Murphy''s report on GATA trip to Washington


10:45p EDT Thursday, May 18, 2000

Dear Friend of GATA and Gold:

John Hathaway of the Tocqueville Gold Fund has followed
Reginald H. Howe of in analyzing
the huge gold liabilities recently undertaken by J.P.
Morgan & Co. Hathaway concludes that bullion dealers
are completely unprepared for the looming reversal in
the gold market.

I've not been able to reproduce the chart that accompanies
Hathaway's essay. The essay reads perfectly well without it,
but you can view the chart with the essay at its original

Please post this as seems useful.

CHRIS POWELL, Secretary/Treasurer
Gold Anti-Trust Action Committee Inc.

* * *

J.P. Morgan To The Rescue

By John Hathaway
May 11, 2000

Bullion banks expanded their short position in gold by
dramatic proportions in the fourth quarter of 1999.

Gold derivatives outstanding increased by a record
$24.2 billion to $87.6 billion, the largest quarterly
increase ever. These positions, reported by the Office
of the Comptroller of the Currency, do not include
activity of large non-U.S. bullion dealers or
investment banks. Including those entities, the OCC
numbers should be "grossed up" by 50 to 100 percent.

J.P. Morgan reported the largest exposure to gold
derivatives, $38 billion, more than 40 percent of the
total. From June 30, 1999, J.P. Morgan's total more
than doubled, from $18 billion.

It is possible that Morgan's activity was part of a
rescue operation for weaker bullion dealers. As the
strongest credit among bullion dealers, Morgan might
have been called upon (or felt a calling) to shoulder
some of the risk of weaker bullion dealer credits
rattled by the gold short squeeze of September 1999.

Perhaps Morgan's vast derivative expansion was a form
of reinsurance, an assumption of a layer of risk to
shore up the misadventures of their less competent
competitors. The shutdown of the firm's New York
trading desk at year end 1999 and transfer of most
trading operations to London is curious in these
circumstances, and raises the question as to whether
the objective was to distance these operations from
U.S. regulators. Notice that the new address is
conveniently near the anti-gold British Exchequer.

The activities of the bullion dealers in general and
Morgan in particular raise many other questions as to
the impact these institutions have had on the behavior
of the gold price.

The unprecedented quarterly increase in paper gold took
place just subsequent to the late September/early
October 1999 short covering rally that took gold from
its 20-year low around $250 to an intraday peak of
$339. Assuming a gold price of $290, derivative
positions expanded by a notional 3,600-4,800 tonnes.
At year-end they totaled 13,350 to nearly 18,000
tonnes. The OCC numbers provide no detail on the
underlying positions.

These figures undoubtedly contain offsetting long and
short positions, lease rate swaps, and numerous other
transactions. Still, why was there such a large
increase in derivatives when the gold market was
threatening to explode? Even more puzzling, the gold
price declined about 15 percent during the quarter.
One would expect that the value of outstanding
derivatives would have declined more or less by that
amount. The 38 percent increase in nominal terms could
hide a larger increase in terms of physical metal.

Stranger still, the producers did very little hedging
the fourth quarter. In the absence of producer hedging,
the predominant and natural source of derivative
transactions, what could have initiated this

The flood of new paper appears to have played a role in
snuffing out the short squeeze that began with the
Washington Agreement. This rally caused extreme
discomfort among the bullion dealers. A brief article
from the Financial Times on Sept. 30, 1999, suggests
that the bullion dealers sensed great peril:

"A second day of chaos in the gold market left some
analysts arguing that European central banks would have
to revise the restrictions on gold sales and lending
announced on Sunday.

"'This is now a disorderly market,' said Andy Smith of
Mitsui, one of the most respected gold analysts. 'Gold
is still a reserve asset. If you had conditions like
this in the bond or foreign exchange markets, it would
not be allowed to continue.'

"'Over the last three days, gold has been trading like
a commodity, not like money. Volatility has shot up;
the cost of borrowing has shot up. The situation is
untenable.' Mr. Smith called for the European banks to
urgently review their strategy."

Andy Smith was and continues to be a leading spokesman
for the bearish view and for the bullion trade. His
outcry was a fair proxy for the sentiments of the
bullion dealers. Since Smith was never one to complain
while gold was steadily declining, his public distress
is a most revealing hint of the agony his sponsors must
have felt.

We have encountered numerous anecdotal indications that
there was much pleading by this beleaguered group to
the Bank of England and the U.S. Treasury. The
possibility of a link between government entities and
the subsequent actions of bullion dealers in this time
frame is too strong to ignore. In rescuing its weakling
counterparts, was Morgan acting strictly in its own
self-interest or as an agent for the Bank of England
and U.S. Treasury? What were its financial incentives?
Did the obvious vulnerability of the bullion trade to a
rising gold price throw the dealers en masse into the
arms of government saviors, adding them to a long list
of bailouts?

