Central Bank Gold Operations and its Ramifications

GOLD PRICE CONTROL BY CENTRAL BANKS

It is common knowledge that banks - especially central banks - have for years been selling (i.e. writing) gold Calls against their holdings of the yellow metal. The reason for this unorthodox banking activity is obvious: it provides income on a non-producing asset.

The gold Call writing activity can also be made relatively risk free - if the gold price can be "stabilized" within a tight range. Although the FRB can easily control the market price alone, price "maintenance" within a pre-determined range - through the cooperation of its financial cohorts - is much easier. Specifically, when gold's market price approaches the strike price of its Call options, the Fed or Treasury simply starts selling bullion (and/or gold futures) to bring gold's market value down, so that near-term Calls may expire unexercised - AND WORTHLESS!

Once the central banks have gained experience in these successful market operations (read profitable with seemingly little to no risk), they are prone to grow more aggressive by writing naked Call options (i.e. Calls against gold deposits THEY DO NOT POSSESS). It then logically follows that after many profitable months, central banks can conceivably become even more audacious in their greed to maximize operational revenues - at seemingly little real risk - from this non-interest bearing asset. Namely, writing Puts against the same gold assets. This is also perceived by the central bankers as a seemingly low risk investment, since they can control the price through covert manipulation. However, in this case when the price approaches the strike price of the Put, the central banks simply start buying the noble metal in order to stem the price decline. Ergo, the Puts also expire unexcersized AND WORTHLESS.

To maintain gold prices range-bound it is not even necessary to sell or buy the physical. Central banks are today sophisticated enough to manipulate gold prices through the use of delta hedges. As the price moves away from them, they simply sell more calls or puts to influence the cash market. The arbitageurs will do the rest by buying or selling the calls and doing the opposite in the cash market - which brings the gold price back in line with the established price range.

Our hypothesis encompasses another possible motive for the central banks' actions. The second assumes the FRB system is running unprofitable central bank operations. Now this flies in the face of conventional wisdom, which heretofore has believed the Federal Reserve System to be hugely profitable, and therefore is probably experiencing no operational losses. Quite frankly, I do not agree with this independently UNAUDITED CLAIM!. Please be reminded that ALL BANKS IN THE US ARE REQUIRED TO BE AUDITED BY AN INDEPENDENT CPA FIRM - that is except the Federal Reserve Banks!

My suspicions are based upon a number of factors: Firstly, the conspicuously rumored increased activity of gold call writing by the Fed in the last three years; Secondly, the declining gold price action (on-balance) during the last three years - vis-à-vis increases in the CRB and Goldman Sachs Commodities Indexes - not to mention the now proverbial stock market's IRRATIONAL EXUBERANCE. And finally, a close examination of the Federal Reserve Bank of New York's 1995 ANNUAL REPORT, which includes the Balance Sheet and Statement of Income.

An analysis of both - discussed later in this study - gives credence to the following observations:

1. Current operations of the Fed could indeed be suffering grievous REAL losses, were it NOT FOR THE ANNUAL INCOME GENERATED FROM OPTION ACTIVITIES IN THE GOLD MARKET.
2. More than 94% of its alleged total operating income may be just accounting book-entries, or fiat money.
3. The Fed may be engaging in the highly risky business of writing covered AND naked gold call options - and may even be writing gold Puts.

Additional Motives for CENTRAL BANK Gold Manipulations

1. To control the public's inflation expectations by keeping the gold price relatively flat.
2. The Fed may fear the horrendous impact of a big short-squeeze in gold due to the record large speculative short posture - and possibility due to a record amount of outstanding NAKED OPTIONS. A short-squeeze would give explosive impetus to the gold price - consequently, the Fed would most probably lose control of its price "maintenance" activities.

FEDERAL RESERVE BANK OF NEW YORK's 1995 ANNUAL REPORT

A critical examination of the FRB of New York's (hereafter referred to as "Bank") 1995 financial statements was made for a number of reasons:

• To try determine if the Bank was indeed operating profitability.
• To scrutinize its sources of income.
• To look for evidence of the Bank's gold call writing operations.

Statement of Condition (commonly known as the Balance Sheet)

There was only one item on the asset side worthy of mention. U.S. Government and Federal Agency Securities investments ($166 billion) represented more than 90% of the Bank's total assets ($184 billion). All the other assets were just pocket change in importance. Likewise on the liability side there was only one item of significance: Federal Reserve Notes outstanding ($139 billion), representing 76% of total liabilities ($184 billion). The only other item worthy of mention is Total Capital ($2.1 billion) - more commonly known as Net Worth (Capital paid-in and Surplus), which represents a minuscule one-percent of the liability side of the ledger.

Statement of Income

Whereas relatively little could be gleaned from the Balance Sheet, the Statement of Income was very revealing.

Total 1995 Net Income is stated as $9.5 billion, which at first glance appears to indicate the Bank is indeed operating very profitably. It implies that the Bank is earning a respectable 5.2% on total assets, and an astounding 452% on Net Worth! This sounds too good to be true! So, let's take a closer and more critical look at these "spectacular" earnings.

Bank Income is divided into two parts: Interest Income ($9.6 billion) and Other Operating income (0.4 billion), producing a Total Operating Income of $10 billion. It is meaningful to observe that $9.4 billion of the total interest income is from U.S. Government Securities - and only $0.2 billion in interest income from investments denominated in Foreign Currencies. THEREFORE, it is readily apparent that the lion's share of total gross income is contributed by interest accruing on paper issued by the U.S. Treasury and other Federal Agencies. That is to say 94% of the Bank's Total Operating Income comes from another government entity. Now, I have a few problems with this!

