The case of banks in Cyprus paints a dark picture for depositors who believe their money is safe in a bank. In a recent interview, Eric Sprott, CEO of Sprott Asset Management, warned that when banks run into problems with capital, central banks now make depositors take the first hit.
The European Central Bank (ECB) put $10 billion into Cyprus and received a piece of paper in return as a promise of repayment. Mr. Sprott emphasized that depositors received no promises. They took a loss right away. For the ECB, the greater the losses to the depositors, Mr. Sprott argued, the greater the likelihood the ECB will get its $10 billion back, since the banks can use the depositor's lost money to repay the ECB.
In my recent interview with Mr. Sprott, he pointed out that this model of depositors losing their money first is the evolving model for bank crises. In New Zealand, the banking authority just passed the same sort of policy, while Canadian authorities are discussing a similar model. The solution to the banking problem globally is to spread the cost among all the depositors, who are the first to lose their money, not the bank. Briefly stated, Mr. Sprott argued that banks are stealing their depositors' money to save themselves. In the new financial world, profits are concentrated in the hands of the few, while losses are socialized to all the depositors.
Which bank will fail next?
Mr. Sprott sees the failure of banks spreading. He gave the example of the Banco di Montepaschi, which recently reported withdrawals of a few billion dollars, although it left the exact amount unspecified. Mr. Sprott believes that the crisis is bound to spread as banks that are facing liquidity issues seek to sell their investments. As more banks face problems, more sell, driving down the price of various liquid investments, such as mortgage portfolios, which only makes it harder for failing banks to raise the cash needed to meet a potential run on their deposits.
While the United States may be able to avoid runs on banks, there is scarce positive news about the future of the economy. The year 2012 was supposed to be better than 2011, Mr. Sprott said, yet GDP was up an anemic .1%. This year, he said, does not look like it will be any better, with tax increases and the sequester reducing government spending, which now forms about 40% of the U.S. economy.
Evidence mounts for a continued sluggish economy and no recovery in sight, Mr. Sprott said. The purchasers manufactured index is falling, while jobless claims are rising again. Caterpillar (CAT), FedEx (FDX) and Oracle (ORCL) have all announced earnings warnings. Restaurant chain sales are down 5.6% in February, which is totally in line with what would be happening to the disposable income of workers because of the tax increase. The housing and auto markets are doing well, but, he argued, are entirely based on massive amounts of almost free money at extremely low interest rates, mimicking the subprime housing market before its collapse.
I asked Mr. Sprott, how do we get out of this mess? Hyperinflation, as was seen in Argentina and Mexico during previous crises in the 1970s and 1980s is one option. Given politicians' great fear of inflation and the analogy to the rise of Hitler in 1930s Germany, which led to World War II, this option appears unlikely.
Fiscal policy could offer a way out, but unfortunately no one has any flexibility with fiscal policy, given the current austerity budgets in almost every country. Monetary policy is equally lacking in options since we already have zero interest rates and governments are printing money by the billion.
Another option would be to write off all the bank's liabilities, which would mean depositors would just lose their money, which is exactly what's happening in Cyprus, and already happened in Greece. As Mr. Sprott convincingly argued, this appears to be the model favored by Central Banks and bankers.
Fleeing to Gold
Investors with more than 100,000 euros, who are the ones at greatest risk of losing their deposits in failing European banks, Mr. Sprott said, are not just waiting for the next bank to fail and seize their money. Since the Cyprus crisis, the precious metal markets have seen a significant increase in buying, as shown by U.S. Mint statistics. U.S. mint sales are up 40% in gold and 40% in silver.
I asked Mr. Sprott, with increasing sales, why are prices falling?
He explained that prices are falling because the Comex market, which is a paper market, determines the price. People are shorting the paper market and driving the physical price down. Big banks that were short, he argued, are scaring hedge funds into thinking gold and silver are going to go down. They all start shorting it. All the while the big bankers have been short the whole time and covering their shorts, and now we've got all the hedge funds going short. The commitment of traders report showed that the specs increased their short position to a massive 22,382 contracts from about 2,900 as of February 5. I believe that such numbers are a key indication of the way the market is being held down.
Buy the Real
At a time when bonds are paying minimal returns, yet carry significant risk of default, and bank deposits are at grave risk, Mr. Sprott argued and I fully agree, the time to shift equity into real investments, such as gold, silver, platinum and palladium has never been better. China, Russia and Turkey continue to buy gold and silver, he argued, viewing this time as a massive sale on precious metals. For American investors concerned about the future of the economy, it may also be one of the greatest sales in history.