Gold Shortage Rumors Abound

“When you hear of wars and rumors of wars, don’t be alarmed!” reads the Gospel according to Mark. “These things must happen, but they don’t mean that the end has come.”

We seldom cite the Bible, but the passage came to mind this morning as we reflected on an e-mail chain among several of our business partners and acquaintances. Only instead of “wars,” the word that came to mind was “fraud.”

Fraud and rumors of fraud abound in the gold market.

“I’ve heard these rumors for a while,” says Byron King. “From ‘No gold in Fort Knox’ to ‘Lots of gold bars from Hong Kong are really gold-coated tungsten’ to the ‘London Metals Exchange is empty.’ They never pan out.

“But like someone phoning a terror threat to the FBI or someone pulling a fire alarm in a school…you can’t totally blow it off.”

The rumor sparking King’s comments goes like this: The London Bullion Market Association (LBMA) – the UK’s version of the Comex – has almost no bullion in its vaults. That is, there’s nothing backing the exchange contracts. And once its holdings are audited, the exchange will collapse.

“I have seen these stories,” says our friend James Turk of, “and do not have any inside knowledge about their accuracy. I do believe, however, that many bullion banks and bullion trading houses operate on a fractional reserve basis, meaning that they do not have enough physical metal on hand to meet all of their obligations to deliver physical metal.

“That is the way banks have always operated and is one major reason why they periodically get into trouble. Historically, bank runs are, in effect, demands for gold.

“Unfortunately, banks and bullion houses do not report their gold liabilities or gold assets. So there is no way of knowing whether they are solvent, i.e., have enough physical metal to meet their liabilities to deliver metal. Basically, if you own paper gold from a bank of bullion house, instead of real, physical metal in hand or in secure storage like we do in GoldMoney, you are dependent upon the bank’s creditworthiness. I don’t recommend being in that position.”

“I have no proof the rumor is true,” adds Egon von Greyerz of Matterhorn Asset Management in Switzerland. But “a lot of people who have studied it closely are convinced that there is a major shortage in physical gold at LBMA. LBMA trades around 700 tons net of gold daily. That is 25% of world annual production and around $6 trillion annually. To back that amount of trading on a 100% reserve ratio basis, it would need several year’s production of physical gold, which they definitively haven’t got.

“So as I have argued many times, LBMA, Comex, and the banking system as a whole has only [a] fraction of the gold required to settle outstanding contracts when investors demand physical delivery. In addition, central banks have leased their gold to the LBMA member banks for years in order to suppress the gold price.

“Of the 30,000 tons that central banks are supposed to hold, I would be surprised if they have even half of that.”

Fine, you say, but what does all this mean?

“I have been expecting for some time,” Egon continues, “that during 2010, more and more investors will demand physical delivery. With gold production working at full capacity, combined with the massive outstanding paper gold position, increased demand for physical gold can only be satisfied at much higher prices, which we are likely to see in the next few months.”

Byron agrees, but adds a cautionary note: “Gold is rising because governments everywhere are incompetent. If a major vault is empty, that’s good for other gold holders. But I’d be careful about making policy on it.”

A major “dislocation” in which physical delivery is demanded, but cannot be fulfilled by an exchange would spike the gold price big-time in a matter of hours. But don’t bet the farm on it. Buy gold because it’s an insurance policy against financial calamity. Like the next item…

This morning, Gold sits at record highs measured in euros, pounds and Swiss francs. And at $1,185, it’s less than $40 off the record measured in dollars set last December. Because of this calamity:

Greek Riots
Riot police fire walking in Athens yesterday

As we write, a new round of protests is under way in Greece. Yesterday, demonstrators set fire to a bank, killing three people. Parliament is debating wildly unpopular austerity measures that are a condition of the EU/IMF bailout.

Addison Wiggin
for The Daily Reckoning