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Silver
Lease Rate Patterns (Thoughts for Tom @
silveraxis.com)
July
5, 2006
By:
Rhody
Courtesy:
Financial
Sense Online
Feedback
to Rhody on Silver Lease Thoughts
By
Tom Szabo
www.silveraxis.com
July
7, 2006
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.
Warehouse
Metal
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.
COMEX/Lease
Spread
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.
Overall
Perspective
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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