Federal Reserve Governor Confirms Fed Gold Swaps

By Patrick A. Heller, Market Update
September 29, 2009

Five months ago, the Gold Anti-Trust Action Committee (GATA), filed a second Freedom of Information Act (FOIA) request with the Federal Reserve System for documents from 1990 to date having to do with gold swaps, gold swapped, or proposed gold swaps.

On Aug. 5, The Federal Reserve responded to this FOIA request by adding two more documents to those disclosed to GATA in April 2008 from the earlier FOIA request. These documents totaled 173 pages, many parts of which were redacted (covered up to omit sections of text). The Fed’s response also noted that there were 137 pages of documents not disclosed that were alleged to be exempt from disclosure.

GATA appealed this determination on Aug. 20. The appeal asked for more information to substantiate the legitimacy of the claimed exemptions from disclosure and an explanation on why some documents, such as one posted on the Federal Reserve Web site that discusses gold swaps, were not included in the Aug. 5 document release.

In a Sept. 17, 2009, letter on Federal Reserve System letterhead, Federal Reserve governor Kevin M. Warsh completely denied GATA’s appeal. The entire text of this letter can be examined at http://www.gata.org/files/GATAFedResponse-09-17-2009.pdf.

The first paragraph on the third page is the most revealing. Warsh wrote, “In connection with your appeal, I have confirmed that the information withheld under exemption 4 consists of confidential commercial or financial information relating to the operations of the Federal Reserve Banks that was obtained within the meaning of exemption 4. This includes information relating to swap arrangements with foreign banks on behalf of the Federal Reserve System and is not the type of information that is customarily disclosed to the public. This information was properly withheld from you.”

This paragraph will likely be one of the most important news stories of the year.

Though not stated in plain English, this paragraph is an admission that the Fed has in the past and may now be engaged in trading gold swaps. Warsh’s letter contradicts previous Fed statements to GATA denying that it ever engaged in gold swaps during the time period between Jan. 1, 1990 and the present.

If the Fed had no such gold swaps during this period, their initial response or Warsh’s letter would simply have said so. Although this damning paragraph does not specifically state that it refers to gold swaps, both of GATA’s FOIA requests, the appeal and Warsh’s letter are explicit that the only swaps under discussion are for gold.

In theory, gold swaps should have no effect on the long-term price of gold. Gold swaps merely refer to the exchange of matching amounts of gold that are delivered in different locations or at different times. For instance, central bank A could swap a ton of gold with central bank B. In this scenario, central bank A may deliver this ton of gold to central bank B or to another party to fulfill an obligation of central bank B. Central bank B would at some point deliver a ton of gold to central bank A.

Central bank gold swaps could easily be used to surreptitiously hide gold dumped on the physical market to suppress the price of gold. Here’s how. In the previous example, when central banks A and B agree to deliver one ton of gold on behalf of the other bank, both of these central banks are allowed (and were required, until recently) by the International Monetary Fund to continue to report the gold they have delivered as if it were still in their respective vaults. While this is being done, each central bank would be free to sell onto the physical market the gold received in the swap from the other bank. That could increase the amount of physical gold available on the market, with neither central bank reporting any sale.

In most instances, swaps are short term, which is why the net impact should be negligible. If the swapped gold were replaced in a few weeks or months, the replacement of the gold would have the effect of decreasing the supply of physical gold to cancel out the earlier increase in supply.

But what if the swaps do not mature for a very long time?

Over the past 10 years, GATA has accumulated a significant amount of circumstantial evidence that the U.S. government, in conjunction with the Federal Reserve System, has secretly arranged to sell or lease central bank gold onto the physical market. Although there have been some attempts at refutation of particular words in the compilation, there has been no evidence produced to disprove GATA’s contentions. Despite the lack of contrary evidence, there are a number of so-called gold market experts who refuse to acknowledge that any central banks are involved in activities such as gold swaps undertaken to suppress the price of gold. Now that Federal Reserve governor Warsh has admitted that the Fed has lied in the past about engaging in gold swaps, what excuse will these “experts” now use to ignore GATA’s research?

