The credit-default swap and the bullion banks; a question and a statement
I apologize for the unusual lack of content on UR. I have been visiting with family, have been working quite a bit on Nock/Watt, and sending too much email to Larry Auster.
(Ponder the fascinating, even (dare we hope?) historic, interaction between Auster and David Mills. I knew Mills had some kind of Hollywood job, but had no idea he was such a big shot. Undercover Black Man, RIP—a real-life Giant Negro. Alas, the real pass and the fake live on.)
Also, I note that the legitimacy of maturity transformation has somehow become a legitimate topic of public conversation. As Kling says:
Evidently some radiation from Mencius Moldbug has leaked into Harvard Yard.
Or not. Let’s not forget that a discovery is not an invention. The truth, being true, is accessible to all—though not all will get it all. And so far as I’m aware, all priority is due to Mises (1912):
The credit that the bank grants must correspond quantitatively and qualitatively to the credit that it takes up. More exactly expressed, “The date on which the bank’s obligations fall due must not precede the date on which its corresponding claims can be realized.”
I.e.: maturity transformation considered harmful. And no one, except Professor Bagus, even gets this citation right. Such is scholarship, in the early 21st century.
Still, the truth is the truth and it is always nice to see people stumbling over the thing, even if they kick it in the wrong direction. And even though it contradicts my predictions and corrodes my pessimism. My pessimism is restored, however, by seeing how few of these distinguished professors understand the problem completely and correctly. More on this later.
We proceed to the matter of the title. I wanted to just briefly make one statement and ask one question. The statement is true, so anyone who cares to believe it may believe it or not. The question is one whose answer I do not know. The information is not public. However, it is quite important, so if anyone has it, they should feel free to disclose it to me. I have a guess at the answer, but I could easily be wrong.
The statement is: the credit-default swap is not a free-market financial institution.
The question is: are bullion banks net short in the metals market?
Let me deal with the question first. First, I know that bullion banks (i.e., financial intermediaries which maintain a balance sheet in gold and/or silver—which, these days, are generally subsidiaries of much larger, more important banks specializing in funny-looking little pieces of paper) are transforming maturity in gold and/or silver. This is why they’re called “banks.” My question is not whether they are transforming maturity, but whether they are (as some claim) net short.
The conventional explanation of the bullion bank is that the bullion bank is not net short. Rather, it has a neutral position, with gold assets balanced by gold liabilities, so that the bank does not suffer automatic and trivial gains and losses, as accounted in either dollars or gold, when the gold-dollar ratio goes up and down. Similarly, a regular bank which calculates its accounts in dollars does not balance these with loans in euros, because then its solvency would be exposed to a highly unstable variable, the dollar-euro exchange rate.
The bank is a maturity transformer, however. It sells gold short and buys it long. Again, this is what a bank does. So, for instance, it balances a liability, such as a promise to deliver Comex gold in 3 months, with an asset, such as a promise by a gold miner to grind up that mountain over there and suck it through a pond of mercury, 3 years from now. The only difference between this and regular banking is that gold is a natural currency, not a fiat currency.
I respect this explanation considerably. One, it is very plausible. Two, I once asked a fellow blogger whom (a) I greatly respect and (b) has experience (albeit from the ’80s) in bullion banking, and he confirmed that, from his perspective, it would be shocking if a bullion bank were to carry such a dangerous exposed position.
Against this we have the various disclosures made from GATA etc.—including, most recently, the strange story of Andrew Maguire. The best I can say is that this is a noisy, untrustworthy source. For one thing, it does not appear to me that they have any individual or collective clarity on the distinction between maturity transformation (which is bad) and net shorting (which would be really bad). They strike me as honest, but not entirely and completely clueful.
For instance: when Jeff Christian says that there are “multiples of hundred times” more “paper gold” than actual gold in London, by “financial gold” does he mean “unbacked promises to deliver actual gold” (i.e., “naked shorts”) or “forward contracts to deliver actual gold?” Of course, mountains are hard to grind and so on, and not all contracts will be delivered. However, there is a very important qualitative distinction between these answers.
For those who feel the bullion banks are neutral, I ask: if Comex gold shorts are balanced by long forward hedges, why does the Comex open interest of commercial sellers, that is, bullion banks, fluctuate dramatically on a short-term basis? Forward mining sales, etc., wouldn’t do that.
