Reprinted with Permission
House of Morgan: From Gold Bugs to Paper Hangers
No bank is more intertwined in the great events of U.S. financial history than the House of Morgan. More than once, J. Pierpont Morgan rode almost single-handedly to the rescue of the U.S. financial system. Never were the stakes higher, nor the outcome more uncertain, than on February 5, 1895. The U.S. Treasury faced imminent default on its gold obligations. In Morgan's view, widely shared on Wall Street and in London, default threatened a complete collapse of the national credit and the dollar. In a last minute effort to avert catastrophe, the great financier met with President Cleveland to try to salvage a plan for the issue of government gold bonds through a syndicate led by his bank. Based on an obscure Civil War statute, Morgan's plan faced heavy political opposition. But in a tense White House meeting, Morgan carried the day. Not until the deal was done did the President notice that the cigar which Morgan had pulled from his pocket upon arrival lay in brown dust on his lap. It would be more than century before another cigar played as famous a role in a White House rendezvous.
No one fought harder for restoration and maintenance of the gold standard after the Civil War than J. Pierpont Morgan. "Gold is money," he thundered. "That's it." Today the House of Morgan appears considerably more ambivalent on the subject. Its participation in GoldAvenue.com suggests some optimism about gold. On the other hand, the derivatives business of Morgan Guaranty Trust Co. of New York (hereinafter "Morgan"), a wholly-owned subsidiary of J. P. Morgan & Co., gives quite another picture.
Recent figures from the Office of the Comptroller of the Currency on the off balance sheet derivatives contracts of U.S. commercial banks show that Morgan continues to play an outsized role on the U.S. financial scene, particularly as regards gold. But there is a difference. When a Morgan ran Morgan, the dollar was as good as gold and the bank aimed to keep it that way. Today's managers at Morgan seem to have placed a huge bet against gold and on the paper dollar.
The following table is taken from the quarterly OCC Bank Derivatives Reports, which can be accessed at www.occ.treas.gov/deriv/deriv.htm. Since these reports cover only commercial banks, investment firms like Goldman Sachs and Merrill Lynch are not included. Neither, of course, are foreign banks. Data on individual banks is reported only for the seven banks having the largest total notional amounts of off balance sheet derivatives. Of these seven, only Morgan, Chase Manhattan Bank and Citibank NA reported any gold derivatives at the end of 1999. The table gives the total notional amounts of all gold derivatives for all reporting banks in US$ billions from March 31, 1995, together with Morgan's share in both dollars and percent from June 30, 1998.Maturity Tonnes @ Gold* Tonnes @ Quarter <1 yr 1-5 yrs >5 yrs Total Gold Pr. Price $327/oz.** 1999/4 46.5 27.8 13.3 87.6 9388 290 8333 Morgan 20.9 11.3 5.8 38.1 4082 3623 % 45% 41% 44% 43% 1999/3 52.3 22.4 8.7 83.4 8676 299 7933 Morgan 21.0 7.6 1.8 30.5 3171 2899 % 40% 34% 21% 37% 1999/2 36.9 20.9 3.6 61.4 7317 261 Morgan 13.8 3.8 0.8 18.4 2188 % 37% 18% 21% 30% 1999/1 34.8 21.5 8.5 64.8 7213 279 Morgan 10.7 3.8 0.6 15.1 1677 % 31% 17% 7% 23% 1998/4 36.0 23.2 9.2 68.4 7392 288 Morgan 10.4 5.3 1.1 16.8 1811 % 29% 23% 12% 25% 1998/3 40.6 24.3 9.2 74.1 7844 294 Morgan 13.5 5.8 0.9 20.3 2148 % 33% 24% 10% 27% 1998/2 37.0 23.5 9.1 69.6 7306 296 Morgan 13.4 4.9 0.9 19.3 2026 % 36% 21% 10% 28% 1998/1 39.7 17.7 4.9 62.3 6438 301 1997/4 42.6 15.4 4.2 62.2 6667 290 1997/3 44.1 13.6 3.1 60.8 5694 332 1997/2 35.0 14.3 2.5 51.8 4816 335 1997/1 34.2 22.9 2.4 59.5 5317 348 1996/4 39.4 17.4 2.0 58.8 4953 369 1996/3 46.8 15.6 1.7 64.1 5261 379 1996/2 36.5 15.6 1.7 53.8 4381 382 1996/1 38.8 16.4 2.4 57.6 4520 396 1995/4 35.9 16.1 1.9 53.9 4335 387 1995/3 28.4 10.6 1.3 40.3 3264 384 1995/2 22.8 9.5 1.4 33.7 2708 387 1995/1 20.4 9.4 1.2 31.0 2515 383 * End of period, London, IMF International Financial Statistics. ** Average of Barrick's strike prices: $319 in 2000; $335 in 2001.
This table shows a pattern of generally rising gold derivatives against generally falling gold prices. At the beginning of 1995, the total notional amount of gold derivatives converted to tonnes at market prices equaled just slightly more than annual new mine production of around 2275 tonnes. Currently new mine production is running at about 2500 tonnes, but total gold derivatives have increased to considerably more than 3 times this amount whether converted at market prices or the average price of Barrick's calls. Morgan's position alone equals some one and one-half years of total world gold production. Coincidentally or not, the total position now exceeds total official U.S. gold reserves of around 8140 tonnes.
