Is Leverage In Gold And Repo Markets Reaching Its Limits?

This article contains the highlights from the latest Thunder Road report (edition: August 2013). We have selected several quotes and paragraphs to summarize the key ideas. Although the report is quite technical in nature, we highly recommend reading the report in detail, as it contains a lot of valuable insights.

Summary: It appears currently that both the gold and repo markets are quiet. However, the data “under the hood” reveal a totally different picture.

From the introduction:

It’s ironic, or it seems that way to us, that two of the least understood financial markets by equity investors are two of the most systemically important – repos and gold. Even more ironic is how so many investors don’t even consider them to be all that important.

In our view, stability in both markets is a pre-requisite for maintaining confidence in the financial system and keeping the credit/asset bubble inflated. The significance of these markets is not lost on governments, central banks and regulators, although the definition of “stability” in each of them is slightly different.

The greatly under-reported repo market sits at the centre of the banking system and the securities markets. It is a primary source of leverage and, therefore, risk. Time after time, the risks remain hidden until events cascade beyond the point of no return. Stability in the repo market depends on confidence in repo counterparties (which can evaporate at near light speed, e.g. Lehman, Bear Stearns, MF Global and Long
Term Capital Management), confidence in the valuation of collateral used in repo loans (remember subprime etc) and a sufficient pool of acceptable securities (e.g. Treasuries, MBS, etc) which can be pledged as collateral.

In stressed market conditions, liquidity crunches, declining collateral values and re-hypothecation (i.e. re-use of the same securities as collateral by more than one party) can undermine this market. This results in capital being wiped out, a run on collateral and the telltale sign of spikes in “fails-to-deliver”, when a scramble to post eligible securities ensues. Late 2008 was the example par excellence.

When stress emerges in the financial system, the problem with the repo market is its tendency to be (very) “pro-cyclical” on the downside. It also operates pro-cyclically in terms of leverage and asset prices on the upside, which always seems to get forgotten.

Stability in the gold market for policymakers and regulators implies a stable gold price, preferably at “low” levels (i.e. well below all-time highs), an efficiently functioning gold futures market, ample liquidity in the gold lending (leasing) market and no heightened desire among gold buyers to take possession of physical bullion. A surging gold price, backwardations and shortages of physical bullion are proverbial “canaries in the mine” regarding an overstretched system.

The repo market

First, what is repo and why does it matter? In our own search, we came across, an excellent website explaining the concept of repo in great detail. The author writes that the repo market was one of the key reasons of the 2008 crash. What’s more, it appears that repo is the most underexposed driver of the financial crash. And here is the worst news: the repo market has not been fixed since then.

It turns out that one-fourth of the mortgages supposedly sold to investors were actually held by the bankers. Those bankers often used the mortgages as collateral to get overnight loans from each other and from other financial institutions. This kind of borrowing has a name. It’s called repurchase (or “repo”) borrowing, because technically the borrower sells the collateral to the lender and promises to buy it back, to “repurchase” it, the next day – although usually the lender agrees to renew the loan for another day.

This was how bankers got much of the money to make home loans.  Bankers got a repurchase loan, used the repo money to make or buy home loans, used the home loans as collateral to get more repurchase loans, used this new repo money to make or buy more home loans … and so on.  The cycle was very profitable for bankers, but it depended on their going deeper and deeper in debt to their repo lenders.

In the US$4.6 trn (daily outstanding) US repo market, Bloomberg is quoting the repo rate for General Collateral at an extremely low 0.055% – and very close to the lowest rate during the last 12 months.


Is the decision to taper based far more on the need to alleviate current and future difficulties in the repo market than the alleged strength of the US economy?

We’ve been arguing that central banks, led by the Fed, are creating the third major bubble of the last 15 years. Low interest rates and monetary stimulus cause financial bubbles and we’ve been maxing out on both in recent years. While equities (not surprisingly) have done well each time, the asset class at the epicentre of each bubble changes – NASDAQ stocks and real estate were obviously the first two – and credit markets are at the epicentre of the current bubble.

In “old” pre-Lehman days, new money (credit) was created in the banking system, although it occurs in the opposite way to what most people believe(d), i.e. new loans created deposits (it’s an electronic, credit-based regime) rather than deposits being used to create new loans. Post-Lehman, with near-zero loan growth, money (new deposits) is created by the Fed via QE. This is a very big change, but has largely gone unnoticed.

“The (repo) market is very dislocated right now because of regulatory uncertainties,’ said Nancy Davis, a managing partner at hedge fund Quadratic Capital, who has worked at big banks as a senior derivatives trader. ‘I’ve never seen anything like it.”


The gold market

The author goes on with an analysis of the increasing signs of backwardation in the gold market.

The logical deduction from both forms of backwardation is that the leverage in the gold market vis-a-vis the exchange between physical bullion and

  • Non-physical gold claims (gold futures); and
  • US dollars (at least at the current low price)

is reaching its limit.

Put another way, the bubble in paper gold versus physical gold and the bubble in US dollars versus physical gold are showing signs of bursting.

Or yet another…there is insufficient physical gold to act as collateral in the system.

Since the most recent peak in the gold price at US$1,792/oz. on 4 October 2012, we have been tracking the transition of US bullion banks from a huge net short position to an increasingly large net long position in COMEX futures.

In addition, the CFTC’s monthly Bank Participation Report showed that the net short position of four US banks has switched from a record number of shorts in October of 2012 towards a record number of longs lately.


What’s happening is alarmingly similar, but in a largely unreported manner, to the events which preceded the collapse of the London Gold Pool in 1968.

It’s consistent with Fekete’s prediction of what would happen when gold futures moved into backwardation…a rapid increase in physical gold demand versus paper gold demand. This was written in December 2008.

“I have argued that we must carefully distinguish between a fiat money regime with an undisturbed flow of gold to the futures market; and a fiat money regime where the flow of gold to the futures market has been blocked by an unprecedented surge in the demand for cash gold. In the first case confidence in fiat money is high; in the second, it is low and waning fast. In the first case paper gold is an effective substitute for physical gold in most applications; in the second, paper gold has been unmasked as a fraud, and discredited beyond repair.”

This was his warning back in the pre-crisis days of June 2006.
“We may grant that gold futures trading has materially added to the longevity of the regime of irredeemable currency. But while the central bankers are buying time, sand in the hour-glass of the gold basis keeps trickling down. When it runs out, the trickle of cash gold from warehouses will have become an avalanche that could no longer be stopped.”

Read the full report


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