Where are all these legitimate hedges? How much gold has actually been sold forward? For the past few years, gold miners have been shrinking their hedgebooks. Has the amount of “paper gold” in London decreased accordingly? According to GFMS at the link above, there are only 236 tons of legitimate commercial promises to ship forward gold, half of which are financial in nature. There are 25 tons of actual gold due and presold from the gold mines in 2010; 30 in 2011. Annual gold production: 2,000 tons.
Why does bullion banking even still exist? And what was Jeff Christian thinking when he said, under oath,
August of 2008 when there was an explosion in the short positions in gold and silver held by the bullion banks on the futures market and he seemed to imply that that was somehow driving the price down. If you understand how those bullion banks run their books, the reason they had an explosion in their short positions was because they were selling bullion hand over fist in the forward market, in the physical market, and in the OTC options market. Everyone was buying gold everywhere in the world, so the bullion banks who stand as market makers were selling or making commitments to sell them material and so they had to hedge themselves and they were using the futures market to do that.
Translation: the short position of the bullion banks exploded. To balance this short position, they purchased a long position… from whom? “Themselves” is not a valid answer.
Everyone was buying gold. Therefore, the bullion banks had to sell a lot of paper gold. They sold so much paper gold that, even though everyone was buying gold, the gold price went down. Everyone was buying gold, but the bullion banks wanted to sell even more paper gold than everyone wanted to buy. Hence, in the unified actual-gold-and-paper-gold market, demand increased, but supply increased even more than demand increased. Hence the price went down.
Christian’s theory, expressed later as a correction, that other random investors in August 2008 were liquidating long positions, does not strike me as reasonable. Who, exactly, holds all these long forward positions in gold? There is a name for an entity which holds long forward positions in gold: a bullion bank. Ordinary large investors, when they hold gold, seem to generally hold futures, sometimes ETF shares. (In the first case a dreadful mistake, in the second demanding strong due diligence.) If futures are liquidated, open interest goes down, not up. If ETF shares are turned into metal and sold to India, it does not change. But in fact, it went up.
This seems like convincing evidence that the bullion banks are net short. However, it just does not make sense to me that the bullion banks are net short. For one thing, I trust my source. For another, gold prices have generally been rising over the last decade. If the bullion banks were net short, they would have been losing money continually throughout this period. This perhaps could be offset by some pattern of manipulation, but it seems like a very ugly, un-bankerly way to make a dime.
When the impossible is eliminated, all that remains is the improbable. Therefore, my guess is that “paper gold” is effectively, although perhaps tacitly, backed by sovereign gold reserves, many of which were “leased” (i.e., balanced with short sales—or, if you prefer, traded for paper gold, or “gold deposits,” at bullion banks) in the ’80s and ’90s.
It is not clear whether the US gold reserve has ever been so encumbered. It would not need to have left Fort Knox to do so—given modern financial engineering. After all, by holding 8000 tons of gold, USG is long 8000 tons of gold. It can certainly afford to sell a few paper promises of gold, future or present. It is not exactly authorized to do so, but words have been bent before.
This would require a remarkable amount of collusion between bullion banks and governments—in the case of 2008, for instance, it would mean that it was actually USG (and friends) that was minting the paper gold, the banks just being low-level pushers of this paper. Without being net short, the bullion banks cannot manipulate the market; they can only profit (perhaps with a bit of front-running) from higher powers which manipulate the market. Short of aliens or Elvis, this can only be the OECD governments. It can only happen with at least the consent of Washington.
If this is a fact, it is not a fact calculated to attract serious and thoughtful investors to “paper gold.” Basically, it means that these governments are surreptitiously using (and, inevitably, consuming) their gold reserves, to artificially increase the price in gold of their paper currencies. It is very easy for people who want to hold gold to exit from this scheme, by holding actual gold and not paper gold.
On a historical scale, this is not shocking at all. We know that the same thing was going on as recently as the ’60s, with the London Gold Pool. But on a historical scale nothing we mention here at UR is shocking. On the scale of current events, this conclusion is quite shocking—because no such scheme can withstand any serious exposure. Again, those who want to get out, can get out. (Even the fact, acknowledged by all, that gold futures are maturity-transformed, is more than enough reason not to hold gold futures. RIP, bullion banking.)
Moreover, if my supposition is indeed correct, there are two questions. One: are the OECD governments, themselves, net short? I.e.: have they issued less paper gold than the actual gold they hold, the same amount of paper gold, or more paper gold? The last would be madness for a mere private enterprise, but a sovereign can get away with a lot. Heck, it’s pretty much the way we got the fiat currency we have. Also note that these governments have quite a bit of gold—but very little silver. And the same patterns are seen, even more distinctly, in the silver market.
