Today In Silver

Ted Butler alleges in his recent piece The Sting that JPMorgan and other big banks forced the liquidation of a huge volume of over-the-counter derivative contracts in gold and silver during the 4th quarter of 2008. Normally I don’t pay much attention to what Mr. Butler says but here he is actually trying to analyze a new set of data. Since he probably got the idea of looking at bank derivative positions from what I wrote back last August, I feel a compulsion to correct the  fantastically twisted job he has done.

According to the OCC’s latest data release, U.S. banks, led by JPMorgan Chase, caused to be liquidated, under intentional duress, more than $20 billion of gold and as much as $9.5 billion of silver in Over The Counter (OTC) derivatives transactions during the fourth quarter of 2008. These derivatives are highly leveraged transactions mostly held by hedge funds and other large investors on the long side and big banks on the short side.

In point of fact, the OCC report does show a substantial reduction in gold and especially precious metal notional derivative positions by large banks but the only place this report proves “forced liquidation” or “manipulation” is in Mr. Butler’s imagination.

During the fourth quarter of 2008, I was repeatedly struck by the viciousness of the sell-off in silver, as we twice plunged below $9 an ounce, down almost 60% from the highs of a year ago. I was puzzled why the manipulators had continued to force the price so low, considering that the bulk of the COMEX liquidation was over by September and October. After all, there was no evidence of physical selling of silver, as all categories and measurements of investor demand for physical silver grew during the quarter. This OCC report explains the exaggerated price sell-off completely, despite strong investor demand for silver.

He then claims that the forced liquidation was caused by driving COMEX prices lower, which resulted in margin calls on the larger OTC positions.

Quite simply, the amount of paper silver (and gold) transacted in the OTC market dwarfed what took place in the real physical market. Further, since the OTC is so opaque, the transparent paper COMEX market was used to set the price for, and cause, the massive liquidation in the larger OTC market. The price that is disseminated from the COMEX is the price that the world goes by and prices all silver (and gold) transactions. Miners, refiners, industrial consumers, investors and paper hedge fund speculators all price off the COMEX. Control the COMEX price and you control the world of silver (and gold). Hedge funds and other large leveraged speculators holding long positions were faced with increasing margin calls as COMEX silver prices were manipulated lower and they sold to the big banks who were short and bought back their shorts.

Do you see the circular logic? Mr. Butler alleges that ” the bulk of the COMEX liquidation was over by September and October” yet he then states in the very next paragraph that during the fourth quarter “COMEX silver prices were manipulated lower”. So apparently we are to believe that the COMEX prices were driven lower by forced liquidations of OTC positions which drove COMEX prices lower resulting in forced liquidations of OTC positions and so on. This “logic” should insult the intelligence of logical silver investors.

The allegation that JPMorgan is short OTC derivatives in a big way falls equally flat in the logic department. For one, JPMorgan and other commercial derivative traders’ COMEX short positions are hedged in part by long OTC derivatives, so these dealers must necessarily hold some long OTC derivatives. The regulators may not enforce “full” hedging of COMEX short positions with physical bullion but they do require at least a paper hedge. Indeed, increases and decreases in commercial short positions on the COMEX generally track the banks’ OTC gold and precious metal positions in direction if not magnitude.

More importantly, the vast majority of OTC positions held by JPMorgan and other derivative-dealing banks are positions for customers and not their own primary trading. Such positions are offset with counterparties or otherwise hedged (see COMEX comment above). A basic if overly simplistic example would be a gold forward purchase agreement with one customer being offset by a gold forward sale agreement with another customer.

We can see this by looking at JPMorgan’s 2008 financial statements. For example, on page 147 we find that the total fair value of assets and liabilities associated with commodities that JPMorgan trades for its own account was $18.4 billion in assets and $11.9 billion of liabilities at the end of 2008. This includes all commodities and although there is no separate breakdown for gold and silver we can estimate the precious metal component by reference to total outstanding notional amounts (see tables 9 and 10 in the OCC derivatives report). On this basis precious metals represent roughly a few billion dollars of trading assets and liabilities. Even if JPMorgan were entirely short in its OTC derivatives precious metal exposure, this would amount to no more than a few million ounces of gold and several tens of million ounces of silver. Certainly big enough to be a major player in the PM markets but not an extraordinary level of concentration. In reality, however, commodity trading assets held by JPMorgan (including $3.4 billion in physical commodities) have exceeded trading liabilities during the past few years, casting serious doubt on the idea that the big banks are big shorts.

