lunedì 6 luglio 2009

Geneva Sees Opportunity in Bern’s Concessions

Geneva Sees Opportunity in Bern’s Concessions on Bank Secrecy

By Stephanie Baker and Warren Giles

July 2 (Bloomberg) -- On a hot Saturday morning in May at the Rolle yacht club on Lake Geneva, Guy de Picciotto, chief executive officer of Switzerland’s Union Bancaire Privee, smears on sunblock as he rallies a professional, lycra-clad crew of six to race his 35-foot, $600,000 catamaran.

“It wouldn’t do to look too tanned on Monday morning,” de Picciotto, 49, says with a grin, before jumping on a high- powered launch that takes him out to his sailboat, Zen Too, one of 12 identical carbon-fiber yachts moored offshore.

De Picciotto’s superlight catamaran accelerates toward the starting line in the light wind, which fades and then dies, leaving the yachts adrift in the heat. Still, the sailors, including Swiss biotechnology billionaire Ernesto Bertarelli, 43, a two-time Americas Cup champion, revel in their sport.

“I don’t have the weight of the bank when I’m out sailing,” de Picciotto says. “These are toys. It’s my leisure.”

De Picciotto and his fellow Geneva bankers were never more in need of stress reduction. Their world -- which converges on the city’s yacht club, the pistes of Verbier and golf in the hills above Geneva -- was shattered by the 2008 market crash and worldwide recession.

The banks’ “relationship managers” are working overtime to assuage angry clients and win new ones, while the risk managers are backing away from their bets on volatile stocks and derivatives.

A refuge for the world’s nervous money, Swiss banks are stumbling. Total assets held on behalf of foreign clients dropped more than 1 trillion Swiss francs ($918 billion), to 2.1 trillion francs, from the end of 2007 to March 2009, according to the Swiss National Bank.

$8.8 Billion Madoff Hit

In addition to getting hit by plunging markets, de Picciotto’s UBP, which manages 100 billion Swiss francs, lost $700 million in Bernard Madoff’s Ponzi scheme. Geneva wealth managers and their funds of hedge funds account for about $8.8 billion of the losses in the $65 billion Madoff swindle, according to the Geneva Financial Center, a foundation that promotes the city’s banking industry.

Not all of the news was bad in Geneva’s banking quarter, where banks and money managers are clustered near the Rue du Rhone. While assets at all of the banks declined due to market losses, some private banks, including Lombard Odier, Mirabaud & Cie. and Pictet & Cie., are picking up new clients who have pulled money out of firms that have been propped up with government subsidies, such as Citigroup Inc., Royal Bank of Scotland Group Plc and UBS AG.

UBS vs. IRS

Zurich-based UBS was hit hard by losses on investments in U.S. subprime housing loans and last year was given a $45 billion government aid package.

Investors have yanked some 130 billion francs out of UBS’s main wealth management unit since the beginning of 2008. The bank is battling the U.S. Internal Revenue Service, which is seeking information on the Swiss accounts of 52,000 American clients.

The Geneva-based banks are selling themselves to flustered investors as safe havens. Some are unlimited liability partnerships, which means the partners bear personal responsibility for losses. Pictet alone banked 17 billion francs in net new deposits in 2008, of which 7 billion francs arrived in the fourth quarter, as wealthy clients panicked after the collapse of Lehman Brothers Holdings Inc.

While UBS bled assets, most of the Geneva-based private banks had net inflows of money, according to data compiled by Bloomberg.

Partners Assume Risk

“Clients face people who risk their entire fortune every day,” says Patrick Odier, who last year became senior partner of Lombard Odier, which was founded by his family six generations ago. “Other firms can go through Chapter 11 and their executives can still keep their chalets. If our people make mistakes, our partners assume it to our very last cent.”

Having survived the market crash, Geneva’s bankers have shifted their focus to their second-highest priority: keeping their account information secret, or, as the bankers prefer to phrase it, protecting the privacy of their clients’ financial information. A decade after other nations pressured Switzerland into tightening anti-money laundering rules, governments around the world are once again targeting offshore centers in a campaign to expose wealthy tax cheats.

Switzerland, a repository for 27 percent of the world’s offshore wealth, is their top target. (Offshore is the industry term for deposits from any foreign country.) And the Swiss government has buckled.

Tax Concession

In March, a month after UBS paid $780 million to the U.S. government to defer criminal charges that it facilitated tax fraud, Swiss President and Finance Minister Hans-Rudolf Merz announced Swiss banks would, for the first time, cooperate with foreign governments looking for tax evaders, if specific information is presented showing they’re using a Swiss account for that purpose.

“The era of banking secrecy is over,” world leaders meeting in London at the Group of 20 summit in April declared in a press release.

Not so fast, the Geneva bankers say. They’ve been pushing back against the attack on their industry, charging that it’s all a grab for their assets by envious bankers in other countries and government bureaucrats eager to bolster enfeebled treasuries.