The intense three-week rally broke as gold lease rates
plummeted, indicating that liquidity had been provided
to alleviate the short squeeze. Soon after, the Kuwait
central bank announced that it had loaned its entire 89
tonnes of reserves into what was a shaky and panicked
market. One might ask: What was the impetus for
Kuwait's sudden move, an action that if taken on its
own would have required large measures of decisiveness,
boldness, and insight that one would not normally
associate with the little kingdom.

Shortly after the gold price broke, Ashanti Goldfields
announced that its supposedly bulletproof hedge book
had failed to survive the stress test of the previous
weeks. The company would need infusions of capital,
extensive asset restructuring, and lengthy negotiations
regarding its troubled hedge book in order to survive.
In the workout sessions that followed, the torture
experienced by Ashanti management and shareholders must
have paled by comparison to that felt by the syndicate
of 17 bullion dealers charged with finding a solution
to the credit crisis.

In the process, the dealers undoubtedly came upon some
hard realizations.

First, their short position was not at all effectively
hedged by the long position of Ashanti's promise to
deliver gold in the future as they had once supposed.
Despite high leverage and poor cash flow, the dealers
had expanded Ashanti's credit lines to hedge under the
doctrine of "value at risk," the absurd notion that the
lower the gold price went, the more credit-worthy
Ashanti's short position became. This thinking ignored
that low gold prices threatened Ashanti's viability as
a going concern.

The second realization was that hedge instruments were
extremely difficult to restructure. After five months
of haggling, the total hedge book declined by only 2
million ounces to 9 million. The complicated, high-
margin instruments the dealers had so willingly
purveyed to Ashanti in the prior months proved to be
illiquid, impossible to value, and difficult to

Third, despite strict margin provisions, Ashanti's
financial woes quickly became those of the bullion
dealers. As intermediaries between central bank lenders
and their clients, bullion dealers were then and will
once again become ground zero for dislocations in the
gold market. A financially weak gold industry is a
direct threat to the credit-worthiness of the bullion
dealer positions themselves.

Our estimate of central bank gold deposits with bullion
dealers at the time of the crisis was 6,000 tonnes.
More recently, Dinsa Mehta, head of Chase Manhattan's
gold dealing operations, estimated this figure to be
7,000 tonnes. While gold deposit numbers are not
precise and both estimates could be off by 10-20
percent, the proportion and trend are accurate.

It appears that gold borrowed by dealers has expanded
since the crisis. To be safe, let's say that lending
expanded by only 5-10 percent, or 6,600 tonnes at the
maximum. Even at the lower end of the range, or 6,300
tonnes, where did this additional liquidity come from
besides Kuwait? The record increase in gold derivatives
outstanding during the quarter suggests a substantial
increase in central bank lending, but aside from Kuwait
and the Vatican, few names have surfaced. In all
likelihood their profiles were similar to Kuwait in
that they were in some way clients of the U.S.

Some 6,300 tonnes of borrowed central bank gold, or
fully 19 percent of world central bank reserves, has
been melted down and sold as jewelry. Still called
"reserves" by the central banks, the gold exists only
as a receivable, an electronic data entry -- due from
bullion dealers. No distinction between gold in the
vault and gold in the digital sense is made in the
financial accounts of the central banks.

This misleading accounting practice obscures the
existence of a short position approximately equal to
three years of new mine production. At current
depressed gold prices, deliveries from mine production
are the only way for dealers to repay their obligations
to the central banks. Confident that gold prices will
behave, the bullion dealers have leveraged their short
position by creating paper obligations, or derivatives,
of up to $150 billion, whose value is affected in some
way by the price of the underlying commodity.

Since the September 1999 scare, it has become obvious
that any hypothetical future sharp, permanent rise in
the gold price would be most harmful to the bullion
dealers. With few exceptions, mining companies enjoy
lenient margin provisions. The bullion dealers, not the
miners, shoulder the risk of their short position,
which represents a collective liability of about $60
billion priced at $280 gold. A $100 increase in the
gold price would represent a $20 billion increment in
their collective liability to the central banks. Such
an increase could prove very costly to the dealers in
terms of higher lease rate payments caused by the
higher dollar liability amount. In all likelihood, a
big increase in the gold price would also generate
heightened credit concerns and therefore higher lease
rates. Such concerns could also lead to withdrawal of
bullion deposits.

