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Impending Gold Futures Default

Silver Stock Report

by Jason Hommel, May 29,2002


The coming default on gold futures contracts by the short sellers and large bullion banks will surprise many (because they don't know what it is and therefore cannot anticipate it), and will most likely act to catapult gold prices into 4, 5, or even 6 figures per ounce.

I have written this article for several audiences. First, for those people new to the gold market, who might be thinking about getting into gold somehow, but are not sure what to buy. Second, I'm writing to those already in the gold market, so that they know what's coming, and so that they don't sell out too soon.

Third, I'm writing for seasoned gold investors and/or a few very wealthy individuals who believe that gold futures contracts represent a sound investment vehicle. There are about 90 of these wealthy people according to Andy Smith, who was quoted in Thom Calandra's CBS Marketwatch report of May 24th, as saying, "Large-account speculators who are "long" gold futures on the COMEX in New York have surpassed 90 in number." (Up from 77.) These 90 people, or funds, or entities, desperately need to get this article into their hands. I don't know who they are, nor do I know how to contact them, but I hope that the publication of this article at gold-eagle.com will help to reach them. Readers, if you know anybody who might be one of these 90 large-account speculators, or if you know anybody who might know somebody who might be one of these 90, please forward this article to them.

If these wealthy people are convinced, and stop playing paper games, and start buying gold bullion instead, the price will really take off, and will cause the default on the futures contracts to happen that much sooner. But if they are not convinced, it won't matter much to the world, because at this point we don't have that long to wait until the default. Yes, even big elephants succumb to the forces of nature and can die during droughts just like any other animal, and the current market forces that are draining away the last bit of liquid (gold) will not be denied.

By default, I mean that promises to pay in gold will be broken. Don't start arguing with me yet, because I'm not implying that we are on a gold standard, and I'm not implying that the U.S. dollar is backed by gold, and I'm not saying that the government will default. Not exactly, but that's because the story is a bit complicated.

In 1933 the default was on the gold contract known as the U.S. dollar held by American citizens. The default in 1971 was the default on the gold contract known as the U.S. dollar held by foreigners. Each event was followed by an explosion in the price of gold. The coming gold default will be on gold futures contracts which are issued by various private and quasi-governmental entities such as the private banks who are the shareholders of the Federal Reserve.

Some readers will stop me right there, thinking to themselves, "Don't fight the Fed." In other words, if the Fed is on the short side of the gold market, then don't take the opposite side. Here's a better rule, "Don't fight the market." The market is bigger and stronger than the Fed.

The point I am making in this article is that investors should avoid buying a gold futures contract, and avoid buying gold call options, because these investment vehicles are paper promises that are prone to default. That's a fact. My opinion is that default on these contracts is both inevitable and increasingly imminent. I believe that those gold industry watchers who have access to key information are saying that when gold crosses $354/oz., that most of those who have written the bulk of the gold contracts of today will be severely hurt financially. Thus, perhaps a default may happen if it is feared that this price level will be surpassed, or soon thereafter.

Gold futures contracts are speculative side bets on the dollar price movements of gold; they are not legitimate investment options, because nothing is purchased but somebody's vain promise to deliver gold, and most of these contracts are settled in dollars. And if an entity who writes the futures contract does not have the ability or intention of paying gold under the conditions that would be most favorable to the speculator (say for example when the gold price per ounce really takes off) then what is that speculator really getting for his money? Buying insurance does no good if the insurance company goes bankrupt. The main reason for investing in gold is to shield one's wealth from the dangers of default by another. Therefore, the benefits of owning gold are simply not there for the owner of a gold futures contract, which can be defaulted on.

Additionally, speculators who buy gold futures contracts or options are hoping to use varying degrees of leverage. Only a fool would think he could beat the banks at their own game, borrowing money from the bank, to speculate in a paper instrument derivative creation of that bank, that, if it appreciates in value, would cause that bank's downfall.

Options and futures contracts are speculative investment creations, derivatives. I believe they are created specifically to separate a man from his money. They are mere gambling devices designed to siphon off capital that would otherwise be employed in direct investment opportunities.

Investment demand for gold, that normally would flow into gold and push the price of gold up, is instead diverted into paper contracts of limited time duration that can expire worthless if price manipulations are successful, and can be defaulted on if not.

