An Endless Supply of Paper Gold
What if I told you that your gold could be multiplied over and over... that a single bar of gold can be turned into a nearly endless hoard of the yellow metal?
I certainly couldn't blame you if you think I was either full of it or living in a fantasy land. But it's true. And all you need to get started is a central bank, a bullion bank, and a bunch of greedy brokers.
Pass around that gold bar, and it'll turn into a nearly infinite supply of gold...
Welcome to the bizarre reality we know as gold rehypothecation.
It may be perverse, fraudulent, and just about the worst idea ever, but don't doubt for a second that banks and brokers are minting an endless supply of gold — at least on paper.
How It Works
Few people understand exactly how far this goes, how it affects the market, and how it creates tremendous risk for everyone out of what we're assured are safe "reserves."
The Fed has this musty, subterranean vault in New York filled with gold that isn't doing anything.
How terribly boring, right?
Luckily, a bullion bank executive wanders along and has a proposal...
He wants to borrow the gold, pay some interest on it, and then return it at a later date. And the Fed loves it. After all, it gets to profit off of some metal that's otherwise gathering dust in its basement — and pump some more wealth into the market in the interim.
Other central banks love the idea, too, and the bullion banker has an easy time getting similar deals from them.
So the bullion banker now has possession of a bunch of borrowed gold, but can't really do much with it, because virtually no one accepts gold payments. So he needs to monetize it while turning a profit greater than the interest due to the central banks.
Thankfully, everyone loves gold as collateral... So our bullion banker hypothecates the gold, meaning he gives the gold — or, more commonly, pledges access to it — as collateral for cash.
Now is when the real fun begins, as that gold gets multiplied time and time again...
The creditor is now making money through the loan and has gold as collateral if anything goes wrong. And no need to stop there... Remember, the creditor has a guarantee that it'll at least get the gold if the loan defaults.
So the creditor goes and pledges the gold that was pledged to it as collateral for another deal. The gold has now been hypothecated again, or rehypothecated.
In the United States, this presents a problem. You see, rehypothecation is capped at 140% of the value of the original collateral. But bankers and brokers are crafty, and they easily found a way around the rules. They just need to get the money out of the country...
So they bury legally binding clauses into their lengthy contracts to get U.S. clients to let them move a client's assets and funds over to subsidiary accounts in the United Kingdom.
Now there are virtually no limits. 100% of any pledged assets (such as collateral) can be rehypothecated in the UK.
So the gold that came from the Fed was used as collateral for a loan. Then that collateral was used as collateral. Then again. And again. From bank to broker to investment firm, the original bullion has become the basis for an endless chain of guaranteed gold.
Since each and every agreement, loan, and contract depends on it, it is mitigating the risk of all of these deals if they go sour. On paper, there is a whole lot of gold being used as collateral, but the actual amount of the precious metal hasn't changed.
What could possibly go wrong?
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Fighting Over the Scraps
The IMF wrote a damning report on rehypothecation after the last meltdown for what should be blatantly obvious reasons...
Consider what would happen if one of the links in this endless chain of collateral fails.
A whole bunch of people in the chain will want the gold that was promised as collateral, but there is only enough for one of them to get what they are owed.
In the end, they'll all have to settle for far less than was guaranteed in a legally binding contract.
This is exactly what happened when MFGlobal imploded after rehypothecating its clients' assets. The firm used pledged collateral and client assets to build a massive bet against EU sovereign debt. Around $1 billion of client funds were rehypothecated into a massive $6.2 billion bet that went bust. The entire hedge fund collapsed.
Part of MFGlobal's assets that were fought over included five gold bars and 15 silvers bars that were underlying eight Comex contracts between MFGlobal and its client, Jason Fane.
HSBC was holding the gold pending delivery, and the MFGlobal implosion threw what should have been a simple armored car trip into disarray. HSBC had to sue MFGlobal's trustee in the bankruptcy proceedings to figure out who actually owned the gold...
As Fane told Reuters at the time, "These bars are mine. We had a letter from HSBC that they were on the loading dock to be shipped to our warehouse contractor when there was some action taken by a third party to stop or delay shipment."
Now, in a sane and reasonable world, there should never be any debate about who owns a physical asset. If you own it but cannot get it, that means someone stole it.
Yet, that is exactly what happens when rehypothecated collateral is used.
The first and most obvious lesson that you might take from this is the importance of holding onto your own precious metals.
Unless you are in absolute control of what you own, your possessions could be subject to competing claims due to rehypothecation. Using a bank or warehouse for storage — although convenient — is not a safe option.
The second is to make sure you have a separate account if you're going to short stocks or do anything involving a margin. If you borrow shares in any way, the funds in your account can be rehypothecated.
The third lesson will undoubtedly fall on deaf ears...
The Fed and other central banks have no business propping up these absurdly risky chains of collateral with gold from national reserves.
That gold is the only thing with intrinsic value that creates a floor for fiat currencies. It is a universal reserve for a reason.
In 2007, right before the economy tanked, rehypothecation accounted for half the activity in the shadow banking system. $1 trillion worth of real assets propped up over $4 trillion of collateral.
No wonder the Fed never entertained the thought of letting a megabank fail. It really would take down the entire house of cards.
Of course, to do that, the Fed had to expand its balance sheet by $3 trillion. It can't do that again, but the threat from rehypothecation persists.
The Fed, Bank of England, and regulatory agencies need to get their act together and end rehypothecation now.
As for investors, they'll need to focus on physical gold and silver bullion and precious metal miners to keep from getting pulled into this mess if things go sour.
Editor, Outsider Club
Adam's editorial talents and analysis drew the attention of senior editors at Outsider Club, which he joined in mid-2012. While he has acquired years of hands-on experience in the editorial room by working side by side with ex-brokers, options floor traders, and financial advisors, he is acutely aware of the challenges faced by retail investors after starting at the ground floor in the financial publishing field. For more on Adam, check out his editor's page.
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