to repay gold, but not all of these have the same risk profile. I've ranked them in terms of risk and the first two are materially different to the third. In the first two the gold loan is backed by gold, either in inventory or below the ground.

In the current gold market, one would have to consider the risk of failure low for the coin/bar business – everyone wants the stuff – and I'm sure that central banks, through bullion banks, would not consider these leases high risk and necessitating recall. For jewellery, the increasing gold price equals less sales, so we could expect some business failures, so while these leases are backed by physical it would have to be considered at some risk.

For miners it is a bit more risky. Sure they have it in the ground, but lets not forget Bre-X or Sons of Gwalia. As long as any hedging is modest and loan maturities tied to production, these would also be considered lower risk by central banks.

In the case of the first two it ultimately comes down to the extent that the lease is secured: the first two are not risk free - business ventures do not always turn out as expected. To the extent that they are not secured in some way, central banks would have to be nervous, but not as much as our third category.

In the case of the short sellers, the gold is gone and only cash is left. To the extent that a miner has excessively hedged (did I hear someone say Barrick?), then they are also in this category. The crux of the issue is to what extent have the short sellers put up collateral and more importantly, have the ability to put up more (or the willingness to put up more)?

This collateral issue I will discuss in my next post. My point for the moment is to not get awe struck by the 16,000t figure (or whatever other figure is bandied about) and think it is all going to have to be bought back, and now, and therefore the gold price is going to the moon.

If central bank reassessment of counterparty risk results in requests for leases to be repaid, then it will occur over a number of years as those leases mature. This will manifest itself as a steady stream of short covers, not as a big bang, and be a source of solid "base" demand for gold for a number of years.

09 September 2009

Bubble top indicators

The report that Hong Kong requested the return of its 2 tonnes of gold to be stored in its new vaults and its suggestion that other Asian countries do the same and store their gold with them resulted in a wave of uninformed hype.

Statements like “the move deals a significant blow to London's historical role as a global hub” (from the aptly named Fool.com) and this weird non-article from a Marvin Clark that is all questions and no answers or opinions are typical of the new breed of gold commentary.

With reported central bank holdings of 30,000t, how can anyone think 2t is “significant”, even if the whole lot had been short sold by whoever they had it “stored” with? As one wit commented, “I moved my BBQ from my mom's house to my house last week. According to the vague premise of this mysterious 'logic', my BBQ must be going up in price soon!” They are in the running for my quote of the year.

I would also note the similarities between the Hong Kong announcement and this report on Dubai: talk of Dubai a “natural choice” for central banks in the region, Dubai to be home to gold backing an ETF. Well, they can't all be. These attempts at cracking London's fix (pun intended) on gold trading and settlement occurs with some regularity and is met with a yawn from experienced gold players. Every now and then a country tries to become a “bullion centre”: Shanghai, Thailand, India. They never get off the ground because the rest of the world doesn’t trust them, or trusts them less than London.

Unfortunately, I have noticed an increase in gold commentary from people who have no experience in the gold markets, and it shows. I suppose if no one wants to read your opinion on a leverage stock play, what else are you going to do but write about what is hot, even if you know sweet FA about it.

Editor to Journalist: “hey, gold seems to have passed some magic number, go write something on it for tomorrow's paper.” Journalist searches for last newspaper article on gold, does a google search and picks up some third hand commentary which misinterpreted “Gold ETFs allowed for EFP transactions” into “Gold ETFs allowed to settle COMEX futures”, and mashes it all together with some clich├ęs and there you have an article for consumption by the general public who believe that the financial journalist knows what they are talking about.

I am thinking of starting an index of commentaries on gold and more specifically, the number by those who have never commented on gold before. I think it would make a very good bubble top indicator to be used along with the “receiving stock tips from a shoe-shine boy” (today to be substituted with taxi drivers I suppose). The number of Kitco forum posts might also be good, particularly the occurrence of the text “to da moon”.

08 September 2009

But when we buy, the price goes up

From China alarmed by US money printing quoting Cheng Siwei, former vice-chairman of the Standing Committee and now head of China's green energy drive:

"Gold is definitely an alternative, but when we buy, the price goes up. We have to do it carefully so as not to stimulate the markets," he added.

This is a strong contender for my quote of the year.

