The Gold Leap Year Massacre

 

While many have speculated that the Fed indirectly manipulates true money (gold &silver) through prime brokers such as JP Morgan to keep a cap on its value while it devalues the dollar through quantitative easing and massive Repo financing to Europe, I prefer to focus on what can be quantified. Today’s massive decline in gold and silver was a massacre regardless of whether it was the free market at work (doubtful) or a Fed backed take down. Instead of speculation, I’d like to compare today’s gold action to large moves in the past.

First, to put things in perspective, even after today’s large loss, gold is still up about 5% since the start of the year.  Secondly, large moves like this in gold are not unheard of.

I looked at the prices of GLD, the exchange traded fund that matches the price of gold, going back to 2004. When I examined the daily moves in percentage terms I found there were many times, most notably in 2008 during the financial crisis, where large moves occurred both down and up. Let’s look at some of these moves in relation to today’s move:

2/28/2012	-5.30%
11/20/2008	7.35%
11/3/2008	6.16%
10/21/2008	-5.68%
10/9/2008	-7.43%
9/29/2008	-5.02%
9/16/2008	11.29%

As you can see, in 2008 we had large moves both directions. The large down days in 2008 were thought to be large hedge funds that sold gold ETF’s to meet margin calls when all other assets other than T-Bills were declining in value.

That’s not to say that today’s move wasn’t important. Today’s move was almost four standard deviations. Using the data going back to 2004, the standard deviation, which measures volitility is 1.35%. Three standard deviations would be plus or minus 4% on any given day.  In a standard normal distribution, 99% of all outcomes would fall within three standard deviations. So, four standard deviations should be extremely rare.

Given the historic events of 2008 its not surprising that we would see this kind of “tail risk”. After all, the entire world financial system was on the precipice. But what about today? Certainly much of the problems in banking still exist and many problems have been kicked down the road. But not even the gloomiest among us would say that on February 28^th, 2012 we were about to see the world financial system collapse on this day. Was there any major market making news today? Well, Ben Bernanke did say we had a slow to moderate recovery. Not exactly earth shattering news.

So where does that leave us?

Nothing has changed, except gold is almost $100 cheaper. Greece is still defaulting on their bonds. The ISDA is still meeting to determine if this is a default which will trigger credit default swaps. The US is still pumping out liquidity like crazy (though now mostly to Europe instead of the US). Great Britain is still in the middle of their own quantitative easing.  Global growth is still woefully low to pay all the debt incurred around the world. The western economies and Japan are still strategically devaluing their currencies trying to stay competitive relative to each other. A single day’s market action is merely noise. If you believe gold is a long term store of value, today is just a chance to buy the same gold at a temporary discount. Today an ounce of gold is still the same as an ounce of gold yesterday. Wealth preservation is not a trading strategy but a long term approach to keeping what you have earned through your labors.

Finally, I leave you with Dr. Paul speaking today to Ben Bernanke (Ignore the old fuddy duddy in the first one minute of the video).

Folks, this is not good

Click the graph to enlarge.

The blue line is GDP. The red line is our debt.

Iceland The Model. Greece The Failure

The contrast between Greece and Iceland are stark to say the least. Both countries had debt problems that seemed insurmountable.  Iceland’s main debt problems came from its banks that went on a lending binge very similar to that of US banks, both making consumer loans and mortgages to people who had no chance of ever repaying. Greece, on the other hand primarily is in trouble because its government spent too much since joining the EU, relying on low interest rates they thought they would last forever.

But what is so interesting is that the two countries have taken exact opposite approaches to resolve the issue which is highly instructive. While countries like Ireland force their citizens (Much like here in the US) to bail out the banks that made bad loans, Iceland twice voted to not pay to bail out their banks and default .

Not only that,

“The island’s households were helped by an agreement between the government and the banks, which are still partly controlled by the state, to forgive debt exceeding 110 percent of home values. On top of that, a Supreme Court ruling in June 2010 found loans indexed to foreign currencies were illegal, meaning households no longer need to cover krona losses.”

