SAN JOSE (SILVERAXIS.com) -- This is a polished version of an e-mail reply that I sent to Rhody explaining some of my own thinking concerning silver and metal leasing in response to his thought-provoking comments which have since been published at various PM websites. My response attempts to raise the quality of our mutual understanding of the metals markets by extending the depth and breadth of analysis and speculation. Before reading the following commentary, it would be useful first to read Rhody's comments.
The COMEX and the gold/silver ETFs (the U.S. versions) all have contractual requirements for the metal to be stored in physical form at the warehouse. I have seen and read these contracts and there is no ambiguity about this. The ultimate owner of the metal may always pledge it "off books" as long as it is not physically removed from the warehouse since at that point it is no longer counted. Ownership is irrelevant, what matters is the reported silver is actually physically located at the warehouse.
An off books pledge would be a private transaction between two parties and is not what is commonly referred to as metal leasing. Leasing as reflected in the published lease rates is institutionalized and conducted according to the confines of a metal exchange such as the main one in London.
There is at least one aspect, however, to leasing that does create some problems at certain warehouses, depositories and reserves. This is the problem of potential double-counting caused by different accounting methodologies employed by the metal lessor and lessee. Since the various parties to leasing and other forward metal transactions often include governments and cross-border entities subject to disparate accounting rules, the issue of double-counting is very real if unavoidable. For example, some double-counting occurs in the gold holdings of central banks who use a particular type of gold swap transaction. Similarly, leases between private parties can potentially result in the counting of the leased metal as assets in both parties' books. But unlike GATA, I believe these problems are somewhat isolated and not as big a problem as they have been made out to be. The fact that there is some double-counting does not mean virtually all leasing is double-counted just like the fact that some corporate CEOs are crooks does not mean that they all are.
The Purpose of Paper and Leasing
Metal leasing serves a number of purposes and impacts all metal markets to one degree or another. Paper is a necessary evil that permits large scale, efficient operations. Properly conducted, a paper-based system reduces transaction costs, fraud and misappropriation while minimizing the risk of default or nondelivery. We all like holding and dealing with the real thing, but many of the uses of paper in the metal markets are quite legitimate such as hedging transactions of a manageable size which are commensurate with a firm's metal trading requirements.
For example, a European silverware manufacturer may opt to lease out excess inventory on 6 month terms to offset warehouse storage costs to another silverware manufacturer whose regular silver delivery may have been temporarily delayed. The net result in this case would be a highly efficient, cooperative movement of metal from where it is not needed to where it is needed. In the U.S., a silver manufacturer might contract for spot or forward delivery in the same way. Or it might sell futures or write options on the COMEX for the same reason without actually moving any metal, which is even more of a paper-based transaction but more efficient than leasing or forward delivery. In any case, the idea being that the manufacturer wants to make money from its finished goods not price fluctuations of its raw material even if it happens to be silver. For these market participants, the concept of default rarely enters the picture.
What Bullion Banks Do
Bullion banks look for arbitrage opportunities - risk free profits from market mispricing using someone else's money. They are never committed to one side of the market. After all, they are "banks". And what banks do is take people's money on deposit and lend it out to borrowers. Banks make money on the spread which is really a profit margin reduced by credit risk. And since they are primarily the ones who would be burned by metal defaults, if that were to occur, it should therefore come as no surprise that they have some incredibly sophisticated tools to gauge market liquidity. I believe the bullion banks will have advance warning of impending defaults well before any of us will.
The Buffett Episode
Without bullion banking and leasing, the concentrated and predatory actions of a few trading firms who got wind of Buffett's silver purchase could have completely disrupted the silver market in 1997-8. As it is, the bullion banks were practically the only ones who made money by laying down extended calendar spreads and providing liquidity to all sides. Rocketing lease rates were an offshoot of the bullion bank's spread strategy. It was basically the pressure relief valve. Of course it didn't help that Buffett initially did not lease his silver through the London bullion market (LBM) even though the silver was headed to London, which displaced silver in the warehouses that would normally have been made available to the market for leasing. Buffett's strategy was eventually modified to lease the silver with credit guarantees, something that apparently caused Buffett to become disenchanted (since the leasing was essentially a derivative activity and he despises derivatives) and eventually to sell his silver.