‘An Economic War’

“We are in an economic war,” says Yves Mirabaud, the 43- year-old managing partner of Mirabaud & Cie., a Geneva-based private bank founded by his ancestors in 1819, as he pauses over a plate of filet mignon in a Mirabaud dining room with a view of the snowcapped Alps and the 19th-century Grand Theatre de Geneve. “Switzerland is a small country not supported by others, so we are an easy target. The big countries want to take market share, wherever it is.”

The global assault on bank secrecy has reinforced the Swiss feeling that the tiny nation is under siege by the big powers, says Stephane Garelli, a professor at the IMD business school in Lausanne.

“They don’t like to be bullied,” Garelli says.

Proudly neutral Switzerland (population 7.6 million) didn’t join the United Nations until 2002 and doesn’t belong to the European Union or the North Atlantic Treaty Organization. Military service is compulsory, giving the country a standing militia of 220,000. By law, every Swiss resident must have access to a nuclear bunker, at home or in the neighborhood.

Swiss private bankers like Mirabaud have come out of their professional bunkers to defend the secrecy laws, which make it a crime for a banker to divulge a client’s financial information to a foreign tax authority or even to the Swiss government.

Bank Secrecy Law

A banker can go to jail for up to three years for revealing bank secrets. In a case of negligence, such as an accidental leaking of information, the penalty is a fine of as much as 250,000 francs.

“As we say in French, ‘pour vivre heureux, vivons cache,’” says Jacques de Saussure, managing partner of Pictet: To live happily, live discreetly. “Most clients like to be very discreet because they were born rich or have grown rich, and they know it’s better not to talk about it too much. This principle of privacy or secrecy is very important to them.”

Even so, in March the Swiss government agreed to follow guidelines of the Organization for Economic Cooperation and Development (OECD) on the exchange of information in tax matters, meaning that in the future its banks will turn over names and financial records of clients if foreign governments provide evidence of tax evasion. That will involve renegotiating tax treaties with at least 12 other nations.

Evasion Not a Crime

Previously, Switzerland had cooperated in cases of tax fraud. Now, it will treat tax evasion, which is not a crime in Switzerland, in the same way. Bankers say there should be no “automatic” exchange of information, which they say is what the IRS is demanding.

At least one of the tax treaties is likely to be subject to an up or down vote in a Swiss referendum, for which only 50,000 signatures are required. And three-quarters of Swiss citizens believe the country should preserve its bank secrecy laws, according to a March poll of 1,000 people by the SBA.

The bankers coordinate their message through bimonthly executive board meetings of the SBA, which is headed by Yves Mirabaud’s uncle, Pierre Mirabaud, who is also a senior partner at Mirabaud & Cie. Pierre doesn’t mince words.

“The idea that Swiss banks live from the tax evaders of the world is a Hollywood invention,” he said at a May lunch of the American International Club of Geneva, which brings together ex- pat business executives and their Swiss counterparts. “There’s no ethical conflict between the right of the state to enforce taxation laws on the one hand and respect for financial privacy on the other.”

Club of Bankers

Geneva’s private bankers form a tightly knit club, with some friendships cemented in the Swiss Army officer corps. Geneva is a small city -- population 186,000 -- and smaller still in the affluent precincts surrounding the Rue du Rhone.

Every day, many of the district’s bankers, lawyers and traders gather for lunch at Roberto, an Italian restaurant popular with Geneva’s wealthy since the aftermath of World War II. On a rainy mid-May afternoon, the place is packed with patrons in hand-tailored suits dining on gnocchi and grilled sole.

That evening, some of Roberto’s patrons meet again at the Beau-Rivage hotel on Lake Geneva, where Sotheby’s auctions off a rare blue diamond for 10.5 million francs to an anonymous phone buyer after vigorous bidding.

A Banker’s Life

The bankers can also be found sipping coffee on the terrace overlooking the marina at the Societe Nautique de Geneve, the lakeside yacht club founded in 1872; hitting balls at the Golf Club de Geneve in the wealthy suburb of Cologny; or attending the ballet at the Grand Theatre.

The foundation that runs Geneva’s Museum of Modern and Contemporary Art reads like a who’s who of the private banking establishment. Bernard Sabrier of money manager Unigestion Holding SA is there. So are Pierre Mirabaud; Pierre Darier, managing partner of Lombard Odier; and Pictet partner Philippe Bertherat.

The bankers maintain that Switzerland is being unfairly singled out by the G-20 while offshore centers like Hong Kong and the U.K.’s Guernsey are given an easy ride.

“This whole debate is full of hypocrisy,” Pierre Mirabaud said in his May speech. “It’s a fight for market share, a fight for tax reserves, and the only rule today is that the strongest wins.” Mirabaud will be succeeded by Patrick Odier as SBA head in September.

Germans, Swiss Battle

Such arguments are sophistry, says German Finance Minister Peer Steinbrueck, whose government accuses the Swiss of facilitating criminal behavior.