Gold derivative positions dictate "delta hedge" buying
or selling of physical gold according to mathematical
formulas. The physical market for gold has become very
thin since the September spike. In February this year
John Henry, the leading CTA hedge fund with presumably
thorough knowledge of the gold market, announced that
it was downsizing its positions in gold to 60 percent
of normal due to market illiquidity. In light of their
near- death experience in September, one wonders what
measures dealers are taking in this very thin gold
market to protect their short positions. Future gold
price spikes will be even more troublesome than in
1999. The physical market will be unable to accommodate
panic buy orders placed by dealers, leading to price
swings almost unimaginable in today's dispirited

Perhaps we are completely wrong in our suspicion and
that the 38 percent fourth-quarter expansion in
derivatives represented a change of heart to a more
bullish stance on gold for this traditionally bearish
group. Even if this were the case, we still have to
ask: Who would have been on the other side of the
trade? If the dealers did become more bullish, which
seems doubtful, which counterparties took the chance
that there was money to be made on the other side of
these bullish bets?

The September episode exposed the flaws in the bullion
trade. The mismatch between paper and physical gold
could not tolerate an unexpected, sudden increase in
the price of gold. The spike in the borrowing cost of
gold (lease rate) reflecting a liquidity squeeze and a
credit crisis turned out to be frightening. Only a
flood of new liquidity saved the day. But the flood of
liquidity came from an expansion of the short position,
not from natural flows in the gold market. It is clear
that the fundamental structural flaws have not been
amended and that the market is still vulnerable to a
new spike in the gold price.

The bullion lending trade is based on the
miscalculation that the price of gold will remain
locked forever in a trading range comfortably below
$350/oz. The low-inflation rationale for anticipating
quiescent gold prices is no longer valid, but the
derivative positions based on these assumptions cannot
be adjusted quickly to the new realities.

In the early 1980's, momentum-driven psychology led
banks to lend aggressively against the value and cash
flow of hard assets; oil and gas, real estate, and
other commodities, on the assumption of never-ending
inflation. Ultimately, these attitudes and practices
led to the banking crisis of the early 1990s. In the
late 1990s banks and other intermediaries aggressively
lent gold on the assumption of secular disinflation.
Once strong beliefs about the economic climate take
hold, they remain in place long after there is
considerable change that invalidates the original
assumptions. This is the case with the bullion lending
trade, which still views every rise in the gold price
as an opportunity to expand its short positions.

In a recent piece on the Euro, our partner Francois
Sicart discussed the elements of making a contrarian

"1. An aging trend. The passage of time is essential.
It allows even the most ignorant groupies to acquire
the superficial luster of theoretical knowledge that
will help them justify decisions really based on
momentum investing....

"2. A deepening consensus of expert opinions. Since
serious academic work requires ample historical and
statistical data, well-documented arguments explaining
a trend become available only late in the cycle....

"3. Straws in the wind. Often, contrary arguments
cannot be as solidly documented as those extrapolating
a trend because the contrarian looks forward rather
than backward."

The gold market perfectly exemplifies one at the cusp
of an opinion change. The weight of institutional
thought and scholarly rationalization is heavily
invested in the propositions that inflation is dead and
that gold, no longer money, has no role to play as an
official reserve asset. The repetition of such thinking
over a sufficient period of time has sanctioned the
establishment of investment positions that have become
inherently inflexible. A shift by definition can come
only through a cataclysmic market event, which
surprises all those with a vested interest in
maintaining their no longer valid posture.

Based on an analysis of mining company hedge books,
which represent a large component of the other side of
bullion dealer positions, there is almost no tolerance
for a gold price that rises and stays above $350/oz.
While risk managers among the bullion dealers may
regard positions as being suitably squared, such
comfort must be blind to the illiquidity of the
physical gold market. The physical market will be
unable to accommodate the delta hedging required by
derivative positions, as was the case in the September

What source of liquidity will save the day for the
bullion dealers in the next short squeeze? When will
the puppeteers run out of ammunition? The producer
hedging well has run dry. Producers have forsworn
incremental hedging for 2000 and are beginning to
realize that any future hedging at current prices would
amount to a liquidation of corporate capital. The
reasons for this will be discussed in a separate essay,
"The Folly of Hedging," to be available shortly on the
Tocqueville web site.

It is a pity that George Soros decided to call it a day
insofar as macro-economic portfolio bets are concerned.
The killing to be made by attacking the gold short
position fits the pattern of some of his most notable
coups. The agony of Ashanti was prologue to what lies
in store for the bullion dealers. Once gold trades
above its long-term replacement cost of $360/oz or
better, the dealers can look forward to a mega-Long-
Term Capital Management experience. When Alan Greenspan
recently warned banks about the risks of derivatives
and in the same breath mentioned that the market should
not overly rely on the doctrine of "too big to fail,"
could a scenario such as this have been what he had in