Banker Bailout Will Send Gold & Silver to Surreal Price Level

Analysis by: John Embry – chief investment strategist at Sprott Asset Management.

The volatility in the gold and silver markets has been intensifying in recent months and such action is often a precursor to a large price move. Considering the fact that gold and silver were recently driven to ludicrously low prices by the paper sharks on Comex in the face of dramatically worsening conditions in the entire financial sphere, there is little doubt in my mind that the next move is going to be a price explosion to the upside that will see the earlier highs this year for both gold and silver obliterated.

The recent events that have occurred on the U.S. financial scene can only be described as mind-boggling. I have been expecting bad things to happen but even I’m amazed. In the space of less than a month, the following events transpired:

Fannie Mae and Freddie Mac became wards of the U.S. government, effectively adding more than $5 trillion in debt to the U.S. balance sheet;

The fourth-largest investment bank, Lehman Brothers, declared bankruptcy;

U.S. icon Merrill Lynch disappeared into Bank of America in a classic example of a swap of bad paper for equally bad paper;

AIG, the largest insurance entity, was bailed out by the government to the tune of $85 billion;

And finally when the tactical moves weren’t getting the job done, the U.S. government announced a historic, wide-ranging plan to purchase impaired assets from financial institutions with an announced price tag of $700 billion.

If gold and silver were free-trading markets, rather than heavily manipulated ones, these events would have both metals at much higher prices than they are today. That day is coming just as it did in the 1970s in the wake of the failed suppression of that era. Thus, what is beyond aggravating in the short term actually provides an ongoing, wonderful opportunity to purchase gold and silver at bargain basement prices.

For those who still cling to the notion that gold and silver are not heavily manipulated, it might be worthwhile and very instructive to consider the recent observations by Don Coxe, the eminent market strategist employed by the Bank of Montreal’s subsidiary, Harris Bank.

In a conference call with clients, Mr. Coxe outlined what went on post- July 15, the day gold and silver peaked at US$986 and US$19.30 per ounce, respectively (preceding breathtaking two-month declines that saw gold fall 24.9 per cent and silver 44.1 per cent).

He laid out how the Fed and the Treasury in conjunction with the CFTC and SEC, collectively known as the infamous President’s Working Group on Financial Markets, rigged the collapse in commodities (including gold and silver) and the bounce in financials with the clear intent to punish those funds and individuals who were making commodity bets and shorting financials. He then went on to state categorically that this was the most massive government intervention into capital markets since the 1930s when President Franklin Roosevelt closed the banks.

I feel his view carries considerable weight. He is a contemporary of mine in Canadian financial circles and is one of the brightest, well-informed individuals that I have had the pleasure to know. He is also a member in good standing of the financial establishment, so for him to make this allegation is truly significant.

I well remember when, a number of years ago, Coxe summarily dismissed my views on gold manipulation.

But now that activities on this front have become so overt and have spread to so many markets (stocks, bonds, currencies, other commodities, etc.), it would appear that it is becoming socially acceptable to finally acknowledge these undertakings.

Giving the Treasury a blank check
to buy any financial asset
deemed impaired from a vast array
of financial institutions,
including foreign entities
operating in the U.S., is akin to
opening Pandora’s Box.

The toll that it has taken on precious metals is perhaps best captured by a recent comment by Nick Holland, the new CEO of the large South African gold producer Gold Fields Ltd. In announcing the company’s updated reserve estimate of 82 million ounces recently, Holland stated that Gold Fields’ mines could not be replaced anywhere in the world at current gold prices.

He then amplified that remark by suggesting it would take a US$2,000 gold price or higher to justify making the investment in the company’s mines today. In my mind, silver may be even more underpriced than gold.

And in both cases, this has happened because price discovery is occurring in what I believe to be corrupt paper markets.

As I stated earlier, gold and silver were counterintuitively annihilated at a time that the banking and financial systems were imploding. I firmly believe this was not an accident and that it was done to reduce the attractiveness of precious metals as an alternative to paper assets. If you had correctly forecast at the beginning of the year what was going to occur, virtually any astute individual would have suggested that precious metals would be go-to assets, as they have traditionally been in past financial crises. Thus, I can only conclude the metals have been intentionally crushed by the financial powers-that-be to display to all and sundry that gold and silver are not the “safe haven” assets that they have been historically.

In an even greater irony, those wishing to buy physical metal in this price environment have found it increasingly difficult to do so. Stories abound of coin and bullion dealers frequently being out of physical metal.

And in those instances where it is available, large premiums to spot are being charged and lengthy waiting periods to receive one’s metal are often the norm. It would appear that, irrespective of what prices gold and silver trade for in the paper markets, the physical market is becoming rapidly divorced from the paper one.

At this point, it is my considered opinion that individuals should only be concerned about how many physical ounces of gold and silver they own, with the obvious caveat being that it should be fully paid for so that there is no vulnerability to any margin calls as a result of future activity by the paper predators. As I write this, Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke are trying to convince a very skeptical Congress of the merits of the massive $700 billion bailout plan for financial firms. Given the gravity of the financial crisis, there is little doubt in my mind that it will pass in some form and it will undoubtedly be hugely inflationary.

Essentially, giving the Treasury a blank check to buy any financial asset deemed impaired from a vast array of financial institutions, including foreign entities operating in the U.S., is akin to opening Pandora’s Box. How the assets are to be valued is obviously a key question.

If they are overvalued in an attempt to unlock the credit system, the taxpayer is being disadvantaged. If, on the other hand, the transactions are based on very depressed market values, what, in reality, will it do to help crippled financial institutions? What at first blush might seem like a creative solution becomes more problematic as one confronts the details.

Providing some empirical evidence is a study by two IMF economists that examined all systemically important banking crises between 1970 and 2007 (some 42 in total spanning 37 countries). The data is sobering.

In about 60 per cent of the cases, governments set up institutions to manage distressed assets and, with a couple of exceptions, the results were largely ineffective, often because politicians used undue influence. However, the truly disturbing statistic was that, on average, the cost of these endeavors over the past three decades was 16 per cent of GDP in the various countries.

Applying this metric to the U.S. in the current instance implies a cost approaching $2 trillion; nearly triple the current estimate being used. Perhaps even more disconcerting is the fact that in the past crises there were a mere fraction of the derivatives outstanding that there are today, making the current cleanup infinitely more difficult.

This whole event confirms my long-held belief that when push comes to shove, the U.S. authorities will not hesitate to debase their currency in an attempt to salvage the financial system. In the fullness of time, this will be wildly inflationary and should propel gold and silver to prices that would be viewed by many in today’s context as surreal.


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