Reprinted with Permission
Fed Options: The Plot Thickens
My commentary of September 20, 1999, suggested the possibility that the Bank of England's gold sales were triggered by a plea from Washington aimed at rescuing the Fed from potential big losses on the writing of gold call options. Nothing that has happened since is inconsistent with this suggestion, and what new evidence there is supports it.
But to go back, an initial question -- on which I accepted the opinion of others -- was whether the Fed has statutory authority to write (sell) call options on gold. In my opinion, it clearly does. What is now codified as 12 U.S.C. s. 354 provides in relevant part:
Every Federal reserve bank shall have power to deal in gold coin and bullion at home or abroad, to make loans thereon, exchange Federal reserve notes for gold, gold coin, or gold certificates, and to contract for loans of gold coin or bullion, giving therefor, when necessary, acceptable security....
This provision, included in the original Federal Reserve Act (Dec. 23, 1913, c. 6, s. 14(a), 38 Stat. 264), has remained unchanged and in force ever since. While it does not specifically mention writing call options, the broad grant of authority "to deal" in gold and to make or receive gold loans can readily be construed to include writing or purchasing options.
This authority, it should be noted, addresses only what the Fed can do for its own account. It has nothing whatever to do with buying, selling or otherwise dealing with the official gold reserves of the United States, which are under the control of the Secretary of the Treasury acting with the approval of the President. 31 U.S.C. ss. 5116-5118. Whether the Fed's authority to deal in gold for its own account may in some respects be limited by other statutes is a question that I will leave to others, but under s. 6a(d) the Commodity Futures Trading Act, any transactions for its account are expressly exempt from trading or position limits.
Testifying in July 1998 before the House Banking Committee looking into the regulation of over-the-counter derivatives, Fed Chairman Alan Greenspan distinguished financial derivatives from agricultural derivatives, saying that it would be impossible to corner a market in financial futures where the underlying asset (e.g., a paper currency) is of unlimited supply. The same point, he continued, also applied to certain commodity derivatives where the supply was also very large, such as oil.
Greenspan further volunteered: "Nor can private counterparties restrict supplies of gold, another commodity whose derivatives are often traded over-the-counter, where central banks stand ready to lease gold in increasing quantities should the price rise." In other words, the Fed Chairman opposed any action by Congress aimed at greater regulation of over-the-counter derivatives, specifically including gold derivatives. One reason -- left unstated -- for this opposition may well have been concern that any new legislation might interfere with the Fed's own activities in the derivatives markets, particularly in the gold area.
Why might the Fed have engaged in writing call options on gold? Their immediate purpose and effect would be to facilitate gold leasing by enabling the bullion banks to hedge more easily short positions resulting from the sale of leased gold. Indeed, as the so-called gold carry trade grew, demand for this sort of hedging by bullion banks likely strengthened since here, unlike in mining finance, their customers were not themselves producers of gold. More generally, by thus exercising control over the amount of leasing and resulting short sales, the Fed could have achieved considerable influence over the gold price. Indeed, perhaps it was just this kind of activity that led a former Fed governor to claim on CNN's Moneyline in October 1998: "The Fed has precise control over the price of gold and therefore over commodities such as crude oil. No inflation, therefore no need to raise rates." Emphasis supplied.
A recent analysis by Ted Butler faults the CFTC for not taking action against certain bullion bankers over the option strategies foisted on certain mining companies. The basic strategy to which he refers is the sale by mining companies of long dated call options to finance the purchase of relatively short dated put options, i.e., the strategy that crippled Ashanti and Cambior. In all that has been written or disclosed about this strategy in recent weeks, two facts stand out. First, the risks were not fully or widely understood. Second, the strategy experienced a surge in use right after announcement of the BOE's gold sales program. No doubt, as many have suggested, this sudden spurt of options hedging reflected the gloom that descended over the gold market in the wake of the BOE's announcement. But to the extent that the bullion banks actively pushed the strategy onto their mining customers, it may also have represented an effort by them to replace Fed call options that were in process of drying up.