The interconnected nature of the metal markets can perhaps be best witnessed by the public through the spread differentials between COMEX futures and LBM leasing rates. This is what I track with my "futures spread" indicator. which is currently telling me that the capacity to sell (short futures) on the COMEX and forward sell (lease) on the LBM are out of whack. Unfortunately, the LBM side lacks lease volume figures and so we must substitute overall market volume figures. These market figures, while admittedly inadequate, show rising volume and interest at the LBM and a corresponding drop on the COMEX. This condition appears largely related to the ETF which currently acquires and stores its silver exclusively in London. No doubt silver which would otherwise be leased has made it into the ETF's warehouse. But more importantly, other market participants who realize the incremental demand the ETF represents have off and on acquired silver and withheld it from, or offered it for, lease with the corresponding movements in lease rates. Large movements in silver warehouse stocks which disrupt the rhythm of the market can many times be found to exert their greatest influence percentage-wise on lease rates instead of prices, as was largely the case during the Buffett purchase.
The London Bullion Market
Extreme anomalies sometimes present in the London market. London, as an over-the-counter market, is more loosely regulated compared to the COMEX, but the LBM does have a cardinal rule: no failures to deliver. The use of a strictly enforced honor code instead of reliance on complicated regulations is analogous to the securities laws in the U.S. compared to the rest of the world. In the U.S. there are thousands of securities laws with little teeth (until Sarbanes-Oxley at least) whereas in many other countries the directors of corporations are not immune from liability even when they exercise due care in performing their duties. The result: we have Enron, Worldcom, etc. while you rarely hear about corporate or securities fraud in other countries. There are several implications of this: one, the absolute necessity to deliver contracted metal despite few trading rules sometimes leaves LBM traders more desperate than their U.S. counterparts, which can result in anomalous lease rate spikes and plunges; two, the LBM is a main source of both speculative shorting and cornering activity in virtually all metals including gold and silver (several copper episodes have become public but there is a long history of capricious trading of other metals in London); and three, the COMEX is often second fiddle to London since it is frequently used to lay off the physical trade conducted on the LBM. Some have even used this fact in an attempt to "prove" that the conspiracy to suppress gold and silver prices originates on the COMEX in New York while London trading is virtuous. But to me at least, the boys in London seem much more capable of pulling off a successful manipulation. For the above and many other reasons, the LBM and its silver leasing operations are probably not where initial defaults would show up.
Early Warnings of Default
Leasing is much more connected to the physical trade of silver and gold than, for example, unregulated derivative contracts or even COMEX futures and options. If delivery defaults start showing up, the LBM would probably be temporarily immune due to the large volume of physical metal traded in London. Meanwhile, lease rates could be a warning sign of default or not, depending on what strategy the bullion banks utilize as they offload the hidden but growing default risk from other metal markets to London. So a much better warning sign might be strange action in the COMEX futures basis amid plunging volume and open interest first on the COMEX and then eventually on the LBM.
But perhaps the earliest sign of impending default will be incremental declines in liquidity among private clients as measured by the bullion banks' early warning systems. A less sophisticated early warning system for the rest of us might be the dwindling availability of 1,000 ounce bars at bullion dealers and especially the private client bullion products offered by firms such as the Delaware Depository.
Yet the most practical public warnings of impending doom will probably be found in the least likely of places: PM websites such as 321gold, gold-eagle, etc., if only because a number of bullion dealers and traders (Franklin Sanders, Larry Laborde, Bill Haynes, James Turk, etc.) are also frequent commentators on precious metals at these websites. We should expect to hear from them and others about signs of plunging liquidity and nonexistent metal availability shortly before the markets are locked up by cascading defaults. When these warning bells all start to join the constant ringing from alarmists like Ted Butler, we might want to start paying attention. But of course by then it will be too late, so you should at all times hold just enough silver (and gold, if you must) under your direct control so that you can sleep at night.
What is enough? The answer to that is subjective, but in general a 5-10% allocation to bullion in physical form (no ETF, warehouse receipt, metal account or the like) that you have access to under any and all circumstances should be sufficient to preserve one's relative wealth in a severe financial meltdown. Each additional 10% allocation to physical bullion with unconditional access should be good for a doubling of one's relative wealth. On the other hand, if a financial meltdown is far off, the increase in wealth could be much slower or worse. Therefore, one indicator of the silver market that I hope to develop at www.silveraxis.com will measure default risk in terms of the portion of one's wealth that should be allocated to the monetary metals, gold and silver. With the lowest risk of default being a 5% allocation to monetary metals and the highest 100%, my guess is that the indicator would currently read at around the 20% level.
