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Milhouse and Hathaway confirm Murphy''s Midas

Section: Daily Dispatches

12:55p EDT Sunday, August 29, 1999

Dear Friend of GATA and Gold:

Two commentaries on the gold market published this week
confirm what you've been hearing in recent weeks from
GATA Chairman Bill Murphy at
and provide very interesting additional detail.

One is by Milhouse posted at Gold-Eagle. Its essence:

quot;Our short-term recommendation is that investors be
'cashed up' awaiting the much more attractive prices
[in general equities] that will likely be available
around October and November, while maintaining a core
holding of gold and technology stocks.quot;

You can find the Milhouse commentary at:

a href=

The other is by John Hathaway of the Tocqueville Gold
Fund. It's called quot;The Golden Pyramidquot; and it predicts
a quot;melt-upquot; in the price of gold because of the
uncoverable short positions taken by the gold carry

To save you a second jaunt into the Internet, I'll post
Hathaway's essay below. But if it comes to you as an
attached file here and you don't like to download
attached files (as I don't), you can find it at:

a href=http://www.tocqueville.com


a href=

Please post this as seems useful.

Gold Anti-Trust Action Committee Inc.

* * *

The Golden Pyramid

August 27, 1999

By John Hathaway

Think about this great business idea for a minute.
Let's borrow some surplus stuff and sell it for
whatever we can get. We'll buy a futures contract to
get it back at some certain future date, so we're
covered. Meanwhile, we'll earn an interest spread plus
commissions. While we're at it, let's sell puts and
calls against the stuff even if we don't have it on
hand. Our mathematical models will guarantee that our
position is always neutral, and we'll clean up on
commissions, interest and other fees on the options

The foregoing approximates the rationale of the present
day, little-known gold derivatives pyramid. John Exter,
a famous gold analyst almost two generations ago, was
the first to suggest that gold related to paper assets
in the form of a pyramid. He described the relationship
of gold to paper assets as an inverse pyramid balanced
on trust. Currency at one time was a gold derivative.
Government issue was backed by physical gold held by
central banks. Because currency was a claim on gold, it
was in effect a short position against a physical asset
that was relatively easy to calculate. Governments
hated the idea because they could never seem to stop
issuing new paper. Even the pretense of a link has been
long abandoned. Since currencies no longer have gold
backing, and the world still appears to function,
nouveau central bankers assert that gold is

The old currency gold/pyramid has been replaced by a
little understood labyrinth of paper claims against
gold. Responsible senior officials of mining companies,
central banks, and bullion banks cannot begin to
understand the internal mechanics in order to make
appropriate judgements of risk. There are few published
figures, no reserve requirements, no supervision or
regulation, and no accountability. It is the private
domain of bullion dealers, central banks, and mining
companies. The credit worthiness of the old
currency/gold pyramid was quantifiable. The credit
worthiness of the new pyramid can only be an educated
guess. Our guess is that it is bankrupt.

The gold derivatives pyramid is a vigorous free market
creature. It cannot be put down with a simple
declaration that the paper is no longer redeemable in
gold, as governments did with currency. It is a short
selling scheme that has become a trap from which few
short sellers will escape. Paper claims in the form of
derivatives far exceed the underlying physical metal on
which they are based. The trust, which balances this
new pyramid, is based on false assumptions and lack of
information. Paper gold claims have proliferated at a
pace rivaling any government printing press. A surfeit
of paper gold has driven down the price of the physical
on which it is based.

The structure can survive as long as bullion dealers,
the mining community and the financial media subscribe
to the bearish case. But the position of short sellers
is precarious. This is true whether gold stays at
current levels, or drops below $200/oz. The point is,
they will be unable to realize their paper profits, and
stand to lose money on their positions in the
aggregate. The compound miscalculations on which the
gold market is based rank with the blowup of the yen
carry trade in 1998. The yen carry disaster illustrates
how over-investment and near unanimity of market
opinion can lead to a vicious squeeze. Compared to the
yen, gold's liquidity is microscopic. The coming
squeeze will lead to a several hundred dollar rally and
a permanent change in attitudes towards gold.

