first majestic silver

Dumb and Dumber

August 16, 1997

The movie was childish, zany, gross and moronically hilarious. OK, I admit it - I loved it. There were just too many funny skits to recall all, but the dead bird repaired with scotch tape, the snowball fight and the scene where the bad guy finally gets the return of the suitcase with the million dollars stand out. As the suitcase is opened, only to reveal scores of pieces of scrap paper upon which are written amounts and notations as IOU's for the money that was stupidly squandered by the two idiot protagonists, one, Jim Carey, seriously explains that they're good for the money and the chits should be handled with care - especially the one for the car that they spent $250,000 on. The humor was in the absurdity between the sincerity of the promise of repayment with the likelihood of its fulfillment. Even if you haven't seen the movie, if you try to picture the scene of the pile of worthless paper being passed off as dollar equivalents, you will have an insight few possess in analyzing the most bizarre financial instrument ever devised in the precious metal world - the metal lease/forward loan. While the comparison between a slapstick comedy and financial instruments with outstanding values measured in the tens of billions of dollars might seem far fetched, I ask you to reserve judgment and decide for yourself.

If you have trouble picturing important financiers, central bankers, executives of major mining companies (along with most of their investors), analysts and commentators of the precious metals world, along with market regulators being compared to the nitwits in the movie, I can understand.

Perhaps they are all not stupid, but it is my contention that the very principle of the precious metal loan/forward sale is dumber than dumb. For 15 years, we have witnessed two of the world's most important markets, gold and silver, distorted beyond reason by an idiotic premise enthusiastically embraced by people who should know better.

What are metal loans/forward sales? While there can be variations, simply put, they are devices intended to allow the owners of gold and silver (mainly central banks and other government entities) the ability to earn interest on their metal and the borrowers (mainly mining companies, but increasingly, large speculators) the access to cheaper money and/or better deferred prices than available from conventional sources. On the surface, they look and work just fine. The central banks are receiving interest (1-2% annually) on assets that never in history before 1980 yielded any return. The mining companies have been given such favorable terms that some have responded by selling forward years of future production. Now even large hedge funds have responded to these magical lease creations by borrowing and selling short thousands of tons of gold and silver. Giant financial institutions and bullion banks provide capital, expertise and guarantees to facilitate incredibly complex deals. There can be no doubt that this is big business. Dumb, but big.

How did these loans/forward sales come about? About fifteen years ago, some enterprising Wall Street commodity guys at a very prestigious investment banking firm came upon the idea that would appear to satisfy the desires of a good number of potential clients with what promised to be very lucrative personal returns in the form of new fees. The idea proved popular beyond belief because it seemed to give the two chief principals to the transaction, central banks and mining companies, offers they couldn't refuse. To central banks and other government entities with large unproductive stockpiles of precious metal, the transactions offered an interest rate and unexpected cash flow for the "lending" of their metal. And best of all, since they were "loaning" metal, not selling it, the central bankers didn't have to report the transactions - they could just receive the income while carrying the metal on their books as if it were still in their possession (since there was no question they could get their metal back at any time). The mining companies, in turn, could report to their shareholders high deferred prices, increased cash flow and protection from falling prices. The investment bankers, of course, did the best of all. This is dumb?

No, this isn't just dumb - this is the dumbest (or most crooked) type of financial transaction ever conceived and embraced in history (although portfolio insurance and dynamic hedging are close). Metal loans/forward sales even overshadow Ponzi's scheme and lasting legacy, since the participants, scope and duration of the metal leasing scam outpace, by far, the original stamp con or any variation since. Let me explain why.

Metal loans/forward sales are dumb because metal can't pay interest. Gold and silver are inert materials that you can't convert to pure income producing assets. Yes, I'm aware that you can sell options for what is called income or arrange for a deferred sale with a built in enhanced price that might be based on current income assumptions, but in the end, these are just contingency sales. Metals can't pay interest because they are not an IOU or a liability, they are elemental substances. They have no utility value other than consumption or sale. Metals can't be "rented" like a car or house. It does a borrower no good to simply posses metal that is owned by another party. That's one reason why metal loans are dumb - the borrowers don't want the metal, they want the cash that they get when they sell the borrowed metal. And make no mistake, every single metal loan/forward sale, with no exception, begins with the actual sale of the borrowed metal. This indispensable first step of a central bank's borrowed metal being sold is dumb because the owner doesn't receive the proceeds, the borrower does. Think about that - the metal physically leaves the central banks' vaults, is sold on the open market, and the proceeds of the sale is not held by the central bank. This is not a joke, trick, nor a stupid movie plot, this is what happens in every single metal loan/forward sale. Of course, the central banks receive something in return - an annual interest payment of 1 or 2 per cent and a paper promise of the return of their metal. But, if you use a little common sense, and think this through, you'll see that Jim Carey's promise of repayment in the movie is better than the promises of metal repayment given to the central banks.

