TED BUTLER COMMENTARY

February 26, 2008

THE REAL DEAL

(This essay was written by silver analyst Theodore Butler, an independent consultant. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

We live in a financial world fraught with increasing risks. To many people, a lot of these risks seem to have come out of the blue, given how rapidly things are unfolding. For instance, for the first time since the Great Depression, we face an epidemic of foreclosures in this and other western countries. This epidemic threatens the viability of our largest financial institutions, down to the individuals defaulting on mortgages. It is easy to see now that the cause was irresponsible lending and borrowing which allowed a bubble to develop in real estate. Less easy is gauging the depth and length of resultant bust.

We read daily of securities rated AAA being marked down as much as 90% in value, of investors unable to redeem their capital, of giant financial organizations revealing billions and billions of sudden losses, of endless new government plans to bail everyone out. Most importantly, a growing distrust of who is on the opposite side of massive financial transactions, counterparty risk, infects the scene. If all this scares you, don’t feel too bad. It should.

Certainly, not everyone was taken by surprise at the unfolding events in real estate and credit markets. Many warned of the dangers for a number of years before the full effects were obvious. Looking back, the truly amazing observation was how so many large and respected financial institutions were blind-sided and badly hurt, when so many warnings were issued.

The common denominator of those who warned clearly and early about the pending real estate and credit bust was their reliance upon common sense. They argued that giving indiscriminant and unlimited credit to those who couldn’t afford that credit without temporary gimmicks, like teaser interest rates, and based upon the assumption that real estate could only go higher, would end badly. They were right.

In my experience, it is hard to argue with common sense. Of course, it may not always seem to work in the short term, like when a collective mob phase of fear or greed overtake a market, but common sense almost always prevails in the long run. The lesson here is that it’s OK to be wrong, but it’s not OK to be wrong when you do something you just know you shouldn’t do. Go against your common sense and you invariably end up kicking yourself.

The purpose of this preamble is launch, once again, into a warning that is intended to save many silver investors from financial loss and heartbreak. It is a warning based upon common sense. It is a warning validated by recurring events. It is a warning that you can easily act upon. It is a warning that highlights just what a great long-term investment opportunity silver represents.

The warning is simply this - if you make, or have made, the decision to buy silver, then make sure you buy or hold real silver in the right form. Make sure you have the real deal and not some pure paper substitute.

This is not an attempt to warn of temporary price risk or reward in silver, that’s an entirely different and separate matter. Every asset is subject to short-term price movement and this is something unavoidable and immaterial on a long-term basis. The danger I am referring to is both very much avoidable and material to your financial health.

In fact, the greatest risk possible to silver investors is not the price of silver, but in holding the wrong form of silver and suddenly discovering that silver doesn’t exist. Investors in such non-existent silver face the very real risk of a total loss, even if silver soars in price. While you must allow for short term prices to fluctuate, there should be no allowance for holding silver in the wrong form. And you can and must rely on your common sense to determine if your silver is in the right form.

Clearly, there is no risk of a total loss to those holding real silver in their own safe personal possession. That’s what makes such silver the very best form of investment silver, and is precisely why investors hold it in that form. The warnings do not apply to this form of silver. The only warning to these investors is that they may not own enough real silver.

But not everyone can hold silver in their personal possession, they must have it stored for them, due to greater amounts being owned, or because it is held in bona-fide retirement accounts. Then there is no escaping the reality of professional storage. Just make sure you do it correctly. Here is where your common sense comes into play.

Just like the giant financial institutions who are growing more wary of who is on the other side of their transactions, in other words, the counterparty risk, and are taking increased precautions, so should private investors who have to professionally stored their silver. Counterparty risk is a new term for many investors, but it reflects an age-old concern, namely, the soundness of whomever holds your money or assets, and your ability to draw on your assets without delay or restriction.