Capital Gains Tax and gold

Question from a reader:

“No-one seems to be able to give a clear answer due to the sorry state of knowledge about PM’s in Australia but seeing as you work for the Mint, are an accountant, and want to make this site a source of information for Australian gold investing, are you able to make some comment about the capital gains treatment of gold bullion in Australia? Are there any precedent cases in tax law? In particular, is the conversion of unallocated to allocated considered a capital gains event? I know that you are not able to give investment advice but perhaps you could give some hypothetical situations or similar.”

Before I start, let me say that my comments below are general in nature and do not take into account the specific taxation circumstances of each reader. Readers should not rely on what I say and should seek their own independent advice on the taxation implications relevant to their own circumstances before making any investment decision.

The only publically available information on the tax treatment of precious metals in Australia I know of is that contained in the Product Disclosure Statement (PDS) for our ASX listed product, Perth Mint Gold (PMG). This product is structured as a right to receive gold, so is different to unallocated or allocated, but it does give some pointers as to the likely treatment of physical bullion.

Note that the PMG PDS advice assumes an Australian resident individual taxpayer who acquires PMGs and holds them on capital account, in other words the frequency of your trading would not constitute carrying on a business of trading or dealing in gold.

Firstly, gold is a Capital Gains Tax (CGT) asset. Some gold investors seem to think that gold is a special asset to which the normal tax rules don’t apply. Sorry, it is just like any other real asset, like property. It is taxable.

The PMG PDS advice notes that gold does not earn any income and that it is held with the intention of selling it for a capital gain. This affects the treatment of the costs incurred in acquiring and storing gold. Below is a summary of the tax issues for PMG:

* Sale of PMG on ASX [same as sale of gold]: Disposal of PMG is a taxable CGT event. 50% Discount may be available if PMG held for more than 12 months.

* Physical Settlement [same as unallocated conversion to physical]: No CGT event. Costs of acquisition and exercise of PMG become part of cost base of the gold.

* PMG Management Fee [same as storage fee]: Not deductible in the year in which it is incurred. Forms part of the cost base of the PMG. Can be utilised to reduce any capital gain on the disposal or cancellation of the PMG. Does not form part of the reduced costs base of the PMG and so cannot increase any capital loss on disposal or cancellation of a PMG. Not a cost of acquiring or exercising the PMG. Will not become part of the cost base of any physical gold a Holder acquires through exercising the PMG.

I think the sale of gold and storage fees advice for PMG would apply to physical gold. I am not so sure about the unallocated to allocated conversion because the exact advice on Physical Settlement refers to the option nature of PMG: “Under section 134-1 of the 1997 Tax Act, any gain or loss on the exercise of an option is disregarded and any payment made to acquire the option, plus any payment made to exercise the option, will become part of the cost base of the asset acquired on exercise of the option. Therefore, no CGT will arise if the Holder completes an Exercise Notice requesting physical delivery of gold bullion.”

I think it would be important in any unallocated to allocated (or unallocated collection) transaction to ensure that you are only invoiced for fabrication and storage/delivery and that it is not processed as a sale of unallocated, purchase of allocated. Common sense interpretation is that conversion of unallocated to physical is merely a change in form and as you do not give up the gold in exchange for cash, there is no CGT event. But since when does tax law make any sense? Always best to get specific advice from a tax expert.

07 September 2009

How to protect your privacy and your gold

Question from a reader:

"I have been acquiring Perth Mint silver and gold in the depository scheme and am concerned about confiscation issues in the long term. Probably it will not happen, but again given the mindlessness of recent policy decisions there is no reason why the Australian government could not just decide to tax the gains at a punitive level – ‘because people are making unfair gains from it’ or some other vacuous reason. Seems to me the main risk is not holding bullion, but also the 'privacy risk' if you want to call it that, that the government knows that you've got it and can therefore either tax it highly or confiscate it. Are you able to make comment about how best to acquire completely private gold and silver (ie no record of the sale therefore no one knows you’ve got it and therefore can’t confiscate it), in quantities of up to 100 oz?"

The scenario you suggest is certainly probable in any country. In an environment where other assets have declined and gold is $5000, the politics of envy may come into play. Classic example of this is the Luxury Car Tax introduced in Australia in 1986. While one can expect that a populist "gold profits tax" would get support, I think it is an open question as to whether it will go down well in Western Australia considering the high profile of gold mining in this state.