“There are jurisdictions -- tax havens and nation states -- that not only approvingly accept but deliberately invite German money transfers with the clear intention of committing tax fraud,” Steinbrueck told parliament on May 7. “This is clearly true in the case of Switzerland, and Liechtenstein too.”

Steinbrueck’s comment was part of an ongoing attack by Germany on neighboring offshore centers. Last year, German officials disclosed that their secret service had paid an employee of LGT Group, the bank owned by Liechtenstein’s princely family, 5 million euros ($7 million) for information on German clients.

Germany is investigating about 900 suspects in the tax- evasion probe, and authorities have raided businesses and the homes of wealthy citizens looking for incriminating documents.

Germany and Switzerland have been trading barbs about Swiss bank secrecy for decades. Swiss Foreign Minister Micheline Calmy-Rey twice this year summoned Germany’s ambassador to Bern to complain about Steinbrueck’s comments.

Fueling the Fire

Swiss lawmaker Thomas Mueller fueled the fire in March when he said in a parliamentary debate that Steinbrueck’s attitude reminded him of Germans “who walked the streets in leather coats, boots and armbands 60 years ago.”

Swiss bankers say Germans cross the border to avoid their own country’s draconian tax regime. “Germany has mistreated its entrepreneurs and citizens for decades by constantly shifting the tax goalposts,” says Raymond Baer, chairman of publicly listed Julius Baer Holding AG, leaning over a conference table in his Zurich offices, hung with contemporary Swiss paintings and art installations. “I have many entrepreneurs moving their holding companies to Switzerland because they cannot reliably plan with Germany’s ever-changing tax code.”

If the attack on bank secrecy results in foreigners doing their banking in some other country, that could be dire news for Switzerland, which derives almost 10 percent of its gross domestic product from the industry.

3.7 Trillion Francs Held

There are 330 banks registered in the country, almost 40 percent of them foreign controlled. Swiss banks held 3.7 trillion francs of securities for domestic and foreign clients at the end of March, more than seven times Switzerland’s GDP.

“Swiss banks are not an endangered species, but the world of absolute bank secrecy is behind us,” says Jeremy Jensen, a London-based partner leading the European private banking practice at PriceWaterhouseCoopers. “Private banks need to plan for a tax-transparent world and work to their strengths.”

Swiss banks could lose as much as 20 percent of their assets if the government agrees to surrender details on possible tax dodgers, says Peter Thorne, a London-based banking analyst at equity research firm Helvea SA.

“Banks are not the tax auxiliaries of foreign governments,” says Steve Bernard, managing director of the Geneva Finance Center. “We have a working relationship in Switzerland between the authorities and the citizens, meaning you don’t fear tax authorities knocking at your doors at 4 a.m.”

No Tax Police

One reason the tax police don’t come knocking is that tax evasion is a civil, not a criminal, offense in Switzerland. Even tax authorities must abide by the country’s strict bank secrecy laws when investigating suspected dodgers.

“Criminalizing a large part of the wealth-producing population is not the answer, especially in a world that needs wealth creators more than ever,” Baer says.

Switzerland has been a center of resistance to taxation for centuries. The legend of William Tell is the tale of how a rebellion against a Hapsburg empire tax collector sparked the creation of the Swiss Confederation in 1291. When Protestant theologian John Calvin arrived in Geneva in 1537, he sanctioned the charging of interest as long as it served the public good, helping to turn the city into a banking center.

Rich History

Starting in the late 17th century, Protestants from France began fleeing to Geneva to escape religious persecution. Successive wars and revolutions in Europe made neutral Switzerland a refuge for moneyed exiles from the 18th century onward. Geneva’s major banking dynasties -- the Mirabauds, the Pictets and the Odiers -- all began as trade finance houses in the late 18th and early 19th centuries after the default of loans to French nobility, deposed in the Revolution, ruined their predecessors.

Switzerland enacted its first bank secrecy law in 1934, a year after Adolf Hitler’s government passed legislation making it a crime for Germans to fail to declare money held abroad. It followed years of allegations that French and German authorities had bribed Swiss bank officials to hand over information on account holders.

A major challenge to bank secrecy came in 1996, when Switzerland waived its laws to facilitate the work of the Volcker Commission, a group headed by former U.S. Federal Reserve Chairman Paul Volcker, whose task was to investigate dormant Swiss accounts opened by Jews fleeing Nazi persecution.

Holocaust Settlement

In 1998, Swiss banks, including Credit Suisse and UBS, agreed to a $1.25 billion settlement with Holocaust survivors. In 2001, the SBA published a list of 21,000 holders of Swiss bank accounts with possible links to Holocaust victims.

In 1998, the Swiss government tightened its anti-money laundering rules to prevent figures such as corrupt dictators from depositing ill-gotten gains in Swiss accounts. The new, “know-your-customer” rules were aimed at preventing a repeat of the embarrassing disclosure that Sani Abacha, the late president of Nigeria, had deposited about $640 million in Swiss bank accounts in the 1990s.