Anatomy of a Bear Trap (Part 1)

Following the May 7th announcement that the UK would
sell more than half of its reserves, gold and gold
shares plummeted. The XAU index of gold shares rose 10
percent from Jan. 1 through May 6, just prior to the
announcement. In the following weeks, the index dropped
by 30 percent. The post UK selling of gold can only be
described as climactic and appeared to discount a
never-ending official sector supply. The UK sale came
out of the blue and could not have been more perfectly
designed to damage investor confidence in gold and gold
shares. Still, gold shares have remained above their
August, 1998 lows, thereby refusing to confirm the new
20 year lows set by the metal itself. A major bear trap
has been set, one that was several years in the making.
Mining companies in particular engaged in an orgy of
hedging since the UK announcement. The rush to the
exits when the bearish case became front-page news is
consistent with odd lot behavior and a good omen that a
major low is in place.

Gold's breakdown was based on two incorrect beliefs:
first, that all central banks will sooner or later sell
all of their gold; second, that today's best of all
possible worlds regarding inflation and financial
markets will last forever. It was nothing less than
capitulation to financial market euphoria.

Central bank and official sector selling represents
only a small percentage of the excess supply of gold.
Far more meaningful and much less talked about is
selling pressure from gold borrowed or leased from
central banks and resold for the accounts of mining
companies or financial institutions. A full examination
of gold leasing will show that the gold market has
already absorbed vast quantities of unreported selling
that dwarf announced outright sales.

Central bank financial accounts refer to leased gold as
quot;gold receivable,quot; an item lumped together with gold on
hand as if it were one and the same. In reality, gold
receivable is a dubious asset, and in some instances
potential bad debt, an asset class new to central
banking. A significant percentage of the borrowed gold
has already been melted down and sold into the physical
markets. It no longer exists in deliverable form. Aided
by poor information and worse governance, physical gold
borrowed from the central banks has been sold over and
over again in multiple transactions. Through the magic
of derivatives, paper claims have multiplied against a
shrinking base of physical gold. The short quot;coverquot;
ratio rivals the most overvalued Internet shares.

How did this happen, especially in the hands of leading
financial institutions that should know better? The
answer: pervasive bearishness, promoted by bullion
traders to build up their lucrative trade, and; lack of
good data on over the counter market positions.
According to Goldfields Mineral Services, central bank
bullion on deposit with bullion banks at year end 1998
was 4,300 tons. Frank Veneroso, a respected and well-
known authority on the subject, makes a credible case
for 8,000 tons. Since year-end, the volume of this
activity has expanded by as much as 30%, according to
Deutsche Bank in a first quarter 1999 conference call.
Volumes expanded further following the UK announcement.

Using the conservative Goldfields number, it is quite
evident that 6,000 tons of central bank gold has
already disappeared forever via the leasing route.
Using Veneroso's, the total exceeds 10,000 tons. Either
way, a vast quantity of central bank gold has already
been disposed of. It can no longer damage the gold
market and could even resurface as a buyback! The gold
is now in the hands of jewelry owners, coin buyers, and
small investors. The amount far exceeds the high
profile outright sales by central banks. It represents
25-40 percent of the total reserves of the 80 or so
central banks known to lend gold.

Anatomy of a Bear Trap (Part 2)

Easy to manufacture paper claims overshadow impossible
to manufacture underlying gold by several orders of
magnitude. There is plentiful evidence as to the
mismatch between paper and physical gold. A bullion
fund manager who has made a career of and a business
strategy based on the chain of custody of the physical
metal told me that he recently attempted to buy
physical from a large commercial bank. The bank officer
tried to persuade him to buy the bank's gold
certificates instead. It turned out the bank possessed
only four bars of gold that were free and clear of
various claims and therefore deliverable. The same bank
had $452mm of gold certificates outstanding as of
December 31, 1998. Holders of the certificates do not
own gold, even though that may be their impression.
What they own is the bank's promise to pay. Another
bullion trader familiar with the notes said that there
was no regulatory requirement for a specific gold

In another instance, a mining CEO mentioned that a
small quantity of bullion, a corporate asset, had been
deposited with a fiduciary. When the company decided to
switch banks, they called for their gold and were told
they couldn't have it within the notice period
specified by the agreement. It was only with great
difficulty that delivery was made, highlighted by a
last minute appearance of a Brink's truck at the
depository institution. The delivery was made with
borrowed gold.

