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August 12, 2009

Unwanted Bequests of Gold, Debt and Bankruptcy
by Adrian Ash

"If gold is 'past its day', what of toxic derivatives and today's deluge of US Treasury bonds...?"

JUST LIKE poor Pip in Dickens' Great Expectations, central banks keep inheriting unwelcome bequests.

Today's "legacy assets" are toxic derivatives; a decade ago it was gold reserves. Both are proving hard to shrug off, but for very different reasons. Both legacies also come thanks to previous central-bank history; the fossils remain only too livid today.

And 10 years from now, if not sooner, just how welcome the current central-bank must-have become - freshly printed government debt, bought with money that doesn't exist until the central bank wills it?

Seeking first to defend against inflation and war, the West's central banks built up huge reserves of the ultimate hard money - Gold Bullion - during the early-to-mid 20th century. Long before the turn of the millennium, however, these hoards grew to look quaint and expensive. Unyielding and relatively useless to industry, gold simply sat there, down in the vaults, costing money to store but returning no interest.

Who needed crisis-proof gold when Western Europe (if not the Balkans or Mid-East) was enjoying its first generation of peace-time in history? And who needed fine gold when the Nasdaq index of tech stocks was priced for 20% annual earnings growth over the next decade and more?

In short, who needed gold when we'd got Alan Greenspan, as the New York Times asked in May 1999. "The argument against retaining gold is that its day is past," wrote Floyd Norris with uncanny timing, just two days before Gordon Brown's Treasury announced its ham-fisted sale of half the UK's gold bullion hoard.

"Once it was useful as a hedge against inflation that would hold its value when paper currencies did not. Now financial markets have their own sophisticated ways, using exotic derivative securities, to hedge against inflation."

You could butter your toast with the irony. But it wouldn't taste sweet or provide much nutrition. Whereas a further glance back at history might.

"With huge gold stocks available for sale, [governments] may discourage excessive price increases but naturally do nothing to prevent sharp decreases," reported an investment piece for Medical Economics published in October 1977. (Our thanks to the author for finding and faxing it to BullionVault this week.)

"The government specter [over the gold market] can't be expected to disappear quickly," F.D.Williams continued, some 32 years ago. "Gold will continue to be part of many national reserves for a long time. The stocks are so large, they can't all be dumped at once."

Compare and contrast with today's unwanted bequest - those toxic derivatives the US Treasury chooses to call "legacy assets" as if it played no role at all in producing them. Unlike state-hoarded gold, it only encouraged their creation; it didn't want to look after the damn things. And quite unlike the market for state-hoarded gold, a ready stock of willing mortgage-bond buyers also looks unlikely to gather.

"The PPIP, which was beset by multiple delays as regulators tried to figure out the best means of removing many of the troubled assets from banks' books," as CNN reports, "is still not up and fully running yet." It's not been for lack of incentives. The $2 trillion Public-Private Investment Partnership, announced to much fanfare in March, offers huge leverage - entirely at tax-payer expense - plus some or other hold-to-maturity value to risk-cushioned investors, albeit as yet unknown. Private investment groups can use up to $1 of non-recourse loans, plus another dollar of Treasury finance, for every $1 they spend on taking toxic housing derivatives off the banks' busted balance-sheets. Yet as a report published this week by the Congressional Oversight Panel put it:

"Whether the PPIP will jump start the market for troubled securities remains to be seen. It is also unclear whether the change in accounting rules that permit banks to carry assets at higher valuations will inhibit banks' willingness to sell. Similarly, it is unclear whether wariness of political risks will inhibit the willingness of potential buyers to purchase these assets."