Nearly one-third of the Abacha funds were sent to Switzerland from banks in the U.S. and U.K., according to the SBA. Most of the money has been returned to Nigeria.

“Today, Switzerland has some of the strongest rules on client identification in the world,” Yves Mirabaud says. “It’s been impossible for years to open an account in Switzerland without being clearly identified.”

Not My Job

Still, once a depositor’s identity and the source of his money have been confirmed, the bankers say it’s not their job to investigate whether he or she has paid taxes.

“We believe in individual responsibility,” says Eric Syz, founder of Banque Syz & Co., a private bank and asset manager he set up in 1996. “Bankers should not be tax agents. It’s the responsibility of the client to pay his taxes.”

EU and U.S. officials maintain there’s no distinction between tax evasion and criminal tax fraud -- and that was the focus of the argument with Swiss bankers and their government until March.

The Swiss first eased up in 2004, when they signed an agreement with the EU to provide more help in cases where there’s evidence of criminal tax fraud such as the forging of documents.

Then, in 2005, after a decade at the negotiating table, Switzerland adopted the EU Savings Tax Directive, which levies a 20 percent withholding tax on interest income earned by EU citizens who hold accounts outside their home country.

Riddled with Loopholes

The tax is riddled with loopholes: It applies only to individuals, not corporations, and dividend income, capital gains and income from derivatives are exempt. In practice, wealthy clients have many ways to arrange their assets to avoid the tax, Helvea’s Thorne says.

Switzerland finally cracked in the wake of UBS’s abuses. The Zurich-based bank says it sent private bankers not registered with the Securities and Exchange Commission into the U.S. to solicit business from wealthy Americans.

In February, criminal prosecution for facilitating tax fraud was deferred after UBS agreed to release the names of about 300 clients and pay $780 million in fines. The next day, the U.S. government sued UBS to force the bank to disclose the names of 52,000 additional U.S. citizens it alleges hid Swiss bank accounts from the Internal Revenue Service.

UBS insists that disclosing the names would violate Swiss bank secrecy laws.

OECD Guidelines

In March, the government agreed to follow the OECD guidelines, and in June Switzerland and France modified their bilateral tax treaty to conform to OECD standards.

“What matters is how it works in practice,” says PWC’s Jensen. “If foreign tax authorities pass a certain burden of proof, Swiss private banks will release the required information -- but probably piecemeal.”

Swiss banks will continue to go to great lengths to protect their clients’ privacy. That involves the well-ingrained use of code names and nicknames when discussing depositors, bankers say. “If the client’s an industrialist, we might call him the widget manufacturer,” says Pictet’s de Saussure. “We know internally who we’re talking about.”

De Saussure says he recently got a call from an important client who was worried that Pictet had hired someone from his home country. “We try to avoid spreading the names of clients even within the company,” de Saussure says. “People who have well-known names tend to be talked about, and that’s why we need to be especially careful about confidentiality.”

Border Danger

Traveling poses challenges to private bankers worried about keeping the identities of their clients under wraps. In Geneva, many private banks bar their relationship managers from living across the border in France -- a mere 20 minutes from the city center -- because it would pose a security risk if they carried client details past customs officials daily.

About four years ago, Credit Suisse began drawing up detailed manuals for each country the bank operates in, laying out rules for what licenses each relationship manager must hold in order to solicit business. “The compliance burden has tripled,” says Walter Berchtold, 47, head of Credit Suisse’s wealth management business.

Swiss bankers say they can cope with any erosion of bank secrecy. A major chunk of the wealth flowing into banks in Geneva and Zurich in the past five years has been from clients in low-tax countries, such as Russia and the United Arab Emirates, who aren’t trying to avoid taxes at home. Instead, they’re attracted by Switzerland’s rock-solid currency and political stability.

A Safe Haven

“Many clients have come to Switzerland as a safe haven -- not to dodge taxes,” Lombard Odier’s Patrick Odier says. “This tradition of protecting the private sphere attracts more and more clients.”

Lombard Odier has opened offices in Prague and Singapore in the past two years. Mirabaud & Cie. opened a branch in Dubai at the end of 2007 and now has more than 10 relationship managers based there. Pictet is expanding the staff at its Frankfurt office to attract more onshore money from German clients and has expanded its money management business for institutional investors around the world. Julius Baer announced plans in May to split its private banking and asset management units after outflows at its GAM hedge fund unit hurt investor confidence.

Pressured by clients for better returns from their portfolios, Switzerland’s bankers in recent years became entangled in the complex financial instruments being peddled by Wall Street and the City of London. Some are rethinking that strategy in the wake of the market crash.

Risk Appetite

“Clients developed a risk appetite for high returns,” says Alexandre Zeller, CEO of HSBC Holdings Plc’s Swiss private bank. “Today, we’re going back to basics. Clients want to see capital preservation, and banks will adapt extremely fast.”