The high-octane enhancements of the foregoing examples
cooked up by the best and the brightest Wall St. minds
are based on the same principle: unbridled credit
extension based on dubious linkage to physical metal.
In a forward sale, a mining company directs the bullion
bank to sell a certain quantity of gold for future
delivery. The bullion bank borrows gold from a central
bank, on a short-term basis and for a very low gold
lease rate, and immediately sells the gold into the
physical market. At that moment the bullion bank is
short. The expected repayment of the gold is from
future production of the mining company. Against one
spot sale, two claims arise. The central bank has a
claim on the bullion bank. The bullion bank has a claim
against the mining company's future production. Two
short positions arise from one physical transaction.

In a forward sale, central bank gold is sold into the
physical markets to be paid back from future mine
production, an innocuous proposition at first glance.
However, substituting yet to be mined gold for gold
bars entails the credit risk that the gold will
actually be mined. Meticulous research is conducted by
bullion dealers to assure that the gold is in place,
and that it can and will be mined. There can be a very
wide gulf between gold in its two states, as a mine
reserve and as refined bullion. If many years elapse
between the forward sale and the future delivery, or if
a very high percentage of mine reserves and future
production are mortgaged in this manner, risks and
profit potential for bullion dealers escalate. With
high confidence in gold's downward price trend, there
has been little reason not to push the limits on risk

In the world of options and delta hedging, the leverage
to physical far exceeds the two to one of a simple
forward sale. In recent years, mining companies have
resorted to writing naked calls to buy put protection.
Ever more exotic and indecipherable instruments are
being brought forth to clutter the market. The $300mm+
of bullion dealer profits is a voracious money machine
demanding more central bank gold and synthetic products
to fuel its growth. Simple puts and calls have been
supplanted by spot deferreds, knockout puts, and most
recently, call options on puts.

Individual strategies too numerous to mention all rest
on the central fiction that the underlying physical
metal exists in the form of yet-to-be mined reserves.
Because of delta hedging, the nominal amounts of gold
vary considerably with the spot physical market. These
option structures are a time bomb. Overall positions at
various strike prices are unknown to the market
participants. As spot prices approach the option strike
price, mathematical models determine the amount of
buying or selling without advance knowledge of market

What can go wrong? First, the mining company may be
unable to produce the gold. Second, the lease rate
charged to the bullion bank could rise sharply, as it
has in the past, and wipe out their profitable spread.
Third, gold could rise suddenly and sharply, triggering
margin calls from the central bank to the bullion
dealer. Fourth, under certain extreme market
circumstances, the counter-party to the bullion bank's
call option may be unable to deliver. Fifth, local
currency fluctuations could undermine economics of the
hedge. Sixth, sovereign risk considerations could
substantially alter credit quality.

The 6,000 to 10,000 ton physical short interest has
three major components. At year-end 1998, 3,600 tons
has been sold short by mining companies against future
production. Possibly 1,500 to 2,000 are payables of
jewelry fabricators against work in process. The 1,000
to 3,000 ton balance represents speculative positions
held by commodity funds, hedge funds, and financial

Mining company short positions are in theory balanced
against their own reserves, which will eventually be
produced and delivered against the hedge. The catch
words are quot;eventually produced.quot; A gold forward
represents an act of faith on the part of the bullion
bank that the reserves are accurately stated, mining
plans will be adhered to, and that economic conditions
will allow production. Such assumptions would be
understandable for periods of a year or two. However,
forward sales routinely extend from two to ten years,
with some quot;strongquot; credits as much as fifteen years.