Warsh’s letter may end up being the evidence needed to overcome the U.S. government’s efforts to avoid clearly and accurately reporting on its gold holdings. If so, there is a significant likelihood that the public would be stunned to learn how much of the U.S. gold stockpile is gone. Any such news would lead the price of gold to explode upward (and for the value of the U.S. dollar to fall sharply). Stay tuned for developments.

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Whose Economic Recovery?

By Danny Schechter

September 10, 2009

President Obama’s highly anticipated health care speech started on a totally different subject: The economy.
“When I spoke here last winter, this nation was facing the worst economic crisis since the Great Depression,” he told Congress and the people at home. “We were losing an average of 700,000 jobs per month. Credit was frozen. And our financial system was on the verge of collapse.”

“But,” he went on, “thanks to the bold and decisive action we have taken since January, I can stand here with confidence and say that we have pulled this economy back from the brink.”

Applause. Applause. Applause.

Are we back from the brink? And what brink is that? On Labor Day, HBO featured a powerful documentary about a GM Plant in Ohio that was shutting down. It showed the workers, teary eyed and forlorn, making the last truck on “their” assembly line. Their faces told the rest of the story as they asked themselves and each other, “What do I do now? What happens to my family and my life?”

They had no answers, and neither, alas, does Barack Obama.

A “jobless recovery” will not give these workers the money to buy into even the cheapest health care coverage, public option or not.

Look around Mr. Obama: the unemployment rate in real terms is over 16%. The consumer economy is shattered. The commercial real estate market is imploding, and, yes, more foreclosures are on the way according to the Washington Post:

A new report foresees another wave of foreclosures, as option adjustable-rate mortgages — an entire class of specialized home loans — will soon reset to higher payments. Estimated to jump by 63 percent on average, the higher rates will likely push many of the already-strained loan recipients over the brink. The loans, also called pick-a-pay loans, are a prime example of the risky lending techniques that created the housing crisis: Borrowers were allowed to pay back the loan with as little as they wanted each month, though that meant many paid less than the interest due…the report says the fallout from the loans could be felt for years, especially in states already hit hard by foreclosures.

Just who is back from the brink?

If you listen to the Fed, the glass is more than half full. If you listen to economists like Simon Johnson, it’s way more than half empty, as he wrote on Baseline Scenario:

In the absence of effective financial regulation – i.e., both during the 1920s and again since 1990 – the Fed has operated in a manner that encourages the formation of sequential bubbles. This destabilization of our financial system is not a minor matter; the damage caused – human, financial, social – is already enormous.

And we are very far from being done.

Don’t take my word for it. Lou Jiwei, the chairman of China’s sovereign wealth fund said recently, “It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that. So we can’t lose.”

Yes, We Can… Lose, that is, Mr. Lou. And Yes We Are, Mr. Obama. The problem is that we are still in some Bernanke fantasyland, thinking that if we keep saying everything is ok, it will be.

Here’s Washington’s blog on real unemployment as opposed to what the Bureau of Labor Statistics is saying:

… Paul Craig Roberts – former Assistant Secretary of the Treasury and former editor of the Wall Street Journal – and economist John Williams both said in December 2008 that – if the unemployment rate was calculated as it was during the Great Depression – the December 2008 unemployment figure would actually have been 17.5%.

Williams says that unemployment figures for July 2009 rose to 20.6% According to an article summarizing the projections of former International Monetary Fund Chief Economist and Harvard University Economics Professor Kenneth Rogoff and University of Maryland Economics Professor Carmen Reinhart,… unemployment could rise to 22% within the next 4 years or so.

Hello, Mr. President? Why can’t you bring to the discussion of the economy the same passion and fact-based arguments that you brought to the health care debate?

Why can’t you propose serious reforms on the financial sector? Why can’t we jail the financial criminals?

The answer seems to be that Wall Street will be a far more tenacious and resourceful enemy than the health care industry perhaps because they already own much of the Congress.

Remember Senator Dick Durbin’s comment, ‘the bankers run the place.”

Alan Blinder a former vice-chairman of the Fed fears that pressure for financial reform is losing steam in part because of the power of what he calls “The Mother Of All Lobbies.” He writes, “in the case of financial reform, the money at stake is mind-boggling and one financial industry after another will go to the mat to fight any provision that might hurt it.”