Especially striking are the increases in the last half of 1999, and particularly in the last quarter. The British gold sales were announced on May 7, 1999, and the Washington Agreement on September 26, 1999. Both events, one presumably bearish for gold and the other bullish, were followed by large increases in total gold derivatives. In the third quarter, these increases were most pronounced in the under one year maturities. However, in the fourth there were large increases in the longer maturities, with the over five years category rising by more than 50%.
But even more extraordinary than the increases in total gold derivatives in the last half of 1999 were their increasing concentration in one bank: Morgan. Prior to 1999, Morgan had never held more than about $20 billion in total gold derivatives, nor more than 28% of the total outstanding for all banks. But beginning in the second quarter of 1999, Morgan took on a much larger role in the under one year maturities, possibly presaging the the British gold sales. Then, during the last half of 1999, Morgan more than doubled its total gold derivatives, taking them from $18.4 billion to $38.1 billion, amounting to 43% of the total for all banks. What is more, Morgan's over 40% dominance stretched across all maturities. In the fourth quarter alone, it increased its gold derivatives with maturities over one year by more than 80% to $17.1 billion from $9.4 billion, which may well answer the question of who sold Barrick the calls.
Typically financial rescue operations carried out by banks involve a sharing of the load and risk more or less in proportion to exposure. Indeed, normally banks strongly object to taking on more than their fair share of a problem, or to giving another bank -- not to mention a major rival -- a free ride. Until Morgan passed it in the third quarter of 1999, Chase was the largest provider of gold derivatives. Its total gold derivatives were $23.7 billion on March 31, 1999, falling to $20.5 billion by June 30. Thereafter they rose just slightly to $22.6 billion on September 30, falling back to $22.1 billion at the end of the year. This huge change in the relative positions of Morgan and Chase during a period of extreme turbulence in the gold market seems quite unusual unless Morgan acted with some sort of official approbation.
Notional amounts are generally the underlying contractual amounts from which derivative payments are determined. They are not typically the amounts at risk. Assessment of risk requires assumptions or estimates about the magnitude, timing and volatility of underlying price movements, the liquidity of the relevant markets, especially as regards the availability of appropriate hedge positions, and the creditworthiness of counterparties. Particularly for over-the-counter derivatives, which constitute over 90% of the total, risk assessment also requires knowledge of the details of the relevant contracts.
For example, Barrick's calls on 6.8 million ounces (211.5 tonnes) of gold at an average price of $327/oz. have a notional value of around $2.2 billion. However, this amount could not really be deemed at risk unless one assumed a doubling of the gold price to $654 before any of the calls expired and with no opportunity to put protective hedges in place. What is more, a provision making the calls dischargeable in dollars rather than bullion would further affect the risk calculation under certain conditions.
Total notional amounts of all off balance sheet derivatives for all reporting banks at the end of 1999 were $34.5 trillion, of which Chase accounted for $12.7 trillion and Morgan for $8.7 trillion. Approximately 80% of the total represents interest rate contracts, 17% foreign exchange, and 3% equities, commodities and credit derivatives.
Obviously gold derivatives are a tiny proportion of the total, about 0.25%. However, not only do they exceed annual new gold production by well over 3 times, but also they are of significant size relative to bank capital. At the end of 1999, Morgan reported total risk-based capital of $12.1 billion, or $12.9 billion for parent J. P. Morgan & Co. as a whole. The parent's total market capitalization is around $22 billion (at $135/share); total stockholders' equity at year end was $11.4 billion. Against these numbers, Morgan's total gold derivatives of over $38 billion, equivalent to roughly 3600 to 4000 tonnes of gold, are scarcely trivial.
How dangerous are these gold derivatives? Apart from dwarfing annual new mine production, they must also be viewed against: (1) reasonable estimates of a current equilibrium gold price on a commodity basis of $500 to $600/oz.; (2) a total net short gold derivatives position estimated at anywhere between 7000 and 14,000 tonnes; and (3) the possibility of a surge in western investment demand for gold caused by stock market declines or other outside events. In these circumstances, a swift upmove to $600/oz., with little or no retracement, cannot be discounted. Assuming that Morgan's book is equally divided between longs and shorts, a move of this size could well create actual liabilities equal to around 50% of the notional value of its gold derivatives. Failure of 20% of its counterparties to perform would imply losses to Morgan equal to approximately 10% of the notional value or $3.8 billion, which is nearly one-third of its total capital.
Of course, the actual situation could be much worse. To the extent Morgan or its counterparties had to deliver physical bullion, it might not be available at all, or only at much higher prices. The known facts already point to a real possibility that in the wake of the Washington Agreement, Morgan may have served to warehouse short gold positions of others, thereby keeping those who wanted or needed to cover out of the physical market and cutting short a potentially huge rally toward equilibrium prices. In this event, Morgan's book is likely far more short than long, and difficulties in securing physical bullion have already manifested themselves. But as dangerous as Morgan's gold derivatives may appear, it is very unlikely that Morgan took on this position without the full knowledge of the Fed.
Why did Morgan do so? What was the Fed's involvement? Is there any connection between the gold derivatives positions of the big U.S. banks and the Swiss gold sales? What are the possible end games for Morgan and the other U.S. banks? Before tackling these intriguing questions, it is first necessary to look at U.S. gold exports and reductions in foreign earmarked gold at the N.Y. Fed. This interesting subject will be the subject of my next commentary. In the meantime, I recommend study of this chart.
For an explanation and discussion of this chart by its author, Elwood, go to http://www.geocities.com/goldtango/analysis1.htm
7 May 2000