One of the most controversial documents in the world, known as "The Protocols…", was written over 100 years ago. Although it is often disregarded by critics as a forgery designed only to stir up racial hatred, it reveals the purpose of speculative investments in Protocol #6:

"At the same time we must intensively patronize trade and industry, but, first and foremost, speculation, the part played by which is to provide a counterpoise to industry: the absence of speculative industry will multiply capital in private hands and will serve to restore agriculture by freeing the land from indebtedness to the land banks. What we want is that industry should drain off from the land both labor and capital and by means of speculation transfer into our hands all the money of the world, and thereby throw all the [world] into the ranks of the proletariat. Then the [world] will bow down before us, if for no other reason but to get the right to exist."

Personally, I don't think it's any secret who these families are who intend to rule the world, and I don't see how the fulfillment of biblical prophecy is anything to worry about.

Deuteronomy 15:6 For the LORD thy God blesseth thee, as he promised thee: and thou shalt lend unto many nations, but thou shalt not borrow; and thou shalt reign over many nations, but they shall not reign over thee.

Deuteronomy 28:12 The LORD shall open unto thee his good treasure, the heaven to give the rain unto thy land in his season, and to bless all the work of thine hand: and thou shalt lend unto many nations, and thou shalt not borrow.

It is rather obvious to me that bankers who lend to the nations rule over those nations, and that they siphon off money (gold) from the world and maintain their rule through the processes of lending money at interest, and by creating paper dollars and other gold derivatives.

If gold futures contracts are so bad, how in the world are investors fooled into buying them in the first place? Greed is the main reason, because these derivatives promise leverage, and promise a much greater return on investment--note that tricky word "promise". I believe futures contracts are designed mostly to fool those with the largest pockets, because today, most of the small investors have already been swindled out of their gold. It is said that less than 1 in 1,000 or even 2,000 investors hold any gold-related investments today. If the paper dollar was designed to plunder the common man with a few ounces of gold, the gold futures contract was designed to plunder the wealthy man with millions of dollars.

On occasion, I have had the opportunity to discuss, at length, the issues of investing in gold with very wealthy people, so I know a few of their concerns, and why they tend to think of gold futures contracts as a viable investment alternative to buying physical metal.

Buying gold in hand gets to be a risky and difficult proposition for people with more than a million dollars to invest. ($1,000,000 / $320/oz. = 3,125 oz. = 195 lbs.). This is particularly troublesome for the wealthy, because they are among the older generation. Some would not feel comfortable with too much physical wealth in their home. Not even with a safe or panic room. Many of those who could invest might not be physically capable of loading up 200 pounds of gold in the family car. What if you had $10 million to invest, or $100 million to protect against dollar devaluation? Could you find a car that could carry a ton, or ten tons? There is a community of thousands of people who all have this much wealth to protect or more. If you couldn't carry or load that much, could you trust the hired help to keep their mouths shut about what they are lifting? Oh, the problems of the truly wealthy. If you don't want to store that much gold near where you sleep, then there is the problem of storage fees. The bankers will want to charge 1% each year. One cannot think about saving wealth for time periods lasting generations under such conditions.

Just for fun, let's consider what would happen to the gold market if one man, Bill Gates, wised up, and decided that Microsoft would be better off to keep its $38.7 billion in appreciating gold instead of devaluing U.S. currency. At $320/oz., that would be almost 121 million ounces, or 3761 tons. Why does Bill Gates trust bankers and the Federal Reserve with the value of his savings? Bill should have started his gold buying program long ago, because he probably could not even buy 300 tons before the next gold default. For a guy who claims to have a company built on intellectual capital, what does that say?

The truly wealthy, for the most part, feel as if they are forced to trust the banks and/or investment institutions already. After all, they are not protected by the mere $100,000 of FDIC insurance per account.

These extremely wealthy individuals and institutions are even presented with the so-called opportunity of writing (selling) their own gold futures contracts. In theory, if they sell a gold futures contract, they don't even have to have the gold on hand to sell, but only enough cash to buy the gold in a margin account, plus a comfortable cushion of perhaps 50%. This means that if a very wealthy lay person wants to short 100 oz. of gold he needs to have the money to be able to buy perhaps 200 oz., thus having enough capital on hand to fulfill the contract even if gold were to double in price. Because of this so-called standard business practice, they may be fooled into thinking that gold contracts are relatively default proof. How so? Because they might assume that all who sell a gold contract must have more than enough money on hand to be able to buy the gold that the contract calls for. But this is NOT a standard practice, and the rules are not the same for all entities who would write a gold contract. The large quasi-governmental investment houses tend to make up and change the rules as they go along, so who will guarantee that they have the ability to come up with the gold that they, or their subsidiaries, or patsies, have promised?