UBP, a Madoff victim, is keeping tight control of new investment vehicles. In May, the firm created a new macro hedge fund that makes bets based on broad economic trends. The de Picciotto family ponied up 50 percent of the initial investment.

“The advantage of hedge funds is that their remit is in line with private banking because they try to make money and limit the downside,” says UBP Chief Investment Officer Christophe Bernard.

However steeped they may be in their tradition of discretion and secrecy, Swiss private bankers are eminently adaptable. “The world thinks Geneva is on its knees, but I think it’s looking to the next level,” says Sebastian Dovey, managing partner of Scorpio Partnership Ltd., a London-based wealth management adviser. “The Swiss private banking industry has a genetic ability to survive, as it has done for centuries.”

Casualties

That doesn’t mean there won’t be casualties. At the Rolle yacht club on Lake Geneva, de Picciotto says the regatta hasn’t been spared. “There are fewer sponsors these days,” he says.

One of the regatta’s original backers, Nicolas Gonet of Gonet & Cie., sold his boat last year, while Pictet & Cie. partner Jean-Francois Demole dropped out and rented his catamaran to Bertarelli.

After abandoning the race in May for lack of wind, de Picciotto returned in June to find the wind whipping violently on Lake Geneva for the next regatta. His black-and-silver-striped Zen Too finished eighth, while the squalls capsized two of his competitors.

The race was a fitting event in one of the worst years in memory for Swiss bankers.

To contact the reporters on this story: Stephanie Baker in London at stebaker@bloomberg.net; Warren Giles in Geneva at wgiles@bloomberg.net

Last Updated: July 1, 2009 20:00 EDT

Those Damned Derivative Thingies

Those Damned Derivative Thingies

by Chris Clancy
by Chris Clancy
Recently by Chris Clancy: Around With Ludwig

This essay is a story about insurance, or rather, a story about a type of insurance policy which underwent a mutation. This mutation was not spontaneous – it was engineered. It was one of the biggest scams ever perpetrated.

Paradoxically, the problem was that it worked too well and just got too big.

I hope you stay with the story until its denouement. Maybe you’ll be gobsmacked. If it moves you to go out and start looking for suitable lamposts – then it’s understandable.

When a business makes a loan to another party it can insure against the risk of default. This would be prudent behaviour if the lender had concerns about the borrower not repaying everything which was due.

Insurance companies, like all industries, work to a set of fundamental principles. Two of their most fundamental principles are indemnity and insurable interest.

Indemnity simply means that no-one should "profit" from making an insurance claim. Instead, the money received should be enough to restore you financially to the position you were in before the reason for making the claim occurred.


Insurable interest means that you cannot insure something unless you have a legitimate interest in protecting yourself against something bad happening to that thing. So, for example, you can insure your car or the life of your spouse. You cannot, however, insure the car or the spouse of a complete stranger since your only incentive would be the hope that something bad happens to either or both. In fact, you would have a very strong motive for making sure that something bad actually does happen to either or both!

What has the above got to do with the present mess?

Everything unfortunately.

Understanding the gravity of the situation we are now in means getting to grips with the dreaded "D" word – and I don’t mean "Depression" – I mean "DERIVATIVES"! Few understand them. The following quote refers to Gordon Brown:

"He … made the extraordinary confession that as Chancellor he 'didn't know a lot about' sub-prime mortgages – a key banking practice that sparked the economic collapse."

Mention of the ‘D’ word is usually enough to turn most people off instantly – therefore in what follows I have attempted to keep it as brief and clear as I can and to avoid mentioning this heinous word. Instead I’ll refer to them as Gherkins, Sprouts and Bananas.

The current crisis was started by cheap money being kept cheap for too long. It found its way into the housing market where things escalated as a result of government encouragement for lenders to make bad loans. The lenders who made the bad loans didn’t care since they could sell them on to someone else.

The buyers of these loans didn’t care either since they knew the government would bail them out if they got into trouble. These loans were then securitised; in other words, they were divided up into securities (financial instruments) called "Gherkins" and then sold on to the financial industry.

The financial industry then employed very clever people to mix these securities up in all sorts of permutations and combinations. By the time they had finished splicing and dicing, mixing and matching a new generation of financial instrument had emerged – these were called "Sprouts."

Why did they do this?

It was done to hide the fact that many of these securities were based on bad loans. As such they could only attract a "junk" credit rating which made them more difficult to sell on. By combining them with good loans in incredibly complicated mathematical models, using all sorts of weird and wonderful statistical techniques, this new generation of financial instruments could all attract a triple-A credit rating. Obviously this made these things highly marketable.

Sprouts were sold in vast quantities all over the world. The buyers simply looked at the credit rating. They didn’t know how these things were constructed. They didn’t realize that the models were flawed – Austrian economics tells us again and again that predictions involving human action cannot be reduced to mathematical formulae. (If you’re into self-abuse and really want to put yourself through it go here for a simplified example of how to create a Sprout – and more).