Obama acknowledged we are not out of the woods yet. (What woods?) But what are the likely consequences? How long can people live without anything coming in? How long can we live on upbeat projections?

“There is no doubt class antagonism is stewing,” says the editor of the blog Naked Captalism. He expressed a fear of a reaction that will go way beyond flag-waving tea parties:

… I am concerned this behavior is setting the stage for another sort of extra-legal measure: violence. I have been amazed at the vitriol directed at the banking classes. Suggestions for punishment have included the guillotine (frequent), hanging, pitchforks, even burning at the stake. Tar and feathering appears inadequate, and stoning hasn’t yet surfaced as an idea. And mind you, my readership is educated, older, typically well-off (even if less so than three years ago). The fuse has to be shorter where the suffering is more acute.

One is reminded of the title of that movie, There Will Be Blood. Rather than show contrition or compassion for its own victims, Wall Street is hoping to jack up its salaries and bonuses to pre-2007 levels. The men at the top are oblivious to the pain they helped cause. They are getting away with the crime of our time.

And the people – The People – who potentially can challenge all this by action on the ground are being mesmerized by the false hope that recovery is here or right around the corner. How long before they realize you can’t eat optimistic speeches?

Inflation… Deflation… Gold

By Ambrose Evans-Pritchard
The Telegraph, London
Saturday, May 23, 2009

The world’s top hedge fund manager, John Paulson, has built a gold position of at least $5.5billion, the biggest such move since George Soros and Sir James Goldsmith bet on Newmont Mining in 1993.

Britain has become the first of the Anglo-Saxon “AAA” club to face a downgrade. As feared, the cancer of bank leverage is spreading to sovereign cores.

Gold prices tend to slide in late May and languish through the summer, because of the seasonal ups and downs of jewellery demand. The trader reflex would be to short gold at this stage after its $90 vault to $959 an ounce over the past month. They may think again this year.

Paulson & Co. has bought $2.9 billion in SPDR Gold Trust, the biggest of the gold exchange-traded funds (ETFs), which now holds 1,106 tonnes — three times the Brown-gutted reserves of the United Kingdom.

Mr Paulson has also built up a $2.3 billion holding of Anglo Ashanti, Goldfields, Kinross Gold, and Market Vectors Gold Miners. The fact that he is launching a “Paulson Real Estate Recovery Fund,” reversing the bet against sub-prime securities that made him rich, tells us all we need to know about his thinking. This is a liquidity-reflation play.

He may be wrong, of course. In his early 50s, he belongs to the baby-boom cohort most psychologically vulnerable to the 1970s “paradigm error.” And perhaps he has never lived in Japan.

It is striking how many of those most alert to the deflation danger are either veterans of Japan’s Lost Decade or close students of it: Albert Edwards at Societe Generale, Russell Jones at RBC Capital, Nobel laureate Paul Krugman, the Fed’s Ben Bernanke, and Athanasios Orphanides, who helped draft the Fed’s study on the Japan trap.

“People always thought Japan’s bond yields had to rise, but they kept falling and Japan is still not really out of deflation,” said Mr. Edwards. Indeed, 20 years after the Nikkei peaked at over 39,000 it stands today at 9,280. Interest rates are 0.01 percent. The yield on two-year state bonds is 0.34 percent. Still there is not a whiff of inflation.

A number of readers have written to me in tones of polite reproach asking why I fret about deflation when governments everywhere are spending and printing as if there was no tomorrow. I admit to being tortured by self-doubt, like others grappling with this extraordinary situation.

What we know is that inflation is already negative in Ireland (-3.5 percent), China (-1.5 percent), Thailand (-0.9 percent), Korea (-0.5 percent), U.S. (-0.7), Japan (-0.3), Switzerland (-0.3), Spain (-0.2). The eurozone may be negative by July. Alistair Darling said Britain’s retail RPI inflation used to set wage deals will be minus 3 percent by September.

Does this constitute deflation in a meaningful sense? Not yet, perhaps. But it is moving too close for comfort in a world stretched by extreme leverage. The economies of the U.S., Japan, the eurozone, and Britain have been contracting in “nominal” as well as “real” terms — which smacks of the 1930s.