The objective of the original gold contract, the paper dollar, was to separate a man from his gold, and it worked exactly as intended. As long as the "open interest" in the gold futures contracts goes up as the price of gold goes up, it appears as if this new gold contract is continuing to do the job for which it was designed; that is to say, it siphons investor demand away from gold, and into paper promises that are more easily created than fulfilled.

We also have to remember that the "open interest" in the gold futures market is not the total amount of gold promised. The vast majority of gold contracts are not on any books that are open to inspection by anyone, so there is no ability of anyone to truly judge when or at what price the next gold default might occur. In the past two gold defaults, the default came early, well before the price rose to any significant extent. The defaults occurred onmy when it became apparent that more and more gold was being demanded by the holders of the paper contracts. Again, the default came well before the ultimate issuers ran out of gold.

Unlike many other gold market writers, I don't believe we need any market transparency or increased regulation of gold market contracts. I'm perfectly content with letting private traders create private contracts, and do business in private, without government interference. It's called freedom, and it's what gold represents. Freedom is good.

If people want to buy promises, they should be free to do so.

If the gold bulls want to take on the forces who are keeping the gold price down, the last thing they should do is trust the enemy and buy their promises and gold contracts. They need to take on their enemy by buying gold in the spot market, not by buying futures contracts. Let others buy the futures contracts and attempt to stand for delivery.

The gold contract (dollar) defaults of the 30's and 70's were preceded by bank runs; when people in the 30's, and then nations in the 70's, demanded gold for their paper dollars. In a bank run, you want to be the first in line, because those at the end of the line simply do not get paid. The coming rush into gold will be like another bank run that precedes the next gold contract default. Waiting for the delivery date of a gold futures contract that is two months away would be as foolish as standing in the line that's two months long during a bank run that you are betting on will occur. Why put yourself at the end of the line of a hoped-for bank run, when you can get in front of the line by buying gold in the spot market? Literally, that's what gold futures contract longs do. They bet a bank run will happen, and then they get at the very end of the line. And if and when the time and opportunity comes that they get near the bank window and they might be next, they jump right to the end of the line again as they roll over their contracts. I believe it's total insanity to do such a thing. But investors get what they deserve, don't they?

We have already been given a preview of a modern-day precious metals futures contract default. Most gold bugs remember the TOCOM default in platinum in 2000. All longs were forced to settle for cash. I assume that since there was not enough of a major outcry from investors around the world, that a similar method of default will happen with gold contracts, namely, a cash settlement, with perhaps a quick resumption of new gold contracts being issued.

Those games worked in platinum, where there was relatively little investment demand, and an actual supply crunch. But will those games work to stem the tide of massive investor demand in the face of declining currencies?

Clearly there is danger in making promises that cannot be kept, but that's the entire game the bankers play with their practice of fractional reserve lending. In other words, don't assume that they will play it safe and not take undue risks and avoid making promises they can't keep; that's their standard method of operation. So, in a sense, gold futures contracts are nothing new; but they are new--they originated as a plan to cap the runaway gold price of the early 80's, and they succeeded.

The only way we will experience a true gold bull market, and a truly free gold market, is if these gold contracts of our modern era fail, and, inevitably, they will.

In order to understand what will happen in the next gold bull market, we need to understand what happened in the last one. It makes sense only in a superficial manner to look at the last high of $850/oz., and adjust for inflation, (either the money creation type of inflation which would give us a new high of a $6,000/oz. gold price, or the consumer price increase type of inflation which could give us a new high of a $1,700/oz gold price) because the high of $850/oz. was artificial and unnatural--it was lower than it should have been!

Many gold bulls of 1980 strongly believed gold would soon be worth many thousands of dollars. I believe the price of gold would have reached those much higher prices if it were not for the introduction to that market of gold futures contracts, which siphoned investor demand away from real, tangible, physical gold. Perhaps a lack of moral conviction, and greed for a gain as measured by the unjust weight and measure of the dollar killed the gold rally of 1980.