Let’s return to the world of insurance.

Organizations which had purchased Sprouts in huge quantities wanted to reduce their risk. Companies like AIG, for example, offered them insurance policies. In return for regular monthly premiums they could insure against their Sprouts going bad. This was quite legitimate since they had an insurable interest – they owned what they were insuring – and would be rightly indemnified in the event of default.

What happened next was that the insurance policies themselves were then securitised and another generation of financial instruments emerged called "Bananas."

These things have been loosely described as "insurance policies." Nothing could be further from the truth! These things had nothing whatever to do with indemnity and insurable interest. The buyers of Bananas were given the mysterious title of "counterparties." Nobody actually knows who they are.

What was their incentive in purchasing Bananas?

Put simply, Bananas were a bet in which the die was loaded in favour of the gambler, or counterparty. They were betting on the failure of bad loans which were purchased and then re-packaged into Sprouts and then sold on! For those in on the scam there was simply no reason to buy Bananas unless they were confident that the sub-prime market would collapse – which it did. They then claimed on their "insurance" policies.

No. Don’t reach for the bottle just yet. You’ll need a clear head for what comes next. Because it actually gets worse.

Just to recap. The housing food chain spawned three types of financial life form – Gherkins (Mortgage Backed Securities), Sprouts (Collateralised Debt Obligations) and Bananas (Credit Default Swaps).

In this must-read article by James Lieber (which I hope you pass on to as many people as possible) he argues that it was Bananas which turned what should have been a recession into a depression – that the failure of the sub-prime market and its concomitant Gherkins and Sprouts by themselves would not have landed us where we are now.

Why?

Because the amount of money which is still out there waiting to be claimed on Bananas is mind-boggling!

How did it become so large?

The answer is the word "replication." One Sprout could be "insured" time and time again. This is why the thing became so large.

Lieber, writing in Jan. 2009, estimated that the Banana liability was in the region of $600 trillion. In fact, Ellen Brown, writing in Sep. 2008, put total trade in Gherkins, Sprouts and Bananas in excess of $1,000 trillion. The latter is called a quadzillion. If so then we’ve made it – not billions or trillions any more – now we’re into quadzillions!

And just where has all this bailout money paid to financial institutions gone? There’s no way of telling because the Fed’s not saying. How much has gone straight into the pockets of the counterparties, whoever or whatever they are?

I pray HR 1207 makes it all the way. Maybe it will yield up the truth about what has been going on – the fact that it didn’t just happen – it was quite deliberate. And let’s be clear, as Lieber points out in his article, it simply could not have been done without collusion between major players.

Is there a way out of this nightmare? Well, call me an optimist, but there must be. If people can devise a system whereby a tiny elite run the world on money created out of thin air, and get away with it, then surely we have the wit to devise a method of neutralising or cancelling these things – of evaporating them into thin air!

Then go after the counterparties who have already received money and prize every stinking penny from their filthy money-grubbing fingers.

This is no conspiracy theory – it’s fact. See here and here for two articles recently published on LRC – laugh or cry, it’s up to you – but we’ve all been conned, scammed, stiffed or any other word you can think of – yet again.

The greatest scam in history has littered the world with banana skins. There’s a lot more slipping and sliding to go before we emerge from this one – if we ever do – and in one piece at that!

July 6, 2009

Chris Clancy [send him mail] is Associate Professor of Financial Accounting at Zhongnan University of Economics and Law in Wuhan, Hubei Province, People's Republic of China.

US chief executives don't have any friends

Rolling Stone gathers no readers at Goldman Sachs

The highly entertaining war of words between Rolling Stone magazine and Goldman Sachs goes on.

You may have heard some of it before but words of this quality are always worth airing one more time.

It was started in a Rolling Stone article by Matt Taibbi in which he described the world's most famous investment bank as "a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money".

The bank's uber-spinner Lucas Van Prag hit back, calling the article an "hysterical compilation of conspiracy theories".

He went on to ask why Goldman Sachs hadn't been implicated in the shooting of JFK and faking the moon landing.

More to the point he said the bank "rejects the assertion that we are inflators of bubbles and profiteers in busts".

What fun.

You couldn't ask for anything better to liven up the quiet summer months.

The ongoing row has been required reading for everyone in the City, er, apart from the masters of the universe at Goldman Sachs. I hear the Rolling Stone website has been barred by some at the bank.

McKenna not so ingenious with staff

More trouble for Patrick McKenna's Ingenious Media Group.

Just weeks after having to close its stockbroking arm, and in the same week the media investment company released its results, and then released the corrected version again the next day, I learn it has lost one of its senior executives, Sanjay Wadhwani to rival Edge Group.

Never mind, bad things come in threes I suppose.

