### **Banks and Gold** A \$66 billion Problem

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Simple Math & Common Sense:

A \$66 Billion Problem

By John Hathaway

Donmt be confused by self-serving outcries from various parties trapped in the gold short squeeze. I am amazed to

hear reports that so-and-so has restructured their hedge book or that this or that group has covered its short

position in gold. Such statements are misleading, if not false. What is happening is that the self-made victims of

the growing gold short squeeze are passing the hot potato back and forth among themselves in a desperate

attempt to wriggle free. This activity amounts to little more than frenetic paper shuffling. The gold market is in

the throes of a spreading credit crisis.

The short squeeze will be over when, and only when, there has been a full repayment of the bullion deposits

owed by dealers to the central banks. These deposits are the foundation of the Golden Pyramid described in our

recent Themes Express article. Ex repayment of central bank gold, the massive short squeeze we forecast when

gold was trading around \$250/oz a few weeks ago will continue even if distribution of risk among various

players changes slightly with their desperate maneuvers.

Letms do the simple math. At 6000 tons, a conservative estimate based on the usual reputable sources, the mark to

market value of the short interest in gold at \$330/oz is approximately \$66 billion. That doesnmt sound like a very

big number in todayms financial markets with flows several multiples of this amount, until you consider how

concentrated the exposure is relative to the thin financial resources of the participants.

For example, a 1% increase in the cost of carry equals \$660mm. When most of this business was put on the

books, the cost of carry was around 1% per year. Based on current lease rates, there has been a negative swing

of \$2.6 billion. By the way, as the price of gold moves higher, so does the interest burden. A \$10/oz increase in

gold equals \$1.9 billion. In the last two weeks since the ECB announcement that lending would be capped, the

\$60 adverse swing has added over \$11 billion to the shortsm obligation to repay. Whoms paying the price?

What is the equity of the gold mining industry, hedge funds and bullion desks involved in this position? The

world gold mining industryms equity on a very rough basis is only \$20 to \$25 billion. The equity of the ten or so

major bullion traders is very likely less than \$1 billion, even though the resources of the institutions that stand

behind them is far larger. The depleted equity of the hedge fund community may stand at \$30-\$50 billion. Only

the bullion desks are committed to trading gold. Hedge funds of course have no generic interest other than to

make a profit. Even the mining companies have other things to do with their capital than trade bullion.

For example, Chase Manhattan reports gold derivative notes outstanding of \$20 billion. These are lstructuredn

notes where the obligation of the issuer varies, possibly quite dramatically, with the spot price of gold. Chase

was among the most aggressive of the bullion banks, doubling its gold derivative position over the last 18

months, at the same time gold prices were plummeting. The book value of Chase was \$23 billion as of 6/30/99.

One of their clients, Ashanti Goldfields, is suffering severe margin calls on their gold hedge, which stands at

10mm ounces. Each \$10 increase in the gold price costs Ashanti and/or its bankers an additional \$100mm of

pain. Ashantims stock has declined by more than 50% in recent trading, despite the sharp run up in gold prices.

Ashanti seems likely to disappear as a freestanding entity, and their shareholder equity could easily vaporize

despite valuable, world-class assets.

Ashanti is not alone. Several other companies suffer from hedge book troubles at current prices. A further \$100

run up in the gold price would raise questions on even more. Since the liquidity and financial resources of the

gold mining industry are limited, the financial exposure to higher gold prices will inevitably pass through to the

bullion dealers that were so eager to put this business on the books in the first place.

In a conference call, Ashanti management characterized the relationship with their 17 bullion banks as lorderly

and stable,n yet another misleading statement emanating from the current mess. In reality, the only step that will

spare Ashanti and its bankers further misery is a 10mm oz buyback and delivery of physical gold to satisfy the

credit. Of course, a \$3.2 billion purchase order for physical gold cannot be filled for the time being. More likely,

Ashanti will be carved up and its credit subsumed by that of Barrick, Anglo, the government of Ghana, or some

other better balance sheet. The price of a rescue will be high both to the existing Ashanti shareholders and the

bullion dealers. The risk profile of the bullion desks will then deteriorate in return for the appearance of lbusiness

as usual,n awaiting the next disaster. As the gold price rises, the credit position of the bullion dealers and

producer hedge books will deteriorate further. The process could well accelerate, and possibly culminate in a

divine intervention by the central banks in yet another spectacle of ltoo big to fail.n By then, the good name of

gold should be restored.

Expect to see a retreat of capital from gold hedging and short selling in the coming months. Within the gold

mining industry, a witch-hunt mentality towards hedge book risks is certain to commence. Pressure for

buybacks will grow. The speculative blood lust for shorting gold among the hedge funds is a thing of the past. If

anything, hedge funds are likely to line up on the buy side to attack the short position. We doubt whether risk

managers of financial institutions will favor additional allocations of capital to the trading of paper claims based

on gold in the bullion trade. Essentially, credit has seized up in the paper gold market.

Once the initial shock has been absorbed, the paper gold market should enter a protracted workout mode in

which producers buy back hedges and speculators steer clear of the short side. Issuance of equity shares to fund

hedge book buybacks, in other words, outright purchases of gold, would not be surprising. There is just one

problem. If the gold producers all act simultaneously, as they did in herd-like fashion on the way down, the gold

price will skyrocket. Reason: there is no physical gold to buy, other than from the central banks, and then only if

they choose to sell or lend additional quantities.

This short squeeze has the potential to send gold hundreds of dollars higher. It took years of stupid collective

actions by many very clever people to set this trap. A miscalculation of this magnitude is unlikely to be rectified

in a few short weeks or with just a proportionally small change in the gold price. We have a long way to go

before the market is correctly balanced. In the meantime, the squeeze has the potential to threaten the health of

some major financial institutions. It certainly has the potential to disrupt the earnings and finances of mining

companies who have hedged excessively or foolishly. The degree of lexcessiven hedging will rise with the gold

price. Even those companies that will soon be proudly proclaiming their lhedge liten position stand to be shocked

at the degree of risk they have undertaken. Officers and directors should understand the potential for shareholder

suits from investors who bought shares as a play on higher gold prices. Without hedging and short selling over

the last several years, the gold price would be several hundred dollars higher based on the short fall of mine

production relative to consumer demand. Panic short covering could drive the gold price well above any

theoretical equilibrium.

The existing and potential exposure of this massive trade gone wrong must be frightening to those trapped in it.

Still many others have no grasp of what is happening and regard themselves as secure. Time will tell whoms

holding the bag on basis risk and lease rate exposure. For now, it is safe to say that nobody knows or is telling

the truth.

John Hathaway

October 7, 1999 ...................................................................... Crash in Oct-Nov....Panic into Dec..Y2k

-- Ponzi (crash@wallstreet.oct), October 10, 1999