What a Run on Gold Looks Like

By Patrick A. Heller
Numismaster.com
Monday, October 19, 2009

http://www.numismaster.com/ta/numis/Article.jsp?ad=article&ArticleId=8039

Rob Kirby of Kirby Analytics in Toronto has reported details of a recent “run on the bank” in the London Bullion Market Association Gold Exchange.

The London Bullion Market is the world’s largest gold exchange with daily turnover now running almost equal to a year’s global gold mine output. Since this market theoretically is trading contracts for actual delivery of physical metal, gold sellers are supposed to be ready to deliver the real thing and not paper.

Kirby attributes his information to impeccable reliable sources that on Sept. 30, the last trading day for the LBMA September 2009 futures contracts, deep pockets buyers “bought” substantial tonnage worth of September 2009 gold contracts. The buyers then told the sellers that they wanted to take immediate delivery of the physical metal.

This created a panic for at least two of the sellers – JPMorgan Chase and Deutsche Bank – because they did not possess sufficient physical gold to deliver. This “naked short” by these banks was technically illegal under exchange rules.

As the banks did not have the physical gold, one or both of them asked the buyers if the contracts could be settled quietly for cash. Kirby reports that the buyers were offered at least 25 percent above the gold spot price to accept cash in lieu of the metal, so that the matter could be kept private. The purchasers continued to insist on physical delivery and agreed to give the banks five business days to come up with the gold.

At least two central banks jumped in to lease gold to help the banks deliver physical metal. One has been identified as the Bank of England because the gold it provided was of too low a purity to meet the good delivery standards of the LBMA.

The crisis caused by these purchases has been managed for the time being. However, this run on the bank indicates that physical gold supplies are much tighter than has been reported. There are other indicators that gold supposedly stored in reliable locations may not all be there.

For instance, in March 2008 a story that was reported in Europe, but not in the United States, detailed how Ethiopia’s central bank had shipped some consigned gold to South Africa’s central bank, only to learn that much of it was gold-plated steel. The Ethiopian central bank sustained losses in the millions of dollars. A number of people were prosecuted, including the assayers who reported that the bars were genuine.

There is a story now circulating that I have to classify as a rumor. Supposedly it has been discovered that some of the gold bars (maybe including some that the Bank of England provided to help JPMorgan Chase and Deutsche Bank) that have come out of bonded warehouses for delivery on LBMA contracts are filled with tungsten. Tungsten is the only metal whose density matches that of gold, so that one could not detect it by weight or physical dimensions. The only way such counterfeit bars could be detected without destroying them is to check for their electrical conductivity.

Curiously, tungsten, which currently trades for about $100 per metric ton, is a metal that has had few new applications developed for some time. Typically, its demand has fluctuated right in line with overall economic growth. However, since 2002, demand has increased on the order of 10 percent a year. A new Far East buyer for a large quantity of tungsten appeared last week, who is suspected of being a front for the real buyers. It is conceivable that some of the rising demand for tungsten is to manufacture counterfeit gold bars.

Should there turn out to be any truth to the rumor of counterfeit gold bars in the “guaranteed” inventories of the LBMA, that would spark a public clamor for audits of all gold bars held by all of the world’s gold exchanges and exchange traded funds. Such an event would almost certainly lead to panic buying of other forms of physical gold such as coins and smaller ingots.

Already known is that some of the U.S. gold reserves are in the form of bars of around 90 percent purity. These were made from U.S. gold coins melted down in the 1930s. Some have been liquidated in the London market over the past few years.

Either tightness in supply or the revelation that some supposedly secure physical gold kept for backing paper contracts is either counterfeit or of lesser purity would spark a surge in physical gold demand. If both turn out to be fact, the effect would be magnified. In the most extreme circumstance, it could literally happen that people could wake up some morning and find that virtually all of the world’s available physical gold had been bought up as they slept.

In another significant development last week, Barrick Gold Corporation announced that it would be issuing $1.25 billion of 10- and 30-year bonds for the purpose of redeeming more of the company’s open gold hedges. The speed with which this followed the company’s $4 billion stock issuance for this same purpose implies that Barrick is even more concerned about the price of gold rising in the near future. In addition, it also indicates that the huge loss that Barrick booked last month for its hedge contracts was not large enough, as I wrote at the time.

Patrick A. Heller owns Liberty Coin Service in Lansing, Michigan and writes “Liberty’s Outlook,” the company’s monthly newsletter on rare coins and precious metals subjects. Reprinted with permission.