Furthermore on page 114 of JPMorgan’s financials we find a disclosure about the fair value of nonexchange-traded commodity derivative contracts and once again we can see that there are both long and short offsetting positions. Not only that, but JPMorgan appears to have consistently held a net trading asset position in commodities which strongly implies that it was net long as opposed to net short during the bull market. At a minimum, these disclosures preclude a concentrated short position of the size alleged by Mr. Butler and others.

Finally and perhaps most importantly, the OCC derivatives report shows gross derivative positions (both long and short) and there is no way to determine the composition or changes from period to period. In general, however, long and short derivative positions are in rough balance at the banking system level in the same manner that long and short derivative positions are roughly in balance for JPMorgan. We can be relatively certain about this given that extreme fluctuations in interest rates, currencies, equities and other markets have not blown up the derivatives books of any major banks (I deal with AIG separately below).

We can see how this works by studying the only long/short breakdown that the OCC provides, credit derivatives. You will note that as described on page 6 of the 12/31/08 OCC Report, total credit derivatives held by the banking system were $15.9 trillion (almost entirely credit default swaps) but this represents $7.8 trillion sold (short) and $8.1 trillion purchased (long). In effect, the $15.9 trillion is made up largely of opposite bets; using notional values to calculate total exposure is thus tantamount to double-counting. Moreover, the 5 largest banks account for the vast majority of these credit derivatives and given the proliferation of netting agreements the systemic risk to the banking industry as a whole is much less than even half the notional amount of $15.9 trillion. In comparison, AIG sold several hundred billion dollars in credit default swaps but it did not buy any offsetting long positions for hedging purposes. As a result, defaults accumulating to only several percent of the insured debt resulted in this gambler/insurer going under.

In the case of gold and precious metal derivatives, netting between banks is likely to be less common but netting of customer accounts within each bank’s dealer swap desk will still result in something similar to what we see in credit derivatives. Thus if the reported bank position in gold and precious metal derivatives is being reduced then it is probable that a roughly equal amount of long and short positions are coming off. At a minimum, Mr. Butler is therefore double-counting the number of ounces “liquidated” in both gold and other precious metal derivatives.

As an aside, silver is most definitely not 100% of the precious metal derivatives considering that each of platinum and palladium are similar sized markets in terms of annual supply and demand. Although the amount of OTC activity in platinum and palladium is significant, I probably wouldn’t argue with precious metal derivatives being comprised of 80-85% silver. At the same time, this percentage likely fluctuates and it might have been actually closer to 50% at some point before the end of 2008. As a result, we cannot say with any degree of certainty that the reduction of precious metal derivatives by the big banks during the fourth quarter of 2008 was mostly in silver. Indeed, both platinum and palladium prices collapsed by a larger percentage during this timeframe than even silver. And unlike silver, palladium continues to trade near its lows while platinum has managed only a very minor recovery (certainly not matching silver’s 75% gain from $8.40 to $14.60).

All the above aside, if the individual counterparties to the bank-issued OTC gold and silver (and platinum and palladium) derivatives were themselves hedged using physical metal and COMEX or other exchange-traded contracts, the liquidation of such derivative positions by these counterparties would certainly have impacted precious metal prices since there would have been “real” buying or selling involved. If so, Mr. Butler has indeed identified a potential source for the price volatility of gold and silver during the fourth quarter of 2008. Cheers for that. At the same time, here’s a loud “boo” for the rife speculation that a forced liquidation was engineered by the big banks (instead of a forced liquidation being caused by the stupidity and imprudence of derivative speculators).

BOOOOOOO!!!

Bottom line, Mr. Butler and his flock can protest all they want but they cannot prove that JPMorgan and other big banks did not actually reduce their own long OTC trading positions in gold and silver during the 4th quarter of 2008 much less that they profitably forced a liquidation of short OTC positions held against hedge fund longs.  While proof either way is nonexistent, common sense dictates that the reduction in derivative positions was most likely at the dealer desk of the big banks as both long and short derivatives customers closed out positions. This is not manipulation, it is simply how the market works. The exact same thing was repeated in crude oil, copper and other base metals and grains, not to mention equities. Silver is not special in this respect, and building a case for special status in spite of the evidence is a disservice to silver investors.

silverax Windbag Wisdom