The “yen GDP” of Japan has shrunk by 10 percent in one year; the “euro GDP” of Germany has shrunk 6.2 percent, and Italy’s by 4.7 percent; the “dollar GDP” of the U.S. has shrunk 3.3 percent. Debts are not shrinking, however.

GMO’s Jeremy Grantham says in his latest note, “Last Hurrah And Seven Lean Years,” that the market value of equities, houses, and commercial property in the US reached $50 trillion in the boom. This “perceived wealth” sustained $25 trillion of debt.

The crash has cut this wealth to $30 trillion, but the debts are still there. America’s debt-gearing has exploded, as it has in the U.K. and Europe. This looks awfully like Irving Fisher’s “debt deflation” trap of 1933. It will be a long slog for households to bring their debt-to-wealth ratios down to manageable levels.

You can argue — as do UBS, Merrill Lynch, ING, and Capital Economics, to name a few — that massive global stimulus is merely struggling to offset a massive deflationary shock.

So how will gold fare in a “Japanese” stalemate world where neither inflation nor deflation gets the upper hand? The eight-year rally that has lifted gold from $254 to $959 may lose momentum for a while.

“The air is getting thin up here,” said John Reade, precious metals guru at UBS. “Rich investors are no longer rushing out to buy gold bars as they did after the Lehman collapse. Still, we think it is highly significant that both China and Russia — two of the biggest holders of foreign reserves — are both buying gold,” he said.

Personally, I remain a gold bug out of fear that the most corrosive phase of this crisis lies ahead. There are two more boils to lance: Europe and China. As the International Monetary Fund keeps telling us, Europe’s banks are still covering up their vast toxic debts. Nor has the G20 begun to address the root cause of the global crisis, which lies in excess exports from East (aided by currency manipulation) to an overspending West. China is putting off the day of reckoning with its crisis response, which is to build yet more plant to flood the world with yet more overcapacity.

For “political bears” the risk is that the EU polity fragments under strain and that governments restrict basic markets to defend themselves — whether by imposing exchange controls to stop bond flight, or shutting derivatives markets used as hedges, or putting up trade barriers. We will find out if and when unemployment hits 10 percent in America, 12 percent in Germany, and 20 percent in Spain, or if migrant workers rampage in Shenzhen.

Some call this the “Armageddon case” for gold. That is going too far. However, gold has outperformed Wall Street’s S&P 500 index by 500 percent so far this century, as if able sniff out trouble in advance. Such runs tend to finish with a “parabolic” blow-off before they die. Mr Paulson may yet make another fortune, whatever his reason.

The Financial Crisis … The Problems Aren’t Over, Not By a Long Stretch

He Who Borrows the Most, Wins
by Niels Jensen

“Never in the history of the world has there been a situation so bad that the government can’t make it worse.” -Unknown

The stock market might bounce for a while, global currencies might stabilize for a while, but don’t be deceived, large problems remain…very large problems. And the price to fix these problems will run into the tens of trillions of dollars. That’s the kind of price tag that could ruin a national currency or two…even the world’s reserve currency.

While equities continue to go up and up, most of us are left scratching our heads. Is this the real thing or will it go down in history as ‘just’ another bear market rally? Not so long ago, the entire financial system stared Armageddon in the face. Now, only a few months later, equity markets behave as if all the worries of yesterday have been washed away.

The dangerous conclusion to draw from the experience of the past few weeks is that all is now well and dandy and it is time to load up on stocks again. I cannot emphasize it strongly enough: The bull market of March-April 2009 is almost certainly a bear market rally. As one of my partners pointed out the other day, NYSE saw four 20%+ rallies between 1929 and 1932. Bear market rallies can be extremely powerful and hence deceiving.

But the problems are not over yet. Not by a long stretch. It will take longer than 18 months to unwind the excesses of the past 25 years. Analysts at Morgan Stanley reckon that the 15 largest banks, which between them have shrunk their balance sheets by about $3.6 trillion so far in this crisis, will shed another $2 trillion in 2009. The US financial sector debt load (as a % of GDP) is now 117%. In the early days of the great bull market in 1982, the same number was 22%. Households are not much better off than the banks, with total household debt now at 96% of GDP vs. 47% in 1982.