And how did Iceland treat their banksters?

“Iceland’s special prosecutor has said it may indict as many as 90 people, while more than 200, including the former chief executives at the three biggest banks, face criminal charges.

Larus Welding, the former CEO of Glitnir Bank hf, once Iceland’s second biggest, was indicted in December for granting illegal loans and is now waiting to stand trial. The former CEO of Landsbanki Islands hf, Sigurjon Arnason, has endured stints of solitary confinement as his criminal investigation continues.”

By contrast, Greece has negotiated one bailout after another adding more EU debt on more EU debt. The latest agreement, at best, kicks the can down the road even further. Just compare the results:

“Iceland’s $13 billion economy, which shrank 6.7 percent in 2009, grew 2.9 percent last year and will expand 2.4 percent this year and next, the Paris-based OECD estimates. The euro area will grow 0.2 percent this year and the OECD area will expand 1.6 percent, according to November estimates.”

In addition, Iceland already is back to having an investment grade rating of BBB- by Fitch.

By contrast, Greece has had a GDP decline of 7% since enacting the first round of austerity demanded by the EU. The latest “rescue” is counting on Greece to return to growth but this is looking highly unlikely.

Conclusion

Iceland recognized that its debt situation could not be resolved. They chose default and the banks were partially nationalized to preserve a functioning system. The needs of the people were put ahead of the needs of the markets and the banks. Greece, by contrast takes on ever more debt and gives up more of their sovereignty to their EU creditors. Their people are suffering under a debt they can never repay. Rather than leaving the EU and the Euro behind, defaulting on their debt, and reissuing the Drachma they are prolonging the pain without the hope of a recovery.

Lesson for us in the US

While Iceland sent its banksters to jail, not a single one here in the US has gone to jail for the massive fraud perpetuated on the American people and the international investors who bought the mortgage derivatives thrown together with loans signed by “Linda Green”.  Even now, not a single arrest has been made resulting from the theft of over a $1 Billion after MF Global stole client money from segregated accounts. In addition, rather than bailing out their banks as the US did, they partially nationalized them. The advantage of this is that there is now an expectation that the government won’t bail them out while in the US the big banks know Bernanke and Congress will always bail them out no matter how bad their behavior. They can keep the profits in the good times and be bailed out by struggling Americans in the bad times.

 Worse, rather than the banks being nationalized, they were allowed to sell their losing mortgage derivative to the US Fed, backstopped by the US taxpayer. Then they were on the one hand allowed to switch from “mark to market” to “mark to myth”. That is, just valuating their failed loans at whatever price they deemed correct. Finally, on the other hand as the Fed embarked on its ZIRP (Zero Interest Rate Policy) policy banks were able to use an accounting trick to revalue their own debt to show phantom income as if they had refinanced their own outstanding debt at the lower rate.

While Iceland’s banks were allowed to fail, Greece is trying to extend and pretend as they always have, following the US’ example. Iceland has endured difficulty but has recovered and is now growing again. The US and Greece however are following the Japanese who have been mired in an economic depression for two decades. We should not expect to have different results.

DOW 13,000! Time to party?

In a word, no. As the chart below shows, although the Dow has gone up nominally (in numbers) it has not gone up relative to real inflation reflected in the price of gold.

What's the lesson here? As western economies continue to print, gold has remained the best hedge. Keep in mind however, equities (stocks) are still better at hedging inflation than bonds or cash which pay you next to nothing.

If you have money in a 401k, stocks are going to be one of the few choices you have to keep up with inflation. You can still hedge that money in your plan by buying some gold outside of your plan

Jim Rickards on wealth preservation

Jim Rickards is the author of Currency Wars. His book provides a historical basis of money and past currency wars and how they affect various economies. He has "war gamed" financial warfare for the US government and explains well, where we have been and where we are currently going.

Listen to his podcast here.

Rickards begins the discussion by describing the role of Credit Default Swaps in the Greece crisis. To understand how these agreements may bring down the global financial system I'll give an example.