The most significant fact about this mess, which I think almost everyone has ignored, is that USG and its little friends just do not have the political and economic strength to either (a) peg the price of metal to dollars, etc., (b) make dollars, etc., freely competitive with metal, or (c) prevent private citizens from hoarding metal (e.g., with a 1933 style gold confiscation). Is there a (d)? There must be, but here my magic 8-ball becomes quite murky. It is also very unclear how long this game, if it is the game, can continue.
So on to the second point: credit-default swaps. This is quite clear. A credit-default swap is not a free-market financial instrument.
Why? Because there is only one reason why a party holds a CDS. They have government permission to overvalue these securities on their balance sheets. CDS are an artifact of incorrect government-mandated accounting (specifically, via the NRSROs).
What is the market value of a CDS? There are two answers, A and B, the wrong answer and the right answer. The wrong answer is: the market value of a CDS is the chance that the credit default will happen, multiplied by the face value of the CDS. X times Y.
The right answer is: the market value of a CDS is the chance that the credit default will happen, multiplied by the chance that the CDS issuer will not default, multiplied by the face value of the CDS. X times Q times Y. So, if you buy a CDS on an IBM bond from AIG, its market value is the face value, times the probability that IBM will go bust, times the probability that, if IBM goes bust, AIG will not go bust.
Now, the people who invented these things are not actually stupid. They didn’t forget about Q. What they said was: Q is the probability that AIG will go bust. They then said: AIG has an AAA credit rating, which means it will never go bust, with 99.999% probability or whatever. Setting Q to basically equal 1, they then arrived at the desired calculation of value, i.e., X times Y.
But this is just bad probability, which makes it bad accounting. The probability that AIG will go bust if IBM goes bust is a conditional probability. X and Q are not independent variables. For one, AIG, having written a lot of these IBM CDS, will lose a lot of money if IBM goes bust. And any event that affects IBM may affect other companies on which AIG has also written swaps.
The CDS buyers also required (or should have required) AIG to collateralize these positions. But collateral, too, is not a magic amulet against counterparty risk. If you’ve insured $3 billion worth of diamonds, and you only have $100 million to cover them, when the probability that the diamonds are stolen flips from very low to certain, someone will get burned. It’s just math. Until capital equals exposure, someone has to end up holding the bag.
Collateralizing an undercapitalized insurance market does not protect the market from insolvency. It just means the market melts down in a flash, as all positions are liquidated—the price of CDS will rise faster than the sellers can buy back their CDS. Someone won’t be able to; and whoever holds his CDS will experience the ugly stick of Q. If collateral is centralized through a clearinghouse, that clearinghouse must be able to cover all the diamonds it insures, or the clearinghouse has significant default risk.
As we saw in the case of AIG, of course, the problem was solved. Who wound up holding the bag? You, of course, dear taxpayer. And this is why I say that CDS are not a free-market instrument. The Q is all on you.
The basic problem with CDS as a free-market instrument is that, while there is quite a bit of demand for the product of exposure X * Y, there is little or no demand for X * Q * Y. For instance, if you buy an IBM bond and an AIG CDS against it, you have replaced your exposure to an IBM default with exposure to an AIG default.
In reality, no party (except USG) is really so much more financially secure than IBM, that it’s worth writing insurance on IBM. The financial product that the market demands is not CDS, but CDS without counterparty risk. This is a useful product indeed, but not a free-market product. No free market can produce any such thing—it takes a fiat-currency issuer. To guarantee IBM’s loans risk-free, you would need to cover every dollar of IBM loan with an insurance dollar, which would be ridiculous, unprofitable, stupid, and completely defeat the purpose.
Thus, people buy CDS because (and only because) incorrect accounting principles allow them to incorrectly disregard Q, the probability of the CDS issuer defaulting, thus assigning these securities excessive value on their balance sheets. When they become insolvent as a result of this miscalculation, USG’s infinitely-flexible rubber-dollar absorbs the slack, and the Fed becomes the new team sponsor of Manchester United.
Well, thank god for funny money! If not for M. Danton’s beautifully-engraved new assignats, there would be no commerce and no work for anyone, and we’d all be sitting around on our butts, blogging and watching Manchester United. Or so Paul Krugman would have you think.