The IMF reckons that both European and US banks – but in particular the European ones – are well behind the curve in terms of recognizing their credit crunch related losses. According to the IMF, there is at least another $1.5 trillion to come.

As the recession bites into the lives of ordinary people, banks will face losses not only on sub-prime mortgages but on all loan products. In fact, sub-prime is indeed a small fraction of the total loan book for the US banking sector. Prime and Alt-A mortgages, together with commercial real estate loans total about seven times the size of the subprime market.

Delinquencies are now on the rise on all mortgage products; however, whereas sub-prime started to deteriorate as early as 2007, it is only recently that delinquencies related to Alt-A mortgages have taken off, and prime and jumbo loans are only now starting to suffer.

These defaulting mortgages pose a very serious threat to the U.S. economy, but they are only part of the economic crisis worldwide. By far my biggest concern at the moment is the enormity of the debt problem facing most OECD countries. In the March issue of the Absolute Return Letter, I referred to an important study conducted by Carmen Reinhart and Kenneth Rogoff back in December of last year.

Reinhart and Rogoff studied every banking crisis of the past generation and made some startling observations. One in particular caught my attention. According to the authors, governments inevitably underestimate the ultimate cost of a banking crisis, because the indirect costs (such as falling tax revenue in subsequent years) end up much higher than predicted.

The IMF estimates that the cost of the current crisis to the United States will eventually reach 34% of GDP or close to $5 trillion. However, the Obama administration, through its various implicit and explicit guarantees, is already using a number close to $9 trillion. And Reinhart and Rogoff’s historical average of 86% of GDP implies an ultimate cost of over $12 trillion!

The true cost is important, because it has to be financed through new bond issuance, and it is my thesis that the sheer size of this tsunami will eventually overwhelm the world’s bond markets. Even using the relatively conservative IMF estimates, the twelve largest industrialized countries of the world will have to issue about $10 trillion worth of new bonds to cover the cost of the current crisis.

However, if you (like me) believe that IMF underestimates the true cost of this crisis, Reinhart and Rogoff offer a more realistic approach. Using their least costly case study (Malaysia 1997) as our best case scenario, the true cost comes to $15 trillion. If one uses the average of 86% instead, the cost jumps to a whopping $33 trillion. I didn’t even bother to produce a worst case scenario – it all got too depressing!

I need to put the $33 trillion into perspective. Total global savings (loosely adjusted for the big losses in 2008) are probably somewhere in the region of $100 trillion. In other words, financing this crisis could absorb one-third of total global savings.

Hence it comes down to the price at which governments can attract sufficient demand from people like you and me. One of two things may happen. Either this crisis will ignite such a bout of deflation that investors will happily own government bonds yielding 2-3% or the deflation scare goes away ultimately, the global economy recovers and bond investors demand much higher yields for taking sovereign risk. I am not yet sure which scenario will prevail, but I do know that both are quite bad for equities longer term.

There is a third route, of course. Governments could print money for themselves, which they could then use to purchase their own bonds. We call that process inflation…and it is already underway.

An Updated Take on the Economic Situation

IMF Bombshell

Neville Bennett

There is a disconnect between the real world and Wall Street. Wall Street prices surge while real economy difficulties increase daily. Exports are falling, house prices are declining, and no-one can sell cars. However, There is a perception of “green shoots” indicate that that the real economy may recover quite soon because the financial sector has recovered, and a bull market is underway.

The financial sector, however, has been singled out by the IMF for a thorough review. It emphasizes the key challenge of breaking the downward spiral between the financial system and the economy. The IMF believes that “promising efforts” are under way to redesign the global financial system to provide a more resilient platform for sustained economic growth.

OVERVIEW

The financial sector needs mending. Banks and corporates need refunding, balance sheets have to be bolstered, and capital needs to flow across borders, especially to the merging countries. There is on-going destruction or corruption of assets, and the latest IMF estimate of write-downs has increased from US$ 2.2 trillion in January, to a possible US$4 trillion in April. The increase arises partly because of worsening picture of economic growth and the spread to other mature market-originated assets. About a third of newly-emerging write-downs will be incurred by non-banking institutions

There have been some improvement in interbank markets but funding remains a difficult issue, especially long-term funding. In some jurisdictions banks can issue government guaranteed, longer term debt. But the funding debt is big, with the result that many corporations are unable to obtain bank-supplied longer term debt or even working capital.