Efforts at market manipulation almost always come to a bad end because ultimately market fundamentals will assert themselves. Central bankers tend to have a better appreciation of this fact than politicians, which is almost certainly why the BOE's gold sales program was ordered by the British government over the objection of bank officials. If the BOE's gold sales were originally intended to rescue the Fed from a losing options position as gold threatened to move over $300/oz. last May, it has probably largely achieved that narrow goal by now. But the cost has been enormous, not only in British gold but also in undermining continued central bank control of the gold price.
Neither the BOE nor its political masters foresaw that their attack on gold would trigger the Washington Agreement, announced September 26, 1999, which overnight caused an almost complete reversal in negative attitudes toward gold created by several years of highly publicized central bank sales and huge increases in their gold leasing activities. The resulting spikes in the gold price and in already high lease rates effectively killed the gold carry trade and forced far more prudent use of hedging by mining companies. While the troubles of certain mining companies caught wrong-footed have been widely noted, the damage to the bullion banks themselves, not to mention certain hedge funds, has yet to be fully disclosed. The BOE's reputation for prudent oversight of the international gold market, long based in London, is badly tarnished. Kuwait's release of its entire official gold reserves for loan through the BOE has only underscored the parlous condition into which that market has fallen.
The BOE itself now appears locked into a gold sales program that amounts to a fire sale of British gold, so much so that two of the world's largest mining companies have successfully used the last two auctions to cover some of their own forward sales. Whether wholly unsubstantiated or floated as a trial balloon, the mere rumor -- quickly denied -- that the BOE might cancel future planned gold sales caused an almost immediate $10/oz. spike in the gold price a couple of weeks ago. Charges fly that the BOE's sales are part of a government plot to join the EMU. If so, it's a pretty dumb plot.
By not joining the first round of the EMU, Britain regained possession of 173 metric tons of gold previously deposited with the EMI (predecessor to the EMU) and increased its total gold reserves to 715 tons, which its gold sales program when completed will reduce to around 300 tons. Should Britain join the EMU, it will probably have to allocate about 140 tons to the ECB, leaving national gold reserves of around 160 tons. Britain would thus be the only major EMU member without substantial gold reserves, and thus the only one not to benefit from any future upward revaluation of gold.
Beyond these direct consequences, some believe that the Fed responded to the October gold banking crisis and presumed problems of the bullion banks by adding liquidity to the banking system, thus providing much of the fuel for the November stock market rally. In this connection, it is worth noting that the bullion banks with apparently the greatest exposure to Ashanti's problems are among those most often associated with suspected Fed activities in the gold market. So too, the question of whether and to what extent short gold positions may have played a role in last year's LTCM affair remains shrouded in mystery. What does appear, however, is that the Fed is very reluctant to allow the U.S. stock market to progress from a correction into a true bear market, adding credence to the growing belief that the stock market, however overvalued, is too big and too important to be allowed to fail.
There is a certain irony in the fact that since Alan Greenspan assured Congress in July 1998 that over-the-counter financial and gold derivatives required no further regulation, these very same derivatives have twice presented the Fed with an opportunity to allow a stock market correction to turn into a bear market for which it could escape much of the blame. In each case the Fed may properly have been concerned that the decline might cascade into a disorderly rout. But by intervening to head off these stock market declines, the Fed may also have undercut the credibility of its own interest rate weapon. Searching for a way to freeze the bubble or at least to let the air out slowly, and unwilling to let market forces have their way, the Fed has steered the whole American economy into uncharted waters.
The Fed was founded to stabilize the gold value of the dollar on the theory that central banking could achieve this goal better than free banking. Having utterly botched that mission, it has accepted a new one: guardian of the American economy's paper wealth.
The Fed has never had, nor will it ever have, "precise control" over the gold price. The question now is whether its control over the stock market will prove equally illusory. No doubt, should its traditional monetary tools or suspected derivatives activities appear inadequate to the task, the Fed will unveil some new weapon. But if the BOE ever announces a plan to achieve greater diversification of its dollar assets by investing proceeds from its gold sales in U.S. blue chip stocks, beware. For if one rule of investing is: "Don't fight the Fed;" another is: "Bet against the BOE." Just ask George Soros.
6 December 1999