Publisher’s Note: We received hundreds of emails yesterday regarding Jimmy’s “nail in a box” trick. For those of you that want to find out how it was done, or would like to create your very own box, please check out this tutorial video.
Now on to today’s editorial from Adam English.
Call it like you see it,
Nick Hodge
Publisher, Outsider Club
As the charred remains of MF Global were being divided up, Jason Fane learned a hard lesson.
Even if you buy something, that doesn’t mean you necessarily own it.
Thanks to the bizarre intersection of commodities and finance, five gold bars and 15 silver bars underlying eight Comex contracts were suddenly in dispute.
HSBC was holding the gold pending delivery, and the MF Global implosion threw what should have been a simple armored car trip into disarray. HSBC had to sue MF Global’s trustee in the bankruptcy proceedings to figure out who actually owned the gold…
As Fane told Reuters at the time, “These bars are mine. We had a letter from HSBC that they were on the loading dock to be shipped to our warehouse contractor when there was some action taken by a third party to stop or delay shipment.”
All of this is due to the obscure and insane concept of rehypothecation. In its own words, HSBC was “exposed to multiple liabilities with respect to the disposition of the properties.”
Now, in a sane and reasonable world, there should never be any debate about who owns a physical asset. If you own it but cannot get it, that means someone stole it or is committing fraud.
Sadly, sane and reasonable do not apply, especially to the stark differences between physical and paper commodities as collateral.
This was a relatively small blip in the big picture. What is happening right now across the Pacific definitely is not.
Rehypothecation Explained
Some explanation is probably warranted here, so here is how it works. I’ll use the gold that may or may not be in the possession of the Federal Reserve as the example.
So a bullion bank executive wanders along and has a proposal…
He wants to borrow gold, pay some interest on it, and then return it at a later date. And the Fed loves it. After all, it gets to profit off of some metal that’s just sitting around in a musty old vault — and pump some more wealth into the market in the interim.
Other central banks love the idea, too, and the bullion banker has an easy time getting similar deals from all of them.
So the bullion banker now has possession of a bunch of borrowed gold, but can’t really do much with it because virtually no one accepts gold payments. So he needs to monetize it while turning a profit greater than the interest due to the central banks.
Thankfully, everyone loves gold as collateral… so our bullion banker hypothecates the gold, meaning he gives the gold — or, more commonly, pledges access to it — as collateral for cash.
Now is when the real fun begins, as that gold gets multiplied time and time again…
The creditor is now making money through the loan and has gold as collateral if anything goes wrong.
And there is no need to stop there… Remember, the creditor has a guarantee that it’ll at least get the gold if the loan defaults.
So the creditor goes and pledges the gold that was pledged to it as collateral for another deal. The gold has now been hypothecated again, or rehypothecated.
In the United States, rehypothecation is capped at 140% of the value of the original collateral. But rules are made to be broken with paltry fines for bankers and brokers. They just need to get the money out of the country…
So they bury legally binding clauses into their lengthy contracts to get U.S. clients to let them move their assets and funds over to subsidiary accounts in the United Kingdom.
Now there are virtually no limits. Pledged assets (such as collateral) can be rehypothecated in the U.K. without limit.
So the gold that came from the Fed was used as collateral for a loan. Then that collateral was used as collateral. Then again. And again. From bank to broker to investment firm, the original bullion has become the basis for an endless chain of guaranteed gold.
Since each and every agreement, loan, and contract depends on it, it is mitigating the risk of all of these deals if they go sour. On paper, there is a whole lot of gold being used as collateral, but the actual amount of the precious metal hasn’t changed.
What Could Possibly Go Wrong?
All it takes is the failure of the weakest link to bring the whole interconnected system crashing down. Once that happens, contagion is guaranteed for all warehouses, trading firms, and banks involved.
No one can ever be paid in full, or even have a true guarantee that they get the agreed upon pennies on the dollar if a creditor defaults.
We may be seeing that start right now in other commodities.
Over in China, the People’s Bank of China has a problem. It seems fraudulent rehypothecation is running rampant in the port city of Qingdao.
The bustling port — the seventh largest in the world — has halted shipments of aluminum and copper due to a PBOC investigation after authorities found that “there is a discrepancy in metal that should be there and metal that is actually there.”
It appears that potential fraud may also have occurred at another port in Penglai, where investigators and banks couldn’t get access to metas used for collateral.
It is too early to tell how far the investigation will go, but it is clear that it isn’t an isolated problem.
Very large multinational banks, like Citigroup Inc. and Standard Chartered, provided loans to trading firms that were backed by metals stored at the port. With the collateral in place, these trading firms get larger loans at better terms.
Commodity funding deals like these are a huge source of foreign money inflows into China, which come with much better terms than the high interest rates that Chinese businesses can expect from domestic loans.
The value of these loans and collateral is reportedly several million dollars. The news has ravaged copper and cast a pall over commodity-backed loans that spread across the globe.
This raises serious questions about the integrity of commodity warehousing in China and the contagion that could rapidly spread if asset seizures are needed.
It is also raising the ire of the PBOC and the Chinese government. The scale of commodity financing and the shadow banking system that depends on it is already raising concerns as the country tries to bolster its international standing.
Moves to position the yuan and policy changes that increase the amount of commodities needed for this type of financing hint to a large-scale reduction in these commodity-backed loans.
Gold Gains?
This fraud and rehypothecation of physical assets has been terrible for the price of the commodities affected so far, especially copper. This may seem counterintuitive, but consider the situation.
The companies that rehypothecated assets were doing it for paper money. They rarely need, or want, the copper or aluminum for anything else.
There is already far more copper and aluminum in storage than is actually needed. Unwinding positions on a large scale would just create an even greater glut and devalue the base metals further.
However, something interesting happens when it comes to gold, which is the most used commodity funding substitute in China by value.
There isn’t a glut of gold in the global market. Physical gold is already trading at steep premiums over spot prices in India and China, the two largest buyers. Mints are selling out of gold and silver coins faster than they can produce them.
If the PBOC and the Chinese government force sales of gold, a large move to cover futures hedges it has used to suppress the price of paper gold will be inevitable.
This would act like a short position squeeze, something China has avoided to date as it stocks up on gold as quickly and quietly as possible.
The price of gold could easily spring back to the highs we saw in 2011 and 2012 as the paper gold market implodes and the physical gold market becomes the benchmark.
It isn’t like China will slow buying either. It needs to continue to transfer its $3.4 trillion of reserves out of fiat currencies and into gold as it attempts to secure global financial hegemony and replace the U.S. dollar with the yuan as the global reserve currency.
The unprecedented secret flow of gold from West to East couldn’t stay hidden forever. Anyone smart enough to own gold now will be able to ride China’s coattails.
