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German Gold "Sales"?

By Alf Field
April 22 2002

What's going on?

The German Central Bank has made 3 announcements over the past couple of weeks about selling some of its gold reserves. The latest one even suggests converting some of the proceeds into equities! This is the country where the fathers and grandfathers of the current generation suffered the hyperinflation of the Weimar Republic in 1923, when a loaf of bread cost more than a million Reichsmarks and the currency was wiped out. This is the country with one of the largest gold reserves in Europe. This is the country that was one of the prime movers behind the Washington agreement of 26 September 1999 between 15 European Central Banks aimed at limiting Central Bank gold sales and gold leasing arrangements for 5 years. As Alice in Wonderland might have said: "It gets curiouser and curiouser". What is going on?

First, here is the latest Press announcement:

Frankfurt, April 11 (AFP) - The Bundesbank wants to be able to sell some of its gold reserves after 2004 once an agreement between European central banks limiting annual sales expires, the German central bank's president Ernst Welteke said on Thursday. "I think that we will have to have the option to sell some gold when the agreement expires in 2004," Welteke said at the bank's annual news conference.
* * *
Under an agreement dated September 26, 1999, the 15 central banks of the European Union undertook to limit any gold sales to 400 tonnes per year or a total 2,000 over five years until 2004.
But any gold sales by the Bundesbank after that date would be very small, Welteke said.
Last month, the central bank chief had said in a newspaper interview that the Bundesbank was considering selling a small part of its vast gold reserves for shares.
"We must consider in the medium term if can't convert some of our gold -- a small volume and without pressurising the market -- into securities," Welteke told the daily Frankfurter Allgemeine Zeitung at the time.
The bank was thinking not only of bonds, but "on a share deposit with a good mixture of blue chip shares and shares listed on the Euro-stoxx-50," he said.
The aim of such a move would be to manage the bank's portfolio of gold and currency reserves more efficiently in the future, he said.
The Bundesbank has some 3,500 tonnes of gold worth some 35 billion euros and a further 50 billion euros in foreign currency reserves, the newspaper said.

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What is strange about these announcements?

Allow me to indulge in a little fantasy and postulate a thesis that might explain this strange conundrum. I stress that I have no evidence that either proves or disproves this thesis. It is all conjecture on my part, but for what it is worth, here it is.

Assume that Deutsche Bank, the large German-based world-wide banking group (and/or a group of German banks) have been involved over the past several years in leasing gold from the Deutsche Bundesbank, the German Central Bank. Assume that about a third of the German gold reserves, say about 1,200 tonnes, have been leased to these banks at a lease fee of say 1% per annum. Assume that the banks sold this gold into the market. Now 1,200 tonnes is 42.2 million ounces, which at $300 per ounce is worth a cool $12.66 billion.

Continuing with the assumptions, the banks must have protected themselves by purchasing call options on gold to cover themselves against the risk of the gold price rising sharply. The balance of the $12.66 billion they invested in whatever way they saw fit, but presumably in a way that ensured themselves of a decent profit margin. For each 1% of margin that the banks were able to achieve, their profit would be about $126 million for each year that the transaction lasted.

So far, so good. But call options have time limits. Assume that the old call options have now all expired. To keep the gold leasing transactions going, the German group of banks needs to purchase new call options on 1,200 tonnes of gold to protect their positions against a sharp gold price rise. With the gold price now in an established up trend, such call options may not be available. Or the German bankers may not be happy with the credit worthiness of the counter parties that are prepared to sell call options on gold. Nothing worse than buying reinsurance and then have the reinsurer go belly up. Either way, assume that the banks find that they cannot buy satisfactory protection.

What to do? One way of closing the transaction is to go into the bullion market and buy 1,200 tonnes of gold. This is not an attractive option at the present time because the gold bullion market is trending upwards quite nicely and an order to buy 1,200 tonnes would send the price ballistic. If the gold price doubles from $300 to $600 per ounce with the banks exposed, the German group would be looking down the barrel at a loss of $12.66 billion. This may be sufficient to send some of them into insolvency.

The banking group has to find some way out of the leasing transaction with the Deutsche Bundesbank, so they call on their friendly Central Banker to tell him: "Sorry mate, you have a problem." This is banker-speak for the old adage that if you borrow $1,000 from the bank and can't repay it, you have a problem. If you borrow $100 million from the bank and can't repay it, the bank has a problem. In this case it is the Central Bank that has the problem. They are not going to get their gold back.

The Central Bank is between a rock and a hard place. They haven't told the German public that they have been leasing out such large quantities of gold. Now they are going to have to admit that a large chunk of the country's gold reserves are gone, something that will not sit happily with the German public. The outcome of this little confrontation is that the Central Bank agrees that it will have to convert the leasing transaction into a fully-fledged sale of 1,200 tonnes of gold to the group of banks.

The next problem is that the group of banks does not have $12.66 billion in cash to pay the Bundesbank for the gold. They have invested it in a range of securities, including bonds and equities. More problems. The German DAX index is down 40% from its peak of two years ago and most of these positions are underwater. Worse still, imagine what would happen to the stock and bond markets if they were hit by concerted selling of some $12.66 billion worth of securities.

So the Bundesbank finally bites the bullet. It accepts that the gold has gone, that the debtor banks cannot pay, so they will have to accept whatever they can get. They agree to take the bonds and equities in part settlement for the gold that has disappeared. The next step in this saga: issue some announcements to soften up the public for the forthcoming "sale" of the country's gold reserves in exchange for bonds and equities!

A far-fetched fantasy or a dose of reality? I leave it to your judgment.
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