Firstly, U.S. Government Securities denotes paper issued by the U.S. Treasury. The FRB is monetizing the national debt by buying Treasury bonds - which were not able to be sold to third parties in the market place at reasonable interest coupons. Therefore, the Fed had to buy the Treasury debt paper. And how does the Fed (i.e. Federal Reserve Bank of New York) pay for these "investments?" Very simply - it is a book-keeping entry (not real money). And how does the Treasury pay the Fed (i.e. Federal Reserve Bank of New York) interest on the Bank's investment (i.e. T-Bonds)? Very simply - it is a book-keeping entry (not real money). Therefore, in my simplistic real-world view of the Bank's allegeded 1995's $10 billion in total operating income, $9.4 billion is nothing but entries on a page - which cannot be used to pay real operating expenses, like salaries, office rent, equipment, supplies etc. Etc.

The question is: What is the Bank's real Statement of Income - that is real Operating Income minus Real Operating Expenses? Tangible (read spendable) Operating Income amounted to ONLY $0.656 billion ($656 million), and Operating Expenses were $0.628 billion ($628 million). THEREFORE, IN REAL WORLD TERMS THE BANK JUST BARELY BROKE EVEN IN 1995 - as the real-world net earnings amounted to a paltry $28 million! This represents a pathetic profit of only 0.015% on Total Assets (versus the "OFFICIAL" financial statement of 5.2%) and 1.3% on Net Worth (versus the "OFFICIAL" financial statement of 452%)! A "slight" discrepancy,... wouldn't you say!

Some might say the Federal Reserve Bank of New York has grossly over-stated its income in REAL-TERMS?????!!!!!

Secondly, the very last line of the Bank's 1995 Statement of Income is really an enigma wrapped in an anomaly.

Per the 1995 Statement of Income the Bank shows $9.5 billion in net income (which in my opinion is over-stated almost in its entirety). From this make-believe money $61 million were distributed as paid dividends to member Banks, and $69 million transferred to surplus. THEN, it states that $9.4 billion were distributed as Payments to the U.S. Treasury!

Thirdly, many international experts have unambiguously stated that the Fed has been engaging in the lucrative activities of writing call options against its gold deposits. Earlier in this report we enumerated the rationale for these non-traditional banking operations. The question we would like to address here is to estimate how much income could be generated by the activity of writing covered gold options.

From very knowledgeable sources it is estimated that over a period of time the Bank could generate an annual income of approximately one-percent on the value of its gold holdings by selling Calls on its bullion. As we all know the U.S. government is the proud owner of 262 million ounces of gold. Taking into account the average gold price in recent years, it is conceivable that the Fed/Treasury complex could earn about One Billion Dollars per year from gold Call option premiums. In view of the real earnings posture (or better said lack thereof), an additional $1.0 billion of REAL MONEY will pay a lot of REAL OPERATING EXPENSES at the Fed and the U.S. Treasury!

THE REAL DANGER -- GOLD CALL SHORT-SQUEEZE

In my mind there is no doubt the Fed as executor of the U.S. Treasury monetary policy is engaging in the suppression of gold prices, and selling gold Call options in order to produce a constant income flow from the government's non-producing bullion. And although the Fed's Annual Report does not show evidence of these unorthodox banking operations, there are many ways the U.S. Treasury may camouflage the tracks of these activities. Whereas increased income for a government drowning in its mounting debt may be rationalized by politicians, the growing risk to the international currency markets seriously questions the prudence of these operations.

Recall the Federal Reserve Bank of New York has the unique custodial responsibility for the gold reserves of about 60 (SIXTY) countries, central banks, and international organizations. Inside its vaults is the largest known accumulation of monetary gold in the world. In fact the FRB of New York stores about one-third of the world's official gold stock, about 12,000 tons - valued at approximately $125 billion at current market prices! One should ask why these operations constitute a danger to the international monetary system?

If the Fed Can Do It - Why Not All Central Banks?

Financial institutions and large speculators have become understandably oblivious to the real risk of the gold options market. Was it not well-known that the central bank "controlled" gold prices within a well-defined tight range? Was it not well-known the central bank is in the business of writing gold Call options in order to generate a constant flow of real income on their idle gold? Was it not well-known the Fed is authorized to execute such orders (selling gold Call options on bullion deposited in FRB in New York) on behalf of foreign banks? What could be easier and more discreet? And all perceived at seemingly no risk!

The REAL DANGER is that gold Call option growth will eventually exceed the amount of gold existing and available in the event the Fed loses control of the market price of the yellow metal. Consequently, there will be the ugly likelihood of a violent short-squeeze causing gold prices to orbit - and conceivably precipitating chaos in the currencies market. The current state of gold's open interest is testament to the growing (indeed explosive) instability of this market. Large commercial hedgers - who are traditionally net short - have been for many months carrying a historically high net long position. On the other side of the gold futures market are the large Specs, who are in an all-time high net short posture. The dynamics of this situation are mind-boggling.

As the Internet's Resident Economist, George S. Cole, so aptly puts it: "LOOKS LIKE THE GOLD CALL OWNERS WILL GET SCREWED AS USUAL. Interesting to see how fast gold recovers AFTER OPTION EXPIRATION!"

 

THE RED BARON

(August - 1997)

Next Week:

Part - III - CENTRAL BANKS GOLD RESERVES DATA