Gold and Banks: Debunking Another Misconception

Gold came under pressure this week as news surfaced that European commercial banks have borrowed money from the Bank for International Settlements (BIS) by putting up nearly 350 metric tons of gold -- currently worth approximately $14 billion -- as collateral. I believe the market's concern reflects a misunderstanding of the dynamics behind these gold swaps, which will prove to be either neutral or bullish for the yellow metal.

Not an everyday transaction
Under the swaps, banks borrow funds from the BIS against gold with an agreement to repurchase it at a future date. The BIS, which typically acts as a bank for central banks, released the information in the annual report it published last week. Such transactions are rare: According to the BIS's historical annual reports, the last time it acknowledged the use of gold swaps was in the 1970s.

3 reasons gold swaps shouldn't hurt gold
More than their rarity, it is the aggregate size of the recent gold swaps that spooked the gold market; investors reasoned that the BIS could sell the gold on the open market in the event of non-payment. Under that scenario, a large new source of supply would weigh on gold prices; however, there are at least three reasons to believe that is highly unlikely to occur:

  1. The BIS said that the gold is being stored at central banks. This suggests to me that the gold could, in fact, belong to national central banks, which are effectively acting as guarantor on the BIS loans on behalf of the commercial banks. If the gold does belongs to central banks, the risk of it being seized and sold by the BIS is small.
  2. Even if the gold doesn't belong to central banks, it's not clear that the central bank of a European nation would allow a commercial bank to default on the gold swap with the BIS.
  3. Even assuming that the first two arguments don't hold up, a third argument is even more powerful. Let's step back for a moment: If a bank were to default on their gold swap with the BIS, that would suggest it is facing a liquidity crisis. If the entire amount of gold backing these swaps were sold on the market, it would represent less than 9% of the gold supply in 2009; however, now we are talking about multiple defaults by European banks. In that situation, it's likely that concerns about the health of the European banking system would overwhelm considerations relating to an increase in gold supply. I'd expect the former to produce a flight to safety into gold that would at least mitigate the latter.

For an indication of this, just look at the rise in the price of gold since the European sovereign debt crisis flared up at the beginning of the year -- the two largest gold ETFs, the SPDR Gold Shares ETF (NYSE: GLD  ) and the iShares COMEX Gold Trust (NYSE: IAU  ) have gained approximately 10% year to date against a 5% loss for the SPDR S&P 500 ETF (NYSE: SPY  ) , which tracks the S&P 500.

Bullish, not bearish
Speaking of timing, it's surely no coincidence these swaps took off during the first quarter -- the same period during which the Greek sovereign debt crisis became a European financial crisis. That event has had a material impact on the ability of some European banks to fund themselves. All but the largest Spanish banks, such as Banco Santander (NYSE: STD  ) and BBVA (NYSE: BBVA  ) , have been frozen out of interbank markets, for example. In that context, it should be clear that the gold swaps with the BIS are rather more bullish than bearish for gold.

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Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (16)

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  • Report this Comment On July 08, 2010, at 5:24 PM, SimonJester753 wrote:

    Yesterday I read this:

    http://www.thestreet.com/story/10799921/1/7-reasons-not-to-b...

    which has me scared about holding GLD.

    What do you say?

  • Report this Comment On July 08, 2010, at 6:06 PM, TMFAleph1 wrote:

    @SimonJester753,

    I have not looked at these issues closely enough to have an opinion on the matter; however, my esteemed colleague Christopher Barker is very knowledgeable in this area.

    For a discussion of alternatives to GLD, see the following articles from Chris:

    http://www.fool.com/investing/general/2010/06/01/how-to-get-...

    http://www.fool.com/investing/general/2010/04/13/everybody-o...

    Best,

    Alex Dumortier

  • Report this Comment On July 08, 2010, at 6:08 PM, XMFSinchiruna wrote:

    Simon,

    I'll let Alex respond separately if he wishes, but I wish to state that I do indeed have many concerns regarding GLD. I am not terribly impressed by the particular article you linked to, which contains a number of rather weak arguments ... but all the same I believe the author is correct to raise doubts about the nature of an investment in GLD. I have my own list of red flags from within the prospectus ... it just happens to be a somewhat different list.

    Here are a few related links, with copious discussion in the comments sections.

    http://www.fool.com/investing/general/2010/06/21/the-story-t...

    http://www.fool.com/investing/general/2010/06/01/how-to-get-...

    http://www.fool.com/investing/general/2010/04/13/everybody-o...

    http://www.fool.com/investing/general/2010/04/05/is-your-saf...

  • Report this Comment On July 08, 2010, at 6:28 PM, XMFSinchiruna wrote:

    Alex ... I'm glad you wrote about this important topic. It's not every day we find hard evidence of the sorts of gold swaps that GATA has suspected are common practice for many years running.

    Here is Adrian Douglas' latest discussion of the topic, which I found very interesting:

    http://www.gata.org/node/8803

    "Mysterious BIS gold swaps are likely a bullion bank bailout"

    Excerpt:

    "This is not about currency liquidity, as the $14 billion reported raised is not liquidity; it is pocket change.

    On the other hand, 380 tonnes of gold is liquidity in the gold market, where mines produce only about 2,200 tonnes per year.

    If the BIS made the swap directly with a central bank, the gold would not be provided to anyone for liquidity.

    If the swap was made between a commercial bank and a central bank, the commercial bank would get its hands on the gold and the gold would change location to the vaults of the commercial bank, a bullion bank.

    This would require the bullion bank to hand over $14 billion of its own money.

    But by doing another swap with the BIS, the commercial bank would get the money from the BIS and technically the gold would now belong to the BIS, even as it most likely would not change location and 380 tonnes of gold would be digitally credited to the BIS' unallocated gold account at the bullion bank.

    In this way the central bank or banks would get cash and the BIS would get the unallocated gold as collateral and as if by magic the bullion bank or banks would get 380 tonnes of gold to bail them out for a few more weeks as massive physical demand for metal eats their lunch."

  • Report this Comment On July 08, 2010, at 7:19 PM, TMFAleph1 wrote:

    Chris--

    Thanks very much. I was going to solicit your feedback since you know more about this market than I do.

    I don't know anything about Adrian Douglas, but I was chuffed to find that he makes the same hypothesis I did: that these swaps are, in fact, tripartite transactions involving a commercial bank, the BIS and a central bank. Perhaps I'm starting to develop the right thought processes for this market ;-)

    Best,

    Alex D

  • Report this Comment On July 08, 2010, at 7:39 PM, Starfirenv wrote:

    Du Mortimer- If as you say "I don't know anything about Adrian Douglas" and "I have not looked at these issues closely enough" then you really have no business writing about it- do you. Zero Cred for you.

  • Report this Comment On July 08, 2010, at 7:48 PM, XMFSinchiruna wrote:

    Starfirenv,

    Alex has been tracking the gold market for several years, and I have enjoyed his perspective on gold considerably. I have high regard for his understanding of of gold's fundamental macroeconomic drivers, and he has kept his finger dutifully on the pulse of this market. Furthermore, his analysis here is spot-on.

  • Report this Comment On July 09, 2010, at 11:37 AM, CPACAPitalist wrote:

    I've enjoyed this impromptu roundtable in the comments section. Gold is an investment that I've avoided mostly due to my lack of understanding of all the factors in the gold market. "Don't invest in something you don't understand" is advice I read once from some guy that apparently has done pretty well in the investing world. But I think I'm going to spend some time doing my due diligence to understand it better, not necessarily to play to gold market, but to understand how it effects everything else.

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