The bad news for the big financial institutions, and silver investors not holding their silver in their own possession or not properly stored, is that it very difficult for them to determine the true financial condition of their counterparties. It seems you can’t even rely on the independent rating agencies (or bond insurers) any longer. If there is a problem, you learn of it too late to do anything constructive about it. If your counterparty goes bankrupt, you get at the back of the line for unsecured creditors at the bankruptcy court.

Usually, you have to know the present and future financial condition of your counterparty to be sure you are not at risk of them defaulting. Or you must be sure your money is insured, like with FDIC guarantees on bank accounts.

This is one of the great attractions of silver and gold, and other unencumbered hard assets; they are immune from counterparty risk when held in your personal possession or in the right form of storage. This is what is meant by them being labeled as no one else’s liability. And as financial conditions worsen, the immunity to counterparty risk grows more important for items like silver.

Unfortunately, for too many silver investors, they are not holding their metal in their own possession or in the proper form of storage. They are holding silver that does not exist. They are holding a piece of paper, in the form of a certificate or pool account or electronic read-out, that states they own silver, but they don’t own real silver. The great irony, and coming heartbreak, for these investors is that, by not holding stored silver in the right form, they have converted an asset that is no one’s liability into an asset that is most definitely someone else’s liability. It is an alchemy of the worst sort; the creation of a counterparty risk where none existed before.

The good news is that investors can spare themselves potential disaster and avoid general counterparty risk for professionally stored silver by taking a few simple precautions. First, make sure your silver is stored at an institution whose name you recognize or can easily research. Second, make sure your silver is stored in a facility separate from the dealer or source you bought the silver from. In other words, don’t let your dealer hold your silver. Third, make sure you have the serial numbers and specific weights of every 1000 oz bar stored for you (the most popular form of stored silver). Lastly, it is preferable that you have the ability to withdraw the specific bars you own on your demand.

I have written about this issue previously. Invariably, I will get questions about this dealer or that storage arrangement. Please don’t ask me. I just listed the simple, common sense precautions you should take. These precautions should be easy to understand and follow.

Investors don’t intentionally seek out storage programs that claim to, but don’t own real silver. No one purposefully puts themselves at great risk. They just don’t think about it much. I understand why people are attracted to hold silver at the dealer they bought it from and without serial numbers (for 1000 0z bars) - it’s easy. I understand why people are attracted to no or very cheap storage plans. Who doesn’t want to save money? Unfortunately, this may amount to being penny-wise, but dollar-foolish.

A year ago, I took the unusual step of highlighting two well-known purveyors of what I believe is non-existent silver storage, the unallocated certificates of the Perth Mint and the pool accounts of Kitco. I was careful to write in a non-destructive manner, as it was not my intention to bring harm to these organizations, but rather help them avoid future problems. http://www.butlerresearch.com/buyerbeware.html While I would suggest you read the entire article, here are some excerpts:

"In the typical pool account or certificate program, the buyer incurs a very small sales charge and zero storage charges. Your common sense should tell you that this is only possible if there is no real silver being purchased. Zero storage charges equals zero real silver. So the trade-off for the buyer is that no real silver exists. There may be statements given by the issuer that there is real silver backing the pool or certificate account, but no specific proof. Further, there is usually a provision that the buyer can get real silver if he is willing to pay an additional charge. While this sounds reassuring, this should further prove to the buyer that no real silver backs a pool or an unallocated certificate account.

What about looking at these transactions from the issuers’ perspective? What’s in it for them? Well, certainly not sales commissions or storage fees. But these are for-profit organizations. They are in business to make money. How do they make money or even cover costs, if they don’t charge storage fees? They make it on the float, or the use of the buyers’ money. That’s the only way they can make money. The issuer puts the buyers’ money at interest or into the business. Since no actual metal backs up these pools, the financial strength of the issuer becomes a factor. In other words, it is not real metal that backs up these accounts, but the financial security of the issuers themselves. Make no mistake – these pool and unallocated certificate accounts are unsecured obligations of the issuing entity."

