TED BUTLER COMMENTARY     

October 23, 2007

MONEY FOR NOTHING

(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.)

On September 24, a Federal Judge in New York heard final oral arguments in the class-action settlement between Morgan Stanley and 22,000 of their clients involving costs associated with the storage of precious metals. The parties have agreed to settlement terms. Morgan Stanley will pay several million dollars and promises to revise their precious metals storage processes. However, there is no admission of any wrongdoing. Unfortunately, the class-action participants will receive very little and it will be, basically, business as usual as far as Morgan Stanley’s precious metals storage practices are concerned. All that’s left is for a final approval by the judge.

The issue specifically concerns whether Morgan Stanley and many other large financial organizations who claim to hold and store silver for their customers, actually possess the silver. This case came into existence as a direct result of a number of articles I wrote several years ago. I admit to a high level of satisfaction that the case confirmed a major contention of mine, in spite of doubts by many when I first wrote about it. (When I wrote the original articles, I did not use the name Morgan Stanley, and had no idea a legal case would be brought that involved them).

I have long maintained and written that there are two types of silver when it comes to professional storage, real silver and paper silver; cold hard metal versus imaginary or make-believe silver. I claimed that investors could be making a mistake in assuming that the metal held for them actually existed. I warned that free storage was a certain tip-off that no real metal existed, but even the payment of storage charges did not prove that real metal existed.

I offered a simple solution for any investor with stored silver to determine if the real metal existed or not. Most stored silver is in 1000-ounce bars, and they are always identified with serial numbers and a specific weight. If an investor was concerned, all he or she had to do was request the serial numbers and specific weights of the bars they owned.

A reader, who held silver in 1000 oz bars, requested Morgan Stanley provide him with the serial numbers and weights of his bars, on which he had paid storage and insurance fees for many years. He was given the run-around and not the serial numbers and weights. I am aware of this through e-mail exchanges with him. I told him that the only plausible reason they wouldn’t give him the information was because the bars did not exist. He contacted a lawyer and that ultimately resulted in the class-action settlement, after years of legal wrangling.

This, obviously, is a concern for those who buy quantities of silver that they can’t reasonably store at home, or in a safe-deposit box, and must use a storage program. A $100,000 worth of gold weighs 10 pounds and platinum weighs around 5 lbs. These are weights easily handled personally by most people. With silver, $100,000 worth weighs around 500 pounds, a weight not easily handled.

Safe storage is more of an issue unique to silver than any other precious metal. While Morgan Stanley issued statements that it was storing all types of precious metals, the largest single amount was silver. It was a client’s inquiry about his 1000 oz bars that precipitated the class-action suit. Logic would dictate that this is also the case with hundreds of other worldwide financial institutions that claim to store precious metals for their clients.

I found it appalling that Morgan Stanley would claim to store silver that didn’t exist and even have the chutzpah to charge for the storage. That would appear to be a clear case of fraud. I am even more appalled that the judge in the case, or any government regulator, would look the other way. The important lesson here is not that Morgan Stanley got caught with its hand in the cookie jar, but what silver investors can learn from this episode.

If you have an investment in 1000 oz silver bars which are stored for you and you don’t have serial numbers and specific weights, you don’t own real silver. If you have a pool account you don’t own real silver. It you have any account where you don’t have the clear ability to demand delivery at anytime with no additional fabrication charges, you don’t own real silver. Period. If the dealer you bought the silver from stores it for you, and it is not an independent storage facility that is holding it in your name, you are taking great risks.

If you have paid full value for your stored silver, including storage and insurance fees, and don’t have the serial numbers and weights on your 1000-ounce bars, you must rectify that circumstance immediately. By not actually buying and storing the real metal to back the customers’ purchase, financial firms can greatly enhance their bottom line profits through the free use of the customers’ funds. Morgan Stanley’s actions were not in any way unique in this practice. In fact, in the court documents summarizing the proposed settlement, one of Morgan Stanley’s defenses was that they were not doing anything unusual by charging storage on metal that didn’t exist, as this is a widespread industry practice.

