Tier 1 Asset Status For Gold: Price Implications

by: Avery Goodman

Back in December, 2009. the World Gold Council began its push to get the Basel Committee on Banking Supervision to accept gold as a Tier-1 asset for bank balance sheets. Recently, David Gornell, Vice President in charge of precious metals trading at Natixis, and Chairman of the London Bullion Market Association (LBMA) has gotten behind the effort.

That is not a misprint. Some of the members of the LBMA consortium of banks may be accused of getting people and entities like Banxico (the Central Bank of Mexico) involved in non-allocated storage schemes by which payment is made to them for storage of theoretical gold that is not in their vaults. They are also regularly accused of rigging the price of precious metals in a way that suppresses prices. Some of these same banks make markets in paper gold at futures and forwards markets.

According to the testimony of Jeffrey Christian, a consultant with CPM Group, who testified for the banks at a CFTC hearing on March 25, 2010, they define "physical" metal in a dramatically different manner than the rest of the market. According to him, "physical" need not be tangible yellow metal. The banks include all gold-related contracts, including theoretical metal in "unallocated storage", options contracts, and other OTC derivatives. Mr. Christian admitted that when all this contract-based "imaginary" metal is added up, the amount of "gold" and "silver" (and presumably the other precious metals) they have "sold" is approximately 100 times the real tangible metal that is in their vaults. In other words, they are storing 1 troy ounce of precious metal for every 100 ounces they "sell".

In spite of the above, bullion banks now appear to see the handwriting on the wall. Like many other people, their executives are supporting the idea of making real tangible gold (the kind you can touch and feel) a Tier 1 asset. Being classified as a Tier 1 asset has important implications for gold prices. Tier I capital is a bank's "core" capital, and is the base upon which all fractional banking leverage is built. Core capital consists of the value of common stock, disclosed reserves and retained earnings. Banks "store" this capital, like other capital, in many forms, including central and local government bonds, corporate bonds, asset-backed securities, etc. If gold is approved as a "Tier 1" asset, regulators will allow them to store capital in the form of gold.

Back in the gold standard era, the Federal Reserve was active in lending against gold held by commercial banks. More recently, it has lent only against U.S. government bond collateral. But, since 2008, it has been lending against all sorts of collateral, including "toxic waste" quality asset backed bonds, and, during the worst part of the 2008 Financial Crisis, it even lent against the value of equities. The ECB has always lent against a wide variety of assets. Both central banks assign different "haircuts", which are discounts from the asset's estimated value, and lent cash in the supposed "value" of the various Tier 1 assets, minus the applicable discount. Government bonds have historically been subject to the lowest haircuts.

Many organizations, like the CME and ICE futures exchanges, with close ties to the world's biggest and most influential banks, are actively accepting gold as collateral, for the first time in decades. J.P. Morgan Chase (NYSE:JPM) is a primary example. For many years, JPM has acted as the main instrument to carry out Federal Reserve spawned market interventions. It is possibly the most influential bank in the world. It has been accepting gold as collateral since February 2010, and this is very important. The powers-that-be, as represented by JPM, are viewing the metal as a Tier 1 asset already. This is in spite of what many believe are intentional price suppression attempts, undertaken in the short term.

All major western central banks keep substantial quantities of physical gold as a reserve asset, in spite of the fact that it is no longer officially a Tier 1 asset. Physical is the key. In spite of how they may define "physical" gold for purposes of trading it in paper markets, neither J.P. Morgan Chase nor the futures exchanges accept their own or anyone else's "paper-gold" futures or forwards, options, or other derivatives as collateral. They accept ONLY tangible gold metal that can be touched and felt. That is a strong indication of how "physical" gold will be defined by bullion banks in the future. When tangible physical gold is included among Tier 1 assets, it will be possible for banks to use it in order to obtain currency loans from central bankers.

It is not clear what type of haircut would be imposed, but if laws are passed to ban leveraged gold trading, the haircut could be very small. Without an end to leveraged trading, the metal would instantly return to being the most stable store of value in the world. But, the end of leveraged gold trading is not going to have a very dramatic effect on the market. Several years from now, which is the soonest that Basel would ever declare gold to be a Tier 1 asset, COMEX will surely have raised its gold performance bond to nearly 100% of the value of the underlying gold. So, in all likelihood, the end of leveraged trading, by then, will have no effect at all on gold prices.

It bears mentioning that, under the classical gold standard, commercial banks were active in trading gold to and from central banks, in exchange for paper notes. Returning gold to Tier 1 asset status is a first step to returning to some type of gold standard. Given the current size of the world's monetary base, the return of gold into the world of Tier 1 assets, will "supercharge" gold prices well into the 5 digits range. The long term outlook for gold, therefore, is excellent. The price of other precious metals, particularly silver and platinum, will piggyback upon gold and also substantially rise.

A long term position in gold can be taken in many different ways. You can buy coins and bars at local stores. You can buy a myriad of ETFs and investment funds that facilitate gold investment through stock brokerage accounts, including GLD, IAU, and more. Some of these fund products, however, have come under suspicion and criticism as to whether or not they actually have the amount of gold they say they have. Other funds, like PHYS and the Central Fund of Canada, are certain to have all the gold they claim, but ownership comes at a substantial premium over the price of gold.

You can also buy gold mining stocks, like NEM, AUY and many others. Or, if you've got sufficient cash available, you can enter the futures market, and take delivery of a 100 ounce bar of gold. Nowadays, you can also buy a micro futures contract that is "deliverable" into a 1/10th interest in one of these 100 ounce bars. If you collect 10 of these, and request physical delivery, you will receive one 100 ounce gold bar.

Make sure to use a real futures broker like PFG, RJO, Lindt-Waldock, etc. Stock brokers like ThinkorSwim, Interactive Brokers, etc. may dabble in futures trading, but they will involuntarily sell you out of your position before it matures. Tiny print in their customer contracts allows them to do that. Such brokers are interested onlly in generating commissions from trading, and won't allow you to take physical delivery.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.