Thursday, 15 April 2010

Where is the gold?

John Mangun
Outside the Box

Do you like conspiracy theories? Is The Da Vinci Code on your most-read list? Still wonder who killed President Kennedy?

Amid all the turmoil in the global financial markets these last two years, several “conspiracy theories” have come to the front. There is no question now that some major financial institutions in effect plotted to conceal the debt problems of Greece by hiding that country’s obligations through a series of transactions that masked the true extent of the Greek government borrowings.

There is no question that bankers knew the potential worthlessness of the subprime mortgages they packaged as respectable investments. Even the Federal Reserve Bank of New York concealed the extent and purpose of the multibillion-dollar bailout of AIG which protected the interests, not of the public, but of private banking firms that did business in the shadowy investment vehicles that AIG bought and sold.

Yet the longest-running conspiracy theory in the financial world and one that you are probably not aware of is, where is all the gold that banks and governments are supposed to be holding in their vaults?

Although the world’s currencies have not been backed by gold for three decades, all major governments have kept some currency credibility by the fact that they hold a substantial amount of physical gold in reserve. The most famous of these holdings is the United States government gold stored at Fort Knox, Kentucky.

It has been taken as an article of faith that this gold exists in physical form. However, there is little proof that governments and banks actually still have all the gold that they claim to possess.

The Bangko Sentral ng Pilipinas (BSP) claims on its statement of assets that it is holding some $6 billion worth of gold. That may be true in an accounting sense, but it may not be true that the BSP is actually physically holding anywhere near that amount.

The US government says it is holding tens of billions of dollars worth of gold. That is possible but no one really knows. There has not been a physical audit of the gold supposedly stored in Fort Knox for nearly 50 years. It is possible that Fort Knox is not filled with shiny yellow gold, but with pieces of paper, receipts for that physical gold that has been loaned to another government or financial institution.

Institutions and individuals buy and hold physical gold. They often store it at companies called bullion banks vaults. When you store it, you are given a receipt saying you have a certain amount of gold on deposit. It works the same way for money deposited at a bank. The bank does not keep your physical money in their vaults but loans it to a third party that signs a promise to pay. The bank can do this because it is unlikely that all of its depositors would want cash at the same time. But if that ever happens, it is called a bank run and the bank can fail because there is not enough free cash to cover the deposits.

Further, a $100,000 cash deposit may be backed by a collateralized mortgage on a house now worth only $50,000. That is what has caused hundreds of bank failures in the US recently.

Because these bullion banks are not well-regulated, it is probable that they have sold or loaned the gold they are supposed to be holding. The latest potential scandal is with ScotiaMocatta, the only bullion bank in Canada. Witnesses who have seen their vaults report that there is very little physical gold inside. They have sold or loaned their depositors’ gold to someone else, and if all the people who theoretically have gold stored there want delivery, there will be a failure.

Financial giant Morgan Stanley was sued and settled the lawsuit for selling clients gold they did not have. Morgan bought the receipts—which are promises to pay—from others to back the claims for the physical gold that their clients purchased. There was no physical gold.

It is likely that many countries (hopefully not the Philippines) have loaned their gold to companies like Morgan Stanley and that many of those government bank vaults are empty, holding only paper receipts.

I am not saying it has happened, but this could be the reality. Say for a moment that the BSP loaned out its gold when the price was $500 per ounce. The borrower sold the physical gold at that $500 price, hoping they could buy it back at $400 to make a profit and then repay the BSP with physical gold. Now that the price is $1,000, the borrower of gold from the BSP cannot afford to buy back.

So the question that is being asked about and to the world’s central banks is: Do you still have the physical gold in storage or are you holding receipts and promises to pay that are potentially worthless?

I want to think that the BSP is holding physical gold because I sincerely believe that the BSP is well-managed by professional and financially prudent executives. Yet when looking at the BSP financial statement and their press
releases, there is no firm confirmation that physical gold is being held in the government’s vaults. The BSP simply includes “gold” as part of its total gross international reserve assets. But the BSP could be valuing the receipts for the physical gold that it has loaned out, not physical gold holdings.

If that is the case, then that $6 billion of gold is not gold but a paper asset which has unknown value, that the Philippines may or may not get back in the future.

I hope I am wrong about this.

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