Seeking Alpha
Long-term horizon
Profile| Send Message|
( followers)

Yesterday, June 18, 2012, the FDIC distributed a rule-making notice to member banks, telling them it intends to change collateral rules, among other things. The changes are not purely the work of the FDIC alone. Prior to the notice, the agency got the approval of all US federal bank regulatory agencies. These include the Federal Deposit Insurance Corporation (FDIC), Federal Reserve Board of Governors and the Office of the Comptroller of the Currency (OCC).

The purpose is to harmonize and address perceived shortcomings in the measurement of risk-weighted assets, in part by implementing changes made by the Basel Committee on Banking Supervision (BCBS) to international regulatory capital standards. It is also intended to implement aspects of the Dodd-Frank Act. The proposed rule would:

1) Revise risk weights for residential mortgages based on loan-to-value ratios and certain product and underwriting features;
2) Increase capital requirements for past-due loans, high volatility commercial real estate exposures, and certain short-term loan commitments;
3) Expand the recognition of collateral and guarantors in determining risk-weighted assets;
4) Remove references to credit ratings; and
5) Establish due diligence requirements for securitization exposures.

One key provision significantly strengthens restrictions on the way banks estimate their exposure to derivative risks. Banks use these estimates, and disseminate them to regulators, for purposes of setting and/or justifying capital levels. Estimates of exposure using so-called "net current credit exposure" (the cost of canceling the contracts prior to the occurrence of a trigger event) and/or purely subjective mark-to-fantasy "models", concocted by the bank financial team, would no longer be acceptable. Notional exposure would become a mandatory part of calculating the "risk" of derivatives.

Under new rules, the following would be entitled to a zero percent risk weighting:

1. Cash;
2. Gold bullion;
3. Direct and unconditional claims on the U.S. government, its central bank, or a U.S. government agency;
4. Exposures unconditionally guaranteed by the U.S. government, its central bank, or a U.S. government agency;
5. Claims on certain supranational entities (such as the International Monetary Fund) and certain multilateral development banking organizations
6. Claims on and exposures unconditionally guaranteed by sovereign entities that meet certain criteria, as listed in the notice.

A set of other assets, which are considered less reliable, are assigned a 20% risk weighting:

1. Cash items in the process of collection;
2. Exposures conditionally guaranteed by the U.S. government, its central bank, or a U.S. government agency;
3. Claims on government sponsored entities (GSEs);
4. Claims on U.S. depository institutions and NCUA-insured credit unions;
5. General obligation claims on, and claims guaranteed by the full faith and credit of state and local governments (and any other public sector entity, as defined in the proposal) in the United States;
6. Claims on and exposures guaranteed by foreign banks and public sector entities if the sovereign of incorporation of the foreign bank or public sector entity meets certain criteria.

Way back, on October 6, 2011, I wrote an article that addressed the probable return of gold to reserve asset status, in the private banking world. Now, the first steps are being taken. Once these rules are passed into law, for example, gold bullion will fulfill bank capital requirements better than Fannie Mae or Freddie Mac bonds. This reflects the real world reality. The proposal is a reform that could prevent future financial instability.

Perhaps, the most interesting thing about the notice, is its choice of words to describe an unspecified US "central bank". Why describe the central bank in an amorphous manner? Why not refer directly to Federal Reserve? Perhaps, many people, in high places, including the top people on the Federal Reserve Board itself, have concluded, as I have, that Fed will not survive this crisis.

The most important thing from the standpoint of precious metals investors is that gold is slated to return to the center of the financial universe. Under this joint proposal, co-sponsored by FDIC, OCC and the Federal Reserve, gold will once again be a zero risk asset in the private banking world. It has been legally barred from that most important of positions for 80 years now. That return will have profound implications.

Gold's return to the top tier in banking assets will result in a big increase in demand. Increased demand will eventually be reflected in an increased price. Other precious metals, like silver (iShares Silver Trust ETF: SLV) and platinum, will probably be floated alongside, because the price of both are now, and have always been, intrinsically linked to the price of gold.

A position in gold can be taken by investing in physical coins and/or bars, ETFs like SPDR Gold Trust ETF (GLD), iShares Gold Trust ETF (IAU) and Sprott Physical Gold Trust (PHYS), gold mining shares like Newmont Mining Corporation (NYSE:NEM), Yamana Gold Inc. (NYSE:AUY) and Gold Fields Limited (NYSE:GFI), among others.

Important Update (July 6, 2012):

Even if no one recognizes an error, if a court recognizes an error in one of its decisions, it is duty-bound to reverse itself. I am now faced with a similar situation.

A number of articles, by many different authors, have been written, based on the idea that gold is being returned to its former status as a zero risk-weighted asset. All, including this one, are incorrect.

The FDIC letter, upon which this article is based, is written in an erroneous manner. The FDIC advised banks in late June, this year, of changes to risk-weighting and collateral requirements. The notice stated that gold bullion would now be a zero-risk weighted asset, and omitted the requirement of an “offsetting gold liability”. Such omissions, under rules of judicial construction, are considered “intentional”.

Apparently, however, the omission in this case was a clerical error. After more careful review, I have discovered that the full text regulation shows NO SUCH CHANGE.

The full text reads as follows, in pertinent part:

“A zero percent risk weight to…gold bullion held in the banking organization’s own vaults, or held in another depository institution’s vaults on an allocated basis to the extent gold bullion assets are offset by gold bullion liabilities”

Gold is likely to rise sharply in price, but it won’t be because of the reasons stated in this article…at least not yet. Continued monetary debasement, the excessive indebtedness of most western sovereigns, high rates of real inflation, and heavy demand from the increasingly wealthy middle class of various emerging markets, will continue to bolster the price of gold. That will happen in spite of any efforts by manipulators to slow it down.

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