As I discuss in Australian Gold Confiscation, secessionism would be "in play" in such an environment. A "gold profits tax" could be considered as an Eastern States Federalist tax grab on Western Australia's wealth, and could provide yet another reason to secede.

As to Government knowledge of your gold, note that the law only requires Australian bullion dealers to record your identity for purchases above $5000, not report them (unless you give cause for the bullion dealer to believe it is a suspicious transaction).

Therefore for the Government to confiscate, it will first need to personally visit each bullion dealer and go through their sale records. This gives you a bit of time between announcement of confiscation and a knock on your door. It is possible that the data collection will happen in advance of an announcement, but it is likely that rumors would circulate quickly.

In any case, those looking to take possession of physical gold should always consider the privacy implications. The risk here is a thief getting hold of the records of a bullion dealer or courier company. One needs to weigh up the convenience and cost of a telephone or Internet sale (which will leave records) versus a cash and carry purchase from your local bullion dealer.

The only way to protect yourself against this risk is to establish a relationship with your local bullion dealer and buy in cash under the relevant reporting/recording limit ($5000 in Australia). There is nothing illegal about buying a little gold with each pay packet, and most bullion dealers would understand that you are a prudent saver and not a drug dealer. But doing twenty $4990 transactions twenty days in a row would be considered a suspicious transaction and reportable.

For those whose personal circumstances mean the risk of theft is greater than privacy/confiscation considerations and thus choose to store their gold in a facility, just a word of warning not to get tricky with your identification. It needs to be clear to the facility operator who is the beneficial holder of the gold, otherwise you may have trouble establishing title to it (or being impersonated) in the future.

For example, even if there were no account identification requirements for bullion, the Perth Mint Depository would still want photo identification as an additional security measure. It is really the only way we can ensure that the person standing at our doors to collect your metal is you.

By way of example, a couple of years ago we had a call from a person who gave us an account number and account name and wanted to sell. However, he did not have the password, nor was he a signatory, so we could not take his instruction or reveal any details of the account. He gave us details, like purchase dates and amounts, that did correlate exactly with the account, but we couldn't confirm or deny any of that - because he was not identified on the account. He became extremely agitated, but to no avail.

It turned out that he had the account opened in the name of a company by a broker/agent of his and they were the nominee directors and signatories. This privacy mechanism may have sounded good at the time, and maybe he had some other agreement with the broker to ensure they could not abscond with his metal. However, whatever structure he put in place, he had not considered the scenario where his broker was arrested and put in jail!

Not being keen contact his broker in jail, there was no way for him to get the broker to give us an instruction. He therefore had to wait, unsure if the broker had cleaned out his account. There is a happy ending to the story, as the broker did eventually get out of jail (but it was some months) and put in the sale instruction for him. In some cases, privacy may be too much of a good thing.

02 September 2009

No Massive Institutional Gold Market Change

Trace Mayer writes some good stuff, but his recent Massive Institutional Gold Market Change article hypes an midly interesting strategic development in the gold market. There are two statements he makes which are not correct.

“gold demand that was previously satisfied with physical bullion through forward contracts between private parties can now be satisfied with unallocated gold accounts”

This is the key on which the whole article hangs. The problem is that a significant majority, if not all, of institutional forwards are already settled via unallocated. Accordingly, this move by CME is not “a massive change” in the market – OTC market transactions are primarily settled via London unallocated accounts, and will continue to be if they move to CME. No change here.

As a result this so-called "scheme" provides no support for his conclusions that it "will allow for gold demand to be shunted into gold substitute products and keep the price of gold in fiat currencies low" or "the reason for this move is that physical gold bullion is getting increasingly scarce".

“Why the CFTC would allow supposedly gold-backed ETF shares to satisfy the physical commodity component in an exchange of futures for physical transaction” and "like settling either COMEX futures contracts or OTC forwards with GLD ETF shares"

That announcement is about Exchange of Futures for Physical (EFP) transactions, not physical settlement of a COMEX futures contract. I checked COMEX rule 113.02 and there is no mention of ETFs being allowed - only physical is allowed.

The issue with EFPs is explained better by Tom Szabo. His key point is that an EFP is an "exchange" and there is no change in the number of futures at the end of the transaction - therefore EFPs do not settle a COMEX futures contract as Trace claims. I would also refer to the comments of a retired precious metal wholesale dealer who comments on Seeking Alpha.