Present Risks

The crisis has deleveraged asset prices causing much distress. Some Pension funds and Life Insurers are now underfunded. Some managed their risks prudently, but others undertook risks which they did not really understand. The greatest problem is, however, the decline of cross-border funding. Emerging market economies desperately need refinancing, probably to the tune of $1.8 trillion in 2009. They had relied on private capital flows but these have been reversed.

Although there have been massive fiscal stimulus packages already, further policy action is necessary to restore confidence and thereby relieve uncertainty. Uncertainties are “undermining the prospects for an economic recovery”. The cost of these packages is causing concern, especially when the debt burden combines with longer-term pressures from an aging population. There is a “home-bias” as officials encourage banks to lend locally and consumers to keep their spending domestically orientated.

These are extremely challenging times as officials try to break a downward spiral which is dragging down the financial sector and the real economy.

Recommendations

The economic recovery will be protracted. The deleveraging process is not over and will continue to be slow and painful. Credit growth will contract in the US, UK, and EU, and only recover after a number of years. But political support for more fiscal and monetary aid by the state is waning. There is a risk that governments will be reluctant to allocate sufficient funds to solve the problem.

Restoring the banking system will take several years. Governments should co-ordinate policies to ensure that the banking system has access to liquidity; the impaired assets are identified and dealt with; and weak banks and other viable institutions should be recapitalized. Lessons from previous crises suggest that very forceful measures are required to resolve financial sector weakness.

The IMF has tried to assess existing losses and possible future write-downs in Western banking systems in 2009-2010. Its lowest estimate is $275 bn for US banks, $375 for Euro and $125 for British banks, and about $100 bn for other European banks. But the banks must first increase certainty identifying their capital needs and disclosing impaired assets. Bank supervisors must be very strict in evaluating bank claims and business plans. Viable with insufficient capital could get sufficient capital injections from the state to encourage private capital to join in raising capital ratios.

While banks use public money, their operations must be closely monitored, dividends and restricted, and compensation closely examined. There will be cases to replace top management. Non-viable banks could be merged with others or undergo orderly closure.

The difficulty in attracting private capital means deep government involvement is necessary, even to the extent of taking control. But ideally, the bank will be returned to the private sector as quickly as possible. It would be helpful to convert Government holdings of preferred shares to common stock.

Funding Needs

Bank funding remains highly stressed. Some governments have guaranteed deposits and some forms of bank debt, but wholesale funding is inadequate. Central banks will continue to need to provide ample liquidity for the foreseeable future.

Emerging markets are hemorrhaging capital and this will continue over the “next few years”. Their central banks will also need to provide ample liquidity, and also perhaps foreign currency through swaps or outright sales. IMF’s enhanced resources can buffer the financial crisis. The larger problem in emerging markets is a lack of capital to roll over corporate debt. Government support seems warranted to keep trade flowing and limiting damage to the real economy. The situation warrants devising contingency plans to prepare for large-scale restructurings in case circumstances deteriorate further.

Pressure to support domestic lending may lead to financial protectionism. In several countries authorities have stated that banks receiving support should expand their domestic lending. This could crowd-out foreign lending as banks face on-going pressure to delever balance sheets, sell foreign operations and remove risky overseas assets. These policies can damage the global economy.

Fiscal issues

Credit growth is necessary to sustain economic activity. In countries with fiscal room for maneuver, fiscal stimulus will be welcomed by markets. But markets are showing concern in countries where debt is an issue, and bond yields have increased and currencies weakened.

There is a universal need for stimulus now, but this clashes often with issues of sustainability. Governments risk a loss of confidence in their solvency if there are no plans for debt reduction

Conclusion

Policymakers have to address urgently the present crisis as well as devising a more robust financial system. Improved financial regulation and supervision are key components in preventing future crises by mitigating future systemic risk. The financial system will remain under pressure for years and require massive new funds.