Let's say you were an institutional investor who bought $100 million of Greek bonds several years ago. You would probably want to hedge your position knowing that Greece had a high level of debt. So you go to an American bank, let's just say JP Morgan for example. They sell you a contract that does not trade like normal securities. Its essentially an insurance contract that says if Greece defaults on their debt, JP Morgan will pay you a specified dollar amount which would offset your losses on the bonds you own. For this insurance JP Morgan makes a substantial amount of money. They do not believe they will have to pay off the insurance. So unlikely they believe, that they sell huge amounts of the same insurance to everyone else who owns Greek bonds.

Now we find ourselves in 2012, and it looks like Greece has no chance to pay off their debts. Their GDP is declining along with their tax revenues and the market is demanding higher rates of returns to hold their bonds. The bonds you bought for 1,000 Euros now are worth 300 Euros. Their next payment is coming up in March 2012. They are negotiating with you and other holders of the bonds to devalue the worth of each bond to 30-40 cents on the dollar. Most would consider this a default sine the buyers of the bonds will not get all their money back and you would expect to get paid from JP Morgan from those Credit Default Swaps that you paid so much money for.

But there's a problem. In this example JP Morgan and other banks sold so much of these CDS' that if they ever had to pay them off they would no longer be solvent. This is exactly what happened in 2008 to AIG who sold more CDS than they could pay at once when Lehman went under. As a result they were bailed out by the US government saving banks like Goldman Sachs who otherwise might have gone under.

This time though, they can see the trouble coming and its no surprise. If Greece is declared in default, these big banks that sold the CDS' will have to pay up. But who decides whether Greece's devaluation of the bond is a default? Well that's determined by the ISDA (International Securities Deal Association). So the ISDA has a lot of influence in the solvency of the big banks (JP Morgan in this example). So just who is in charge of the ISDA who will determine if many of these banks stay solvent or go bust? Well, just take a look for yourself.

I'll save you the suspense. Its the banks themselves. If Greece defaults, the big banks will have to decide if they commit suicide by declaring the default or call it something else and save their hides. What do you think the banksters will do?

Iran Uses Gold to Buy Grain, Sidestep Sanctions

On January 23rd, I posted a report that India was buying oil from Iran using gold as currency. Turns out that may have been exactly backwards. Reuters reports:

Iran is turning to barter - offering gold bullion in overseas vaults or tankerloads of oil - in return for food as new financial sanctions have hurt its ability to import basic staples for its 74 million people, commodities traders said Thursday.
Difficulty paying for urgent import needs has contributed to sharp rises in the prices of basic foodstuffs, causing hardship for Iranians with just weeks to go before an election seen as a referendum on President Mahmoud Ahmadinejad's economic policies.
New sanctions imposed by the United States and European Union to punish Iran for its nuclear program do not bar firms from selling Iran food but they make it difficult to carry out the international financial transactions needed to pay for it.
Reuters surveys of commodities traders around the globe show that since the start of the year, Iran has had trouble securing imports of basic staples like rice, cooking oil, animal feed and tea. Grain ships have been held at its ports, refusing to unload until payment can be received for cargo.

So Iran, hit by crippling sanctions, is attempting to bypass the bankers that control international trade by using their gold in foreign vaults. What's interesting is that they are, out of necessity, doing what they have always wanted to achieve: getting away from using "The Great Satan's" currency the US dollar that all oil has been priced in since 1973. Zerohedge provides some background:

The Petrodollar System
To explain this situation properly, we have to start in 1973. That's when President Nixon asked King Faisal of Saudi Arabia to accept only US dollars as payment for oil and to invest any excess profits in US Treasury bonds, notes, and bills. In exchange, Nixon pledged to protect Saudi Arabian oil fields from the Soviet Union and other interested nations, such as Iran and Iraq. It was the start of something great for the US, even if the outcome was as artificial as the US real-estate bubble and yet constitutes the foundation for the valuation of the US dollar.
By 1975, all of the members of OPEC agreed to sell their oil only in US dollars. Every oil-importing nation in the world started saving its surplus in US dollars so as to be able to buy oil; with such high demand for dollars the currency strengthened. On top of that, many oil-exporting nations like Saudi Arabia spent their US dollar surpluses on Treasury securities, providing a new, deep pool of lenders to support US government spending.
The "petrodollar" system was a brilliant political and economic move. It forced the world's oil money to flow through the US Federal Reserve, creating ever-growing international demand for both US dollars and US debt, while essentially letting the US pretty much own the world's oil for free, since oil's value is denominated in a currency that America controls and prints. The petrodollar system spread beyond oil: the majority of international trade is done in US dollars. That means that from Russia to China, Brazil to South Korea, every country aims to maximize the US-dollar surplus garnered from its export trade to buy oil.
The US has reaped many rewards. As oil usage increased in the 1980s, demand for the US dollar rose with it, lifting the US economy to new heights. But even without economic success at home the US dollar would have soared, because the petrodollar system created consistent international demand for US dollars, which in turn gained in value. A strong US dollar allowed Americans to buy imported goods at a massive discount – the petrodollar system essentially creating a subsidy for US consumers at the expense of the rest of the world. Here, finally, the US hit on a downside: The availability of cheap imports hit the US manufacturing industry hard, and the disappearance of manufacturing jobs remains one of the biggest challenges in resurrecting the US economy today.
There is another downside, a potential threat now lurking in the shadows. The value of the US dollar is determined in large part by the fact that oil is sold in US dollars. If that trade shifts to a different currency, countries around the world won't need all their US money. The resulting sell-off of US dollars would weaken the currency dramatically.

You may recall from an earlier post that this was just a few years after Bretton Woods was abolished and the dollar was no longer convertible to gold. Are the pieces of the puzzle falling into place? Without the Petrodollar system the US Dollar would have greatly lost its value, neither backed by gold nor used for international commerce. This agreement gave the US another 40 years of privilege and economic hegemony in the world. As central banks begin to diversify their holdings from dollars to gold and countries such as India, China & Japan engage in bilateral agreements to move away from the US dollar the US itself will lose power, influence and purchasing power. Zerohedge  again provides the conclusion:

The short version of the story is that a 1970s deal cemented the US dollar as the only currency to buy and sell crude oil, and from that monopoly on the all-important oil trade the US dollar slowly but surely became the reserve currency for global trades in most commodities and goods. Massive demand for US dollars ensued, pushing the dollar's value up, up, and away. In addition, countries stored their excess US dollars savings in US Treasuries, giving the US government a vast pool of credit from which to draw.
We know where that situation led – to a US government suffocating in debt while its citizens face stubbornly high unemployment (due in part to the high value of the dollar); a failed real estate market; record personal-debt burdens; a bloated banking system; and a teetering economy. That is not the picture of a world superpower worthy of the privileges gained from having its currency back global trade. Other countries are starting to see that and are slowly but surely moving away from US dollars in their transactions, starting with oil.
If the US dollar loses its position as the global reserve currency, the consequences for America are dire. A major portion of the dollar's valuation stems from its lock on the oil industry – if that monopoly fades, so too will the value of the dollar. Such a major transition in global fiat currency relationships will bode well for some currencies and not so well for others, and the outcomes will be challenging to predict. But there is one outcome that we foresee with certainty: Gold will rise. Uncertainty around paper money always bodes well for gold, and these are uncertain days indeed.

Finally, I want to bring this back to a central theme. Though Ben Bernanke may not seem to think gold is money, central banks around the world do. From 2003 to 2009 China added 454 tonnes of gold with a total of 1,054 tonnes. We don't know how much they have now but we do know China has been selling US Treasuries and gold has found solid support in the market since then despite the US Fed's attempt to keep the price down with negative lease rates and likely, sales of US gold into the Comex market. And if you think gold can only be a currency for large purchases, I leave you with this...