Ashanti Goldfields, a major West African producer has
hedged 11mm ounces as of June 30, up from 8.75mm at
March 31st. Ashanti qualifies as an active and
sophisticated hedger. They have hedged 50 percent of
their reserves, somewhat higher than other large
hedgers, but the rationale for their actions is similar
to all other hedging programs, regardless of

The recent market value of Ashanti's hedge book was
$290mm, using conservative assumptions. What is
interesting is that this major corporate asset would be
worth nothing if gold traded at $325. At $350, the
company would begin to face margin calls. These numbers
assume the company takes no action in a rising market.
Management would of course defend the hedge book by
buying calls with a higher strike price, close out
profitable positions, and other assorted maneuvers. The
company is quick to point out that their hedge book
would not withstand a spike in the gold price very
well. The value of the book could not be realized in a
compressed time frame. If the gold price did rally
sharply, it is assumed it would settle back after the
spike to allow the company to realize the hedge book
profits. In theory, a run in the gold price could take
place, but management sees nothing imminent. The
Ashanti hedge book is a bet that the gold market will
remain quiescent and trouble free. They are merely
quot;rentingquot; their gold in the ground to enhance
realizations. Ashanti's sanguine view is not unusual.
Few in the industry are prepared for a spike in the
gold price, especially one which does not retrace. We
expect this to happen, not only because it would
inconvenience so many, but because markets that are far
out of balance change in a volcanic, not an
evolutionary, manner.

Given the risks inherent in the mining business, the
credit worthiness of deliveries the distant years
strains rational belief. If gold prices remain low,
many of today's reserves are uneconomic. Fourty to 50
percent of today's production is losing money.
Deteriorating finances of mining companies caused by
dwindling cash flow and survival tactics such as high
grading to buy time add doubt to repayment prospects.
In the fourth quarter of 1998, the production of
several leading North American companies exceeded the
life of mine reserve grade by 39 percent, and in the
first quarter of 1999, by 28 percent. Some but not all
of this discrepancy reflects high grading. Curtailments
of exploration and new project investment complete the
picture. The credit outlook for the industry's hedge
position has weakened dramatically in the last year.
Continuing low prices will damage it beyond repair.

Hedging allows uneconomic mines to remain open, and in
so doing, depletes firm capital. At the end of the day,
the most important asset of some mining companies is
their hedge book. The mining business is just an excuse
to hob nob with bullion dealers. Without hedging, many
mines would have already shut down. But hedging can
only prolong the life of marginal assets temporarily.
New hedges must follow declining spot prices. Salvation
for the industry lies not in hedging, but in its

If gold cannot be delivered against hedges, the
financial intermediaries (bullion banks) will be caught
short. The bullion banker's usual retort is that hedges
can be bought back in the open market should a mining
company founder. However, past examples were isolated
incidents. The pattern of red ink, rising debt levels,
and shrinking production could trigger multiple
simultaneous buybacks that would sharply lift the gold

The Coming Melt-up

Bullion banks and miners are vulnerable to rising lease
rates. Bullion banks borrow short and lend long. Credit
lines extended by bullion banks have terms of several
years, but they must roll over their gold borrowings
from central banks on a short-term basis. Roll overs
have been routine in a benign environment of low
interest rates, stable financial markets, and a
declining gold price. But concern over the ability of
the mining industry or the bullion dealers' ability to
repay would lead to a sharp rise in the lease rate and
calls for repayment. A spike in the gold price through
certain chart points would trigger margin calls to
dealers or miners as the market value of the hedge book
erodes. Almost all participants in this trade assume
they will have plenty of time to address these risks. A
sharp rise in the gold price or a prolonged rise in the
lease rate would do the most damage. Both events are
likely to occur simultaneously once confidence erodes
in the beliefs on which the rickety market structure is

It is interesting to note that Barrick Gold, the icon
of all hedging, is largely unprotected on its funding
costs. The average duration of Barrick's gold lease
agreements is six months. The $4 billion off balance
sheet asset, a hedge fund in the estimation of some, is
invested in long term financial instruments. The
mismatch is essential in order to earn the contango,
which is the positive carry between the cost of
borrowing gold and the returns from investing the
proceeds of gold sold short. Barrick, and most other
hedgers, face the risk that a prolonged upturn in lease
rates will erase all the benefits of hedging. We would
not be surprised if increased focus and concern arises
over this issue from both shareholders and corporate

In contrast to mine company and jewelry trade short
interest, financial shorts have no prospect of covering
their positions from natural business flows. In the
midst of universal pessimism, thoughts of covering are
remote. To date, the shorts have had a field day.
Shorting gold has been a one-way street to prosperity.
Low interest rates of 1-2 percent and bullish financial
markets (both the case until very recently) have made a
compelling case to be short. There has been no cheaper
source of funding in recent years.