Funnily enough, as the US authorities struggle to sell toxic debt, Western Europe's Central Bank Gold Agreement has also stalled in 2009. This comes, however, despite prices and private-investor demand both holding near record levels. First signed ten years ago this September, back when no one at the New York Times, Economist, Financial Times or big central banks could see a use for the metal (simply owning this secure, liquid store of value is use enough, by the way), the CBGA capped annual gold sales and made them plain in advance for the coming five years. It aimed to avoid a repeat of May 1999, when the UK Treasury's announcement drove prices down to what then proved their floor. In contrast to Washington's PPIP, however, central-bank gold sales weren't arranged in the hope of achieving maximum price, but merely curbing a rush for the exits instead. And as it is, they needn't have bothered.

Gold Prices have since risen three-fold and more against all major currencies, even while the 16 signatories to date sold almost one-fifth of their hoard in aggregate. Thus gold's weighting in their reserves portfolio has doubled regardless, rising as gold outperformed all other assets from the start of this decade.

Hence the dramatic slowdown in central-bank gold sales since the financial crisis began in August '07. Because it's tough selling gold when its use becomes so clear, so present. Here in the fifth and last year of 2004's renewed CBGA, "Net central banks sales likely to be in the order of 140 tonnes this year, down from 246 tonnes in 2008," reckons London market-maker Scotia Mocatta. Yet the annual ceiling for CBGA sales currently stands at 500 tonnes!

The new agreement - just signed and due to commence on Sept. 27th - tips its hat to the facts, reducing that limit by one fifth. But who's left to sell any way? Just as in the gold mining sector worldwide, the "easy metal" has already gone from West Europe's vaults, pretty much emptying Spain, the UK and those excess Swiss holdings which maintained the Franc's 100% gold-backing until the turn of this century. The two largest holders, Germany and Italy, continue to face down political calls for "mobilization", refusing to yield one ounce so far despite signing all three agreements. France, the third largest owner, has pretty much sold the 600 tonnes from its hoard announced when it joined the central-bankers' Cash4Gold party in 2005. That leaves only the International Monetary Fund's 400-tonne sale, hardly enough by itself to meet the next half-decade's 2,000-tonne limit.

Back at the Federal Reserve, meantime, tomorrow's central-bank legacy - of freshly printed Treasury bonds bought with magic money from nowhere - continues to swell. Yes, the Fed's stockpile of T-bonds may be smaller today than it was back in August '07 before the Great Inevitable broke, thanks to record Wall Street demand for the safety of Washington's debt. And yes, the Fed isn't quite collecting new bonds from the Treasury door directly, waiting instead a few days or so before picking them up (as Brian Benton, Chris Martenson and others have found) from those primary dealers who do bid at auction, rather than out-and-out monetizing the debt for all to see with its newly created cash.

And sure, private-sector demand for Treasuries continues to look so strong right now - what with overnight rates at 0%, plus the ongoing collapse of house prices, world trade and jobs creation - that the Fed says it will stop financing Uncle Sam's spending in, umm, October rather than in September as previously stated.

But hoarding gold looked rather more sensible amidst the violence and misery of the mid-20th century, and no one at the Fed or Treasury guessed two years ago that they'd be offering leverage incentives to try and revive the market in mortgage-backed derivatives. When the global economy gets off the floor...or risk assets become more attractive to private investment...or China and Japan find they really don't have any space left for US debt in their central-bank vaults, the market into which the Fed will want to sell its Treasury hoard will look very different to the market from which it's currently buying.

Whether a decade from now, in 2010, or perhaps this fall - when the $300 billion of quantitative easing ear-marked for Treasuries is spent - trying to quit the Fed's newest "legacy asset" could prove tougher even than finding ready buyers for today's toxic junk. And given the soaring interest rates and potential US bankruptcy that in turn might trigger, spurred by whatever's added to the Treasury's $11.7 trillion of debt between now and then, perhaps Buying Gold will look a smart move to the Western world's central bankers once more.

Adrian Ash
BullionVault.com

Head of research at BullionVault.com, the fastest growing gold bullion service online, Adrian Ash is also City correspondent for The Daily Reckoning in London, and a regular contributor to MoneyWeek magazine.

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