Friendship that money can buy

So US chief executives don't have any friends, at least according to a review of their Facebook sites by Business Week. Sad, but sadder still is the answer to the problem: buy some.

An Australian company, I won't name it here, has just launched a service selling followers on Twitter. For A$87, or £42, you can buy 1000 followers, for A$3497 you can get a Messiah-like 100,000 followers.

Or you could spend nothing and get a life.

The most dangerous economic experiment

QE just acting as a sugar rush for insolvent banks that deserve to fail

The UK is in the midst of the most dangerous economic experiment for generations. Yet it's the subject of no debate. Since March, the authorities have been using "quantitative easing", or QE. This involves the Bank of England expanding its balance sheet from nothing in order to purchase debt instruments from the market.

The idea is that the proceeds of such sales boost the money supply and kick-start lending. By decreasing the supply of gilts in the market, QE is also meant to push up gilt prices, driving down the yields that determine borrowing costs right across the economy – not least for commercial loans and mortgages.

At this point, people in my position are supposed to explain that QE isn't "printing money". I'm not going to do that. For the only difference between the UK's current policy and Zimbabwe-style economics is that QE involves the creation of electronic balances rather than actual notes.

That last paragraph will have caused a sharp intake of breath among my friends in the higher-echelons of the UK's economics profession. Unable to dismiss me as a "non-economist", they'll say I'm being alarmist – perhaps due to some kind of personality trait.

I would suggest they sit down, turn off their mobile phones, take a cold look at the evidence and then ask themselves if they've got the guts to help expose the madness of the current policy consensus – the debt-funded fiscal boosts, the non-conditional bank bail-outs and, above all, QE.

Over the past three months, the Bank has spent £106bn of QE funny money. By the end of July, it will have purchased the £125bn of assets it has so far been authorised to buy. At this week's meeting of the Monetary Policy Committee, interest rates will be held at 0.5pc. But, with the original QE "pot" almost gone, the Treasury and Bank could well signal there's more to come.

I accept the start of QE caused share prices to rally and business sentiment to improve. But that sugar rush has gone. The harsh reality is that despite the huge inflationary dangers posed by QE, the credit crunch is getting worse.

The Bank of England has more than doubled the monetary base since March, yet mortgage approvals remained at 43,000 in May – consistent with house prices falling at double-digit annual rates. Lending to non-financial companies contracted 3pc last month.

Banks are keeping the QE cash on reserve or lending it to their own off-balance sheet vehicles (the ones stuffed with sub-prime toxic waste). So rather than helping solvent firms and households access credit, QE is re-capitalizing, by the back door, banks that are otherwise insolvent and should be going bust. Gilt yields haven't come down either. The 10-year yield remains where it was before QE began, having been much higher in the interim.

Around a third of the Bank's QE purchases are, anyway, from overseas investors – doing nothing to ease credit in the UK. Such sales by foreigners reflect mounting concerns about the UK's wildly expansionary policy stance and sterling's related medium-term fragility.

As someone who spends a lot of time talking to overseas asset-managers, I can't tell you how often I'm asked: "Liam, why this money-printing? Have your politicians gone mad?" I can only reply that I ask myself the same thing.

There is, in extremis, an argument for QE, but only to buy commercial paper, not sovereign debt. When used to re-purchase gilts, QE allows governments to carry on borrowing like crazy, rather than facing up to the reality the country must balance its books.

When QE was announced, the emphasis was on the commercial debt purchases the authorities would make. In the event, gilts have accounted for a staggering 99pc of the total. That's why QE will inevitably lead to high inflation – whatever nonsense is spouted about "withdrawing the monetary stimulus".

History shows you can't get the inflationary toothpaste back in the tube. That's why price pressures are rising – and gilts yields refuse to fall.

At the outset of QE, the Tories called it "a leap in the dark" – failing to reveal if they backed it or not. Since then, HM Opposition has been silent on a policy that's destroying the last vestiges of this country's policy-making credibility.

Such credibility is what keeps inflation benign and borrowing costs low. By providing a solid macro-economic platform, such credibility is vital if this country is to create the jobs and wealth that will be so important to our citizens in the years to come.

Such credibility, tough to win, is easy to lose. Because of QE, the UK is now losing it – at breakneck speed. Yet those who will form our next government are silent – not yet in power, but complicit in this grotesque policy vandalism.

Related Articles

Royals bargain deals at taxpayers’ expense

July 5, 2009

Royals win ‘sweetheart’ land deals

Prince Andrew has been granted “sweetheart” property deals with the Crown Estate which have made him millions of pounds and secured a rent-free royal residence for his two daughters.

A Sunday Times investigation has found the Crown Estate has been privately offering the royals bargain deals at taxpayers’ expense. The statutory body manages land and property owned by the crown but has an obligation to protect the interests of taxpayers.