The gold carry trade is based on a macro view that
inflation will remain tame forever, and that the risk
of a steady up trend in this cost of funding is non-
existent. As with any successful investment strategy
that is long in the tooth, latecomers to a party tend
to swell the volume of capital at risk with relatively
little gain. In the final stages, almost every investor
is on the same side of the boat. Negative sentiment
readings confirm that the gold market is offside.
Market Vane bullish sentiment on gold has stayed under
20 percent for over two months, an unprecedented stretch of
extreme bearishness. The recent hint of a more bearish
chill in the financial markets and a rise in lease
rates threaten to destroy the rationale for the carry
trade. The case to cover speculative short positions is
compelling. The four pillars of the carry trade are
shaky. Lease rates are up, eroding the spread.
Financial markets are turning bearish. Inflation signs
are multiplying, possibly awakening investment demand.
Finally, the prospect of official sector supply has
become far less certain.

How will the financial short sellers cover? The
prospective flood of official sales, which triggered
intense short selling only a few months ago, is
evaporating. The IMF sale is all but cancelled. The now
politically-correct Swiss may soft pedal their plans
based on social concerns for Black African miners.
Similar social concerns seem to be weighing on the
deliberations of other central banks. Even the
hopelessly stubborn UK posture is under siege, based on
recent revelations of strong opposition by Eddie
George, governor of the Bank of England. The political
sensitivity of these institutions was alluded to in a
recent conference call held by Goldman Sachs, which in
the same call abandoned its long-held bearish view. JP
Morgan, another institution prominent in the bullion
trade, has also adjusted its bearish stance.

Gold mining reserves are likely to decline at year-end
if current prices prevail. Exploration budgets are
being curtailed. Development projects have been put on
hold. The raw material for hedging is peaking out. High
lease rates undermine the economics of hedging. Panicky
hedging by the industry in the last three months was at
an unsustainable pace. Anglogold has stated that it
will not expand its hedges at these prices. Their
stance is equivalent to a 240 ton per year buyback,
greater than the recent pace of industry hedging of 200
tons. We believe that certain producer hedgers are
considering bypassing bullion dealers and purchasing
whatever official sector supply becomes available to
close out segments of their hedge books. Perhaps one or
two major mining companies that have missed the boat
would be foolish or desperate enough to initiate hedges
in this depressed market, but the fresh supply would be
trifling relative to the short interest. There will be
no answer to short seller prayers from the mining

Only gold leased from central banks can provide
liquidity in a short covering rally. With physical gold
owed to the central banks by bullion dealers no longer
in deliverable form, the short sellers' only
alternative will be to borrow additional gold. The
short will remain short, a situation that can only
cause great discomfort to the central banks. At current
market prices, the aggregate short position represents
$40 to $80 billion of capital at risk. A short covering
rally of $50 to $100/oz would cost $8 to $16 billion,
enough to make the problems of Long Term Capital
Management seem insignificant.

The Great Gold Fire Sale

It is axiomatic that the way to create a shortage of a
particular asset is to under price it. The US
government has proved this beyond doubt across a wide
assortment of commodities. There are various ways to
set prices such as ceilings or price supports. These
methods have been applied to gold with stellar results.
Golds special characteristics, which include a large
above ground inventory and monetary attributes, subject
it to other forms of price fixing. As with paper
currency, gold's value is affected by the cost of
interest, or the lease rate.