Without a doubt, the largest amount of non-existent silver is held in large bank and financial institution certificate programs, especially European banks. I am convinced that these certificates represent much more than a billion ounces of silver. While I have reiterated this statement over the years, validation finally came in the past year when Morgan Stanley agreed to settle a class action suit alleging them charging storage fees for non-existent silver and other precious metals. The suit originated as a result of an investor taking legal action after reading my articles on the matter.

I raise this issue to make several points. First, that the practice of banks and giant financial institutions issuing certificates on silver that doesn’t exist actually takes place. I’m sure many doubted that this went on, until the Morgan Stanley case (in which they admitted it was common industry practice.) Also, seeing how badly they misjudged the mortgage and credit markets, it is not as difficult to imagine large institutions agreeing to sell vast quantities of silver they didn’t own.

Second, as I have long maintained, these unbacked silver certificates are true and naked short sales, exposing the banks to large losses as silver rises in price. These short sales are separate and distinct from the historically large concentrated short position on the COMEX. Already, the rise in the price of silver from the sub-$5 level, has cost the issuing banks many billions of open losses. And while these losses may appear small next to the tens and hundreds of billions being lost on mortgages and credit derivatives, the silver certificate losses are spread among fewer banks than the credit fiasco, and the silver losses now far outweigh the long term profits the banks generated on the utility value on the silver buyers’ deposits.

Third, the principal buyers of these bank silver certificates are predominantly large and sophisticated investors, particularly in Europe, the Middle East and Asia, mainly because large transactions were customarily handled through known financial institutions. In a very real sense, there was no alternative to buying real silver. Or getting serial numbers, or avoiding VAT taxes. Now there is an alternative for these large and sophisticated investors, the ETFs.

That these unbacked silver certificates are true short sales adds a profoundly bullish prop to long-term silver prices, especially now that large foreign investors have the means and growing knowledge to insist that their silver investments be backed by real silver. The evidence of real silver are the serial numbers, either in ETFs or held in a direct ownership storage program.

Let me be clear, not all issuers of unbacked silver certificates or accounts will default or renege on their silver obligations. But some will, devastating their investors. More importantly, all issuers of unbacked silver certificates are cheating their silver investors by preventing the true price impact those purchases should have in the silver market from being realized. In this regard, issuers of unbacked silver certificates, no matter how large or respectable they may appear, are no more legitimate than the notorious "bucket shops" of the past, or boiler rooms of today.

As time rolls by, more of these large and sophisticated foreign investors, both existing silver certificate holders and new buyers alike will insist on the evidence of serial numbers, because they know it will enhance the value of their investment and increase the safety of their holdings in an increasing unsafe world. After all, a child could tell you that the purchase of real silver will have a more powerful impact on price, than will a purchase of fake silver that a counterparty issuer is only pretending exists. A bigger price impact and no counterparty risk, just by insisting on serial numbers. That’s a strong motivation for switching from unbacked silver certificates to a form that includes serial numbers.

While I have intentionally tried to deliver this message as a warning, so that innocent silver investors can avoid a nasty potential surprise, there is an almost unspoken upside if enough investors follow my advice. Because I am convinced there are more than a billion ounces of silver tied up in unbacked silver certificates and storage schemes, if only a small percentage of those investors, say 5% or 10%, switch to storage programs holding real silver with serial numbers, the impact on the price of silver could be profound. All other things being equal, such an amount of switching could cause a doubling in the price of silver, in my opinion.

One thing should stand out to every objective observer. This is a very unique situation, that so much silver has been pre-sold by those who don’t have it, from the big COMEX shorts to all those entities that have issued unbacked certificates and pool accounts. Yes, there is a very large combined short position in gold, but nowhere near the levels in silver, where more silver is pre-sold than real metal that exists in the world. This will invariably drive prices to unbelievable heights.