The gold ponzi scheme

I have written a couple of posts on how there is more gold paper than there is physical gold.  A year ago, Adrian Douglas wrote that there were four owners for every ounce of physical gold that is traded.  Recently, he told Peter Schiff that 45-100 times more gold paper exists than physical gold (see this post).

I concluded yesterday that banks which sell gold certificates do so on a fractional reserve basis.  How can they dare take such risk?  If the price of gold doubles, so would their liabilities!  I was thinking about it after writing yesterday’s post.  It is clear that the banks count on always being able to sell new certificates as their old customers begin to cash in the old ones.  Thus, they count on an active trade in gold certificates and continue to make a profit on the premiums, as well as continue to lend out the proceeds from the sales.  The Bank of Nova Scotia, which today has a market capital of 55 billion dollars, had 3.5 billion in Gold and silver certificates and bullion liabilities in their 2009 Annual Report.  Now let’s imagine a scenario in which the majority of holders of gold certificates become anxious and therefore go to their banks and demand delivery of physical gold–a bank run–and that this happens not just in Canada to Scotia Bank but globally to all the sellers of paper gold.  Suddenly a 3.5 billion dollar liability could become a 35 or even a 350 billion dollar liability, as banks scramble to buy physical gold, but suddenly gold becomes scarce instead of plentiful because no one is accepting the paper anymore.   This is something that could bankrupt the banks–indeed, it is the classic means by which banks have bankrupted themselves.  They issue more paper than what they have physical money, and people suddenly all come in to redeem their paper for real money (gold and silver).  Some financial institutions have even charged their clients storage fees for the gold and silver that they were supposedly holding for them! (See e.g., regarding Morgan Stanley).

Now, perhaps an esteemed reader of this blog says to me, “The banks wouldn’t be that stupid.”  But these are the same banks that bundled good and bad mortgages and sold them to the world in the form of derivative products called “CDOs”, saying that the housing market will never go down; this resulted in the sub-prime mortgage crisis and it has proven that banks are not run by the brightest people, but rather by immoral people whose desire to become rich leads to destruction and chaos.

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Gold certificates vs. Sprott Physical Gold Trust

I picked up some shares of Sprott Physical Gold Trust on a tip from a friend who is a lawyer at a Bay Street firm here in Toronto.  What backs up Sprott Physical Gold Trust?  Its Net Asset Value (NAV) as of close Friday is $11.60 per share, based upon 820,753 oz of physical gold held in the Canadian Royal Mint.

It is possible to buy Gold certificates from major banks.  What backs up the gold certificates of banks?  Well, the Bank of Nova Scotia says,

Scotiabank gold certificates are backed by the assets of The Bank of Nova Scotia.

And this:

Allocated gold is bullion held by a bank on behalf of the owner. The gold is separated from other metal that may be held by the bank and is identifiable by its unique bar numbers.

Unallocated gold is a claim on The Bank of Nova Scotia for the ounces entitlement to a specific quantity of gold bullion.

And finally, this:

RSP Gold Certificates sold through Scotia McLeod are allocated, while all other non-registered certificates are unallocated

This means that the Bank of Nova Scotia likely sells a great deal more gold certificates than the physical gold that they have to back it up, because they only hold allocated gold if the certificates are bought within an RRSP plan at their Scotia McLeod brokerage.  The rest is just paper.

The idea, therefore, that there is far more gold paper than there is physical gold is not at all far fetched.  This was exactly the point of a previous post that suggests that gold should be worth $56,000.  But because there is many more times more paper gold than physical gold, the gold market is actually flooded with worthless papers.  The Bank of Nova Scotia is not alone in this practice of selling unallocated gold.

The fractional reserve system of gold selling is a dangerous practice and it puts the buyer in a position of assuming the bank’s default risk.  If you put your money in a savings account, it is insured up to certain amount.  But it doesn’t seem that unallocated gold certificates are insured at all.  This website seems to give a pretty good explanation of unallocated gold certificates:  gold.bullionvault.com/How/UnallocatedGold