The mis-pricing of gold credit has been a central cause
for the late stages of the gold bear market. The
development of deep forward markets has only occurred
in the last decade. The gold pyramid that we have
described is nothing more than a conduit for the
divestment of central bank gold into the physical
markets. Gold in the vault has been replaced by phantom
quot;gold receivables.quot; If the lease rate were comparable
to market rates for paper currency, the gold derivative
pyramid could not function. The carry trade would blow
up and the arbitrage between paper currency and gold,
which is the foundation for mine hedging, would not

Pierre Lassonde, President of Franco and Euro Nevada,
recently wrote in the Northern Miner: quot; The single
greatest damage caused to the gold price has been
indiscriminate leasing, by central banks, of their gold
reserves at giveaway interest rates.These suicidal
rates are a gift to the speculators, hedge fund
managers and producers who hedge.quot; Low lease rates of
1%/year, he observes, represent an inappropriate 75%
discount to US T-bills.

If gold leased by central banks totaled 10,000 tons as
of June 30, the interest differential exceeds $2
billion. Since the new age central bankers view their
institutions (incorrectly) as profit centers, sub-
market lease rates appear to be a glaring departure
from their mission. The ill-conceived leasing trade has
depressed the value of a major reserve asset, and it
has also transferred an embarrassing level of wealth to
non- citizens.

What is the correct interest rate for gold? No one can
answer the question. Interest rates set by committee
lead to distortions and miscalculations. While the
interest rate on gold has not been set by a committee,
it does reflect the collective negative attitudes of
central bankers towards a reserve asset they inherited
from the previous generation and a willingness to trust
in paper assets, which they did not inherit. In
reality, the rate is based on nearly unanimous
acceptance by central bankers and mining executives of
the bullion dealers' sales pitch, in short, a virtual

Who is benefiting from the fire sale? Financial
speculators and bullion bankers are high on the list.
Even higher up, however, are the world- wide consumers
and investors who form the physical markets into which
central bank gold is disappearing. Thanks to the gold
pyramid, they are able to acquire vast quantities of
the precious metal at prices well below the cost of
production: present, future, and probably past, if
inflation adjusted. Recent dispatches on gold
consumption show very positive trends. For example,
India, the largest consumer, reported 80 tons of
imports in June, on a pace to shatter last year's
record. Other Asian economies show similar patterns.
The US is minting gold eagles at an annual rate of 365
tons, a record pace. Jewelry consumption worldwide is
showing strong positive trends. According to the World
Gold Council, consumer demand rose 16% in the first
half of 1999. Refineries, which melt down central bank
gold bars, are as heavily backlogged as any time in

Consumer demand for gold is breaking all records.
Thanks to the depressed gold price, consumption for
jewelry and investment exceeds sustainable sources of
supply, mine production and scrap by a wide margin.
Without the giveaway engineered by the bullion banks,
there would be a shortage and the gold price would be
much higher. As with the US dollar, there are twin
deficits. The first deficit is the short interest
arising from the mismatch between gold derivatives and
physical gold. This is a technical market condition,
which will be resolved at some point by short covering.
The second deficit arises from the growing appetite of
world gold consumers, fed by artificially low prices.
This chronic, fundamental market deficit will be closed
only by much higher gold prices, over a period of
years. At some point, frenzied short covering will
crowd out consumer demand. Perhaps the grass roots
owners of gold will oblige the shorts by melting down
their holdings. Issuers of gold derivatives choose to
ignore these facts in pursuit of ever greater profits
in their risky business, girded in the belief that they
have the staunchest of allies in the witless compliance
of nouveau central bankers and death-wishing gold
mining executives. Few of these players are receptive
to a wake up call. Denial is still in high gear.

The recipe for a shortage has been carefully followed.
A few finishing touches may be required before a market
epiphany. There is no known reconciliation between
paper and physical positions, and none will be
attempted until after the squeeze. The weakness of
credit analysis and supervisory oversight, as well as
the many ambiguities in the linkage between paper gold
and physical can flourish only if there is supreme
confidence in gold's permanent downtrend. The trust and
confidence essential to balance the gold derivatives
pyramid depends on three critical errors: that mine
reserves = physical gold; that gold receivables = gold
on hand; and that financial markets will enjoy smooth
sailing indefinitely. Trust is nothing more than a
state of mind. When this levitation is finally exposed
and its illusions shattered, it is ludicrous to think
the imbalances can be corrected by a small rise in the
price and within a comfortable time frame. Expect the
resolution to be swift, furious, and uncomfortable for
those caught short.