The price of gold rose both in the 30's and 70's because of inflation, the fraudulent paper-printing money-creation kind of inflation. If that inflation were fully reckoned with, gold price should have risen to a level where the total amount of fraudulent dollars that had been issued would be equal in value to the gold held by their issuing authority. This never happened. If it did, gold would have been worth about $5,000/oz. back in 1980 based on the number of dollars that had been fraudulently created by that time. Therefore, in that sense, what happened in the 30's and 70's was not yet a complete and full gold contract default, but merely a series of minor gold bank runs in comparison to what we may now be facing. Today, since more dollars have been created since 1980, gold may well rise to $35,000/oz., and that's if not even one more dollar is printed or created on a computerized ledger somewhere.

But we have to remember that every dollar in existence is a potential claim on gold, because every holder of a dollar has the option to go and buy some gold with his money. Investment demand (monetary demand) is potentially infinite, and not limited to the number of dollars in existence, nor even to the number of yen in existence. Investment demand is limited only by men's greed and desire, and those levels are infinite. As we all know, if the value of paper money goes to zero, as it must someday do, then the dollar price of an ounce of gold reaches to infinity.

The last remaining factors holding back the meteoric rise in the price of gold are fear and ignorance. Fear of holding physical wealth personally on hand, and the ignorance of thinking that one's wealth is safe in the hands of people who have proven themselves to be crooks. Hopefully this article has helped to dispel some ignorance. Fear is overcome by bravery and faith in knowing your knowledge is correct, and bravery and knowledge both lead to freedom and wealth.

I can't conclude an article without writing something brief about silver. Everything that I've written about gold also applies to silver, but silver has more favorable supply and demand dynamics for the investor. In the silver market, the same schemes are being played out, but in different relative amounts. The silver market is tiny in comparison. The silver market could explode upward even without a dollar devaluation. And the silver futures market is massive in comparison. In other words, the physical price of silver is more highly influenced by the paper futures markets, which are also prone to default. With silver, nobody knows how large private hoards might be. With silver, existing known reserves are much smaller than gold. We have about 3,500 million ounces of gold in the world, and only 100 million ounces of "known & official" silver. You can buy a $1,000 face-value bag of silver for about $3,500 today. For most of human history, a bit of silver the size of a silver quarter was worth about a day's wage. In the early 80's, when silver hit $30-50/oz., you could buy a nice house in California for a $1,000 face-value bag of silver coins.

Silver has an ongoing supply and demand gap that has run 12 years, and drawn down the known silver available at the COMEX from about 1,500 million ounces to 100 million over that time.

I recommend investing more in precious metals stocks right now than precious metals, since certain stocks will be very likely to go up in value faster than the metals themselves. Perhaps a good ratio of metal to metals stocks is 1:5, or 5 times as much invested in stocks right now, depending on your level of wealth. Obviously, if you have $5 billion to invest, you just can't pour that much into small cap metals stocks, and you'd have to allocate more into gold. For the small investor who is not concerned with unduly affecting the stock price of a company with a market cap of $100 million with his purchases, I might recommend something like the following:

DROOY45%
HGMCY   10%
SSRI     25%
PAAS  10%
SIL        10%

As an exit strategy, I believe that by the time gold reaches about $600 to $1,000 per ounce, one should begin selling the stocks and investing in the metal, and increase the dollar value of one's metals holdings to be about equal to one's stock holdings. Between a gold price of $1,000 per ounce and $30,000 an ounce, I'd recommend selling all metals stocks, and look to buy other undervalued assets, perhaps real estate, or companies with P/E ratios of 7 to 10.

But 10% or more of one's portfolio should always be invested directly in physical gold or silver. Now is a great time for more.

Disclaimer: I am not a licensed investment advisor. I am not a broker. I hold positions in precious metals and mining stocks. I am biased against what I consider to be the fraud of fiat money. I am biased against the fraudulent practice of creating money out of nothing. I am biased agains7t debt, particularly when money is lent at any interest rate whatsoever, a practice called usury.

For a list of many reasons why I believe now is a good time to buy gold and silver, see my web site at silverstockreport.com

I will do my best to reply to all questions and comments on this essay or the subject matter, and I would love to hear from those who thought this piece was helpful to their understanding of the gold market.