Yes, that's what I said - the bad guy in the movie has better statistical odds of being repaid the squandered million dollars than the central banks do of being repaid their gold and silver loaned out. Why? Because the nutty characters in the movie could conceivably hit the lottery or inherit a windfall, but the central banks don't even have that hope, there is no possible way they can get their metal to be collectively returned. That's because of the inherent dumbness of metal loans. You see, the only way even a cockeyed idea like metal loans/forward sales could have persisted for as long as it has, is because there is, and has been, a pronounced deficit in the real supply/demand of gold and silver. If there were not an ongoing shortfall between production and consumption in gold and silver, metal loans/forward sales could not possibly exist. Please think about this carefully, as it is the key to deciding the legitimacy of these transactions. What I am saying is that the real physical release of metal, in enormous quantities, onto the markets that metal loans undoubtedly involve, could not possibly be absorbed in an orderly manner unless the markets were desperately short of supply. It is the persistent uneconomic dumping of precious metal via loans/forward sales that has created the gold and silver deficits, satisfied the deficits, and controlled/depressed the price for all these years. The metal flooding the market from these loans has depressed prices, in turn discouraging production and increasing demand, thereby escalating the deficits and increasing the dependence of the markets for more gold and silver from the central bank loans. It's a vicious circle. Do you think it's just a coincidence that metal loans/forward sales have existed for precisely the same time as the 15 year bear market in gold and silver, while the real deficits in those markets have been exploding? How else would a reasonable person explain, for instance, how silver could remain comatose in price while stockpiles are evaporating and the real deficit reaches the insane level where total consumption exceeds total production by almost 40%?

Which leads us back to our dumb central bankers and the metal they're never going to recover. For if these metal loans have created this distorted current situation in gold and silver of severe shortfalls and depressed prices, as I've tried to convince you, what's going to happen when this stupid business ends? And make no mistake, it will end. Then the market will be faced with accommodating a real shortage the only legitimate way known - by price rationing. Unfortunately, there can be no way possible that years of distortion of the laws of supply and demand can not end violently. Can you picture a scenario where the market struggles mightily by adjusting the price to discourage consumption and increase production once the central banks cease their manipulation, that could allow the repayment of the loaned metal? It doesn't matter what their loan covenants dictate, the metal that has been loaned for 15 years by the central banks is gone, consumed or dispersed. And as far as future production from the mines who have pledged same for repayment, forget it. You see, when the central banks awake from their stupor and stop giving away their metal for free, the supply side of the ongoing metal fundamentals will develop an immediate vacuum. If you think on top of that (remember we're talking about the instant removal of 30-40% of total supply), the market would permit the remaining lion's share of supply (mine production) to bypass 6 billion consumers and simply be returned to the central banks, it's time see the movie again. There is no way the central banks (aside from the first few who panic and call in their loans) can get their metal back. Maybe some type of paper settlement, but definitely not metal.

I am not going to elaborate on the stupidity of those in the mining community and regulatory circles, except to say that if the mining world had not partnered with the central banks in this hare brained scheme (apologies to all rabbits), and sold years of production forward, prices would be nowhere near current complained about levels. And on a true price spike, legitimate hedges could then be transacted. As it stands now, when the markets explode, because so much future production is already sold, there will be weeping and gnashing of teeth in the mining world, where there should be joy. To the regulators, congratulations on blowing another one.

I would have thought the inherent fallacy of the "leasing" of a precious metal (or any basic commodity) would have been exposed to all with the failure of the platinum and palladium lease market nearly two months ago. While all the talk of default and the Dresdner Bank's pleas for US taxpayer bailouts have disappeared from print, we still see quotes of 20 to 80% for loans where 2% was the norm (remember, metal loans are supposed to be lower than all other rates because there is no inflation risk - metal is replaced with metal). If the rates on bank or government loans or debt increased 10 to 40 times the prevailing rates in a matter of weeks, would that not alert all that something was seriously wrong? That the central banks choose to ignore such a clear signal that things are amiss in the world of metal lending is amazing. I guess they won't get it until they have loaned out the last ounce of gold and silver. I might as well end on a mixed movie metaphor
- stupid is, as stupid does.

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