On a purely financial basis, the institution is given cash by the client and does not have to return it until the client sells his silver, which may not be for years or decades. For the entire time the client does not sell, the firm has full use of his money on a zero cost of funds basis. Those firms who charged, and still charge, storage and insurance fees for the non-existent silver rake in even more from the client. Honest dealings aside, this is a very cash-flow positive business for these institutions. Even if silver doubles or triples in price, there is no margin call to the selling institution, as clients don’t issue margin calls. As long as clients don’t sell on a net basis, the issuing institution still doesn’t experience negative cash flow. In our short-term world, that is all that matters. If you or I arranged to do what hundreds of world financial institutions have done, we would quickly be put in jail, as it is fraud, pure and simple.

Due to its bulk, silver is often stored in large quantities and dollar amounts. Because the unbacked silver storage accounts have been in existence for decades, the amount of non-existent silver is very large. I would conservatively estimate that at least a billion ounces of this silver is on the books (although I feel the true amount is much larger).

I prefer to deal in documented facts and figures, and not to guess what the total amount might be, but there are no reporting requirements or clearinghouse data available. Were it not for the class-action settlement involving Morgan Stanley, I’m sure many would deny this situation existed at all. Fortunately, because of this case, no one can deny the practice of unbacked silver certificates exists.

Had the actual silver been purchased, as it should have been, when the clients deposited funds to pay for the metal, that would have been reflected in the price. In addition to deceiving the client, they short-circuited the normal supply and demand function of the free market. This was an unfair restraint of trade and the free market. To those who would say this is no big deal, ask yourself this – would you knowingly do business with a stock or bond broker who never actually bought what you instructed them to buy, but just treated your investment as a bookie and bet you were wrong? Would securities and banking regulators look the other way?

This is a short position, pure and simple. The firms and banks that have sold silver to clients without immediately going out and buying the real silver that the clients paid for are short the metal. That means the issuers are liable and responsible for any price rise in silver over the price to the client. For small and medium sized firms, this is a huge risk.

This is a short position separate and distinct from the short positions on the COMEX or from forward selling/leasing. This puts the combined short position for silver in the billions of ounces. To suggest this unbacked short position is somehow hedged (just as some contend, the forward selling/leasing position is somehow hedged) is nonsense. The documented commercial long position on the COMEX is so small that it couldn’t cover even one medium-sized issuer of unbacked silver certificates.

It is important to remember that this incredibly large, additional short position unique to silver has the same price effects that all large short positions have in any item. First, comes the artificial price-depressing impact it has when it is created, then comes the artificial price-enhancing effect when it is eventually closed out. What that means to investors is this – the price-depressing phase of short sales of unbacked silver storage programs is behind us. This is one more reason why silver is still so cheap. That’s good news because what could be better than buying a high-quality asset at a big discount to its real value?

Furthermore, the price-enhancing impact is still to come. The banks and firms that issued these unbacked silver certificates haven’t panicked and rushed to buy back silver to limit their liability and exposure. So far, their individual losses are manageable, and I’m sure they still believe silver will go down in price in the future and the problem will go away. While it’s true that these large institutions have a higher tolerance for financial pain than most, it’s also true when they do panic, they panic big. I believe they will panic at $30 or $50 or higher.

I am sure that eventually we will read about the great losses some institutions have suffered from very high silver prices because they sold silver to clients that they never actually purchased. People will scratch their heads and ask how those firms could do something so foolish, just like many today question how big firms could offer mortgages to borrowers of poor quality. The few who are aware of these facts in advance are afforded the opportunity to take advantage of the coming silver price explosion. This storage fiasco is another one of many factors we have pointed out about silver that has proven to be correct. We are just as certain that the price of silver must multiply many times over. Don’t let this once-in-a-lifetime opportunity pass you by.