Isn't Leasing Really Just Borrowing Money and Selling Metal?
To see why lease rates are not truly an indication of default risk but rather a balancing act of metal availability and demand, we need to examine the leasing of metal from the perspective of both the borrowing of money and the selling of metal.
Here's how. Someone who acquires silver by lease could alternatively borrow the money and buy the silver, using it as collateral for the loan. However, the fluctuating price of silver means that the collateral value of the silver would be discounted up to 50% which means the other 50% needed to buy the silver would have to be uncollateralized or contributed from the firm's own capital. Thus, the cost of borrowing money to acquire silver is somewhere between a prime rate and a firm's cost of capital. Considering international finances, the floor on the prime rate could be as low as the Bank of Japan interbank rate around 0% while the cost of capital could approach 20% in the case of junk debt.
If this were the end of it, leasing silver at historical lease rates might always seem like the preferred alternative. But not so fast! Leasing silver can leave the borrower with a short position in the metal while borrowing money to acquire silver is a synthetic long position. In both cases, you have silver to use as you wish but with opposite exposure to price moves. Someone who wishes to remain delta neutral might therefore decide to lease 50% and borrow money to acquire the other 50% of the silver they need. The acquired silver could therefore be held back and used to satisfy the lease if necessary while the overall borrowing and lease cost would in most cases be lower than borrowing alone. This works as long as lease rates stay relatively low, because otherwise silver users will look to other markets to lower their risk and borrowing cost (such as the COMEX or bullion bank paper). In fact, many silver users employ this type of strategy indirectly using the services of a bullion bank. In any case, this all has little to do with the risk of default and everything to do with market interest rates.
The supply side is much simpler if not similar. Someone looking to lease out silver is basically either seeking to offset holding costs or is an indifferent, uncommitted long who believes silver will appreciate less in the short term than what could be earned at the risk free rate of interest. Basically, the lessor of silver is simply worried about holding a wasting asset. And while the apparent form of silver leasing may be a fee for temporary use of the metal, in substance the transaction is actually a sale with the right to repurchase. The lessor could instead sell the metal, investing the proceeds at a risk free rate of interest, and simultaneously enter into a forward purchase transaction. Thus, leasing will only make sense if the lease rate is higher than the risk free interest rate less the forward premium to the spot price. Again, this results in only minor consideration of default risk and in any case the creditworthiness of the lessee is more important than the potential future availability of silver. In fact, leasing will continue in earnest only to the extent that silver is viewed as a wasting asset and then only if interest rates make it attractive to lease.
In summary, when you combine both the demand to lease which is really about cost and borrowing ability and the supply which is about interest rates and the appreciation potential of the metal, you get a somewhat complex interrelationship that at times can be self-reinforcing and at other times mutually nullifying depending on the price behavior of silver and the general level of monetary liquidity in world financial markets. Mix in fluctuating levels of supply and demand in metal leasing based on prevailing trading strategies and rates of commercial offtake in physical metal and you probably have a rather complete list of factors that impact metal lease rates.
Silver leasing associated with published silver lease rates is just a small portion of worldwide silver trading activity. Most large transactions do not take place on any exchange but rather they are the result of often complicated private contracts. Once again, it is the bullion banks who write most of these contracts, which gives them a huge advantage in understanding the underlying trends in metals markets well before the public becomes aware of them. Initial defaults could very well be hidden from public view, but it will be the bullion banks doing the hiding using the excuse (rightfully at first, abusively later) of client privacy. At the same time, these banks will do their darndest to stem the tide by trying to provide liquidity while at the same time attempting to keep the various markets including leasing from showing clear signs of impending default. Unlike many commentators in the precious metals arena, I do not believe the bullion banks are afraid of rising silver or gold prices. Quite the contrary, they welcome any market development that increases investor involvement in precious metals. What they are afraid of is falling trading volume and liquidity which reduces their deal flow and profits and exposes them to cross-defaults in a delicately balanced portfolio of offsetting derivative and metal transactions.
I hope the preceding has provoked some independent thinking and different ways of looking at the silver market. I welcome any feedback and look forward to advancing the discussion on this important topic.
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