The bargains on the royal portfolio include: The sale of the Crown Estate freehold of Andrew’s former marital home, Sunninghill Park, for £12,265 in August 2003. The property was subsequently sold by Andrew for £15m and now lies abandoned. A 75-year lease on Royal Lodge, the Queen Mother’s former home in Windsor Great Park, for £1m. Princesses Beatrice and Eugenie can inherit the lease on the 30-room mansion and live there rent-free until 2078. A 150-year lease for Prince Edward on Bagshot Park for £5m. Property agents say the imposing mansion would have fetched up to £30m on the open market.

The Crown Estate says it took independent advice for the valuations, but special circumstances – such as security issues – mean such properties cannot always get the “highest market value”.

MPs warned this weekend that preferential deals risked undermining the royal family.

“Junior members of the royal family are apparently obtaining substantial financial benefits from sweetheart property transactions with the Crown Estate,” said Ian David-son, a Labour MP and member of the House of Commons public accounts committee.

“All the terms of these deals should now be disclosed.”

The Crown Estate is charged with the environmental stewardship of its land. However, Sunninghill Park, near Ascot in Berkshire, now lies derelict after Andrew obtained the freehold from the Crown Estate and sold it to a Kazakh buyer. “It has been left to rot,” a neighbour said last week.

Bracknell Forest council said it was investigating the property and trying to find out whether there was any requirement to use the Housing Act, under which abandoned homes can be seized by local authorities.

The Crown Estate manages a £7.3 billion land and property portfolio. Although the land and property are owned by the Queen in name, the body is accountable to parliament and returns revenues to the Treasury.

Buckingham Palace said the lease extension for Bagshot Park was at “an agreed market price”. It said the terms of any future lease arrangement for Royal Lodge was confidential.

The Crown Estate confirmed that the Royal Lodge deal meant the lease could not be sold, but could in future years be “assigned to Prince Andrew’s daughters”, Beatrice and Eugenie.

It said there had been “selective” marketing when Edward was offered Bagshot Park and the deal had been checked for value for money. The freehold of Sunninghill Park was sold under normal valuation procedures and there had been “no reason” to keep it.

Understanding Legislative Corruption

Capitolism

Understanding Legislative Corruption

posted by Christopher Hayes on 07/06/2009 @ 12:34pm

Ezra has a smart post up on the mechanisms of influence that the health insurance industry is using to affect the legislative process. "It's Not the Money. It's the Relationships," he says and includes a chart showing the various former Senate finance staffers who've gone to work for the insurance borg.

This is a really crucial point. We have a tendency to understand the economy of influence in DC has almost entirely a product of campaign finance, and the exchange of money. But in my two years here, I've been amazed at how much more powerful establishment social networks are. For another (depressing example) of this phenomenon, check out this item from Sam Pizzigatti's newsletter Too Much:

The Managed Funds Association, the industry trade group, has just hired a well-connected D.C. lobbying firm. How well-connected? Th e firm's newest star lobbyist, Carmencita Whonder, used to serve as the top financial policy adviser for Senator Chuck Schumer, the powerful New York Democrat. Hedge fund managers are hoping Whonder can save the loophole that lets them claim fee income as a capital gain. Ending this bit of tax sophistry, as the White House proposes, would over double the tax due on hedge fund windfalls. In 2008, the top 25 hedge fund managers averaged $464 million each.

Charlie Cray and I wrote about the scandal of the carried interest loop hole last year. If you want to know why it persists, this is more or less why.

Money Tsunami Capsizes the Global Economy

Money Tsunami Capsizes the Global Economy

leadimage

07/06/09 Tampa Bay, Florida

I was surprised that Barron’s reported that the banks show their Total Reserves fell from $896 billion to $848 billion, which is a simple math problem that seems custom-made for my abilities in that regard.

And to prove it, I deftly subtract one from the other and get – voila! – $48 billion, which is not only factually correct, but more than enough to quiet any naysayer saying, “Nay, I say!” as regards my computational skills.

Then, to add that essential touch of surreal whimsy that seems to permeate all things fiscal and monetary these days, I additionally note that not only did Total Reserves go down in the banks by $48 billion to $828 billion, but I will note that Total Reserves one year ago were a miniscule $41 billion! Hahahaha! They fell last week by more than they totaled one year ago! Hahaha!

In fact, Required Reserves are only now starting to rise from “nearly zero” to “slightly more than zero,” and banks are now “required” to have a miniscule $56 billion in reserves against their zillions of dollars in assets and liabilities, while meanwhile, a mere couple of lines up on the same Barron’s page, the Federal Reserve reports that “Reserves F. R. banks” went down by an astonishing $125 billion last week to $692.6 billion! Wow! Big move!

These huge tsunamis of money, joining all the other tsunamis of money sloshing back and forth around the banks and the world, around and around, getting everything all wet, are not only ruining the patio furniture and making a mess of everything, but are such that even the World Bank has revised its estimates, and now says the global economy will contract by 2.9% this year instead of their previous forecast of 1.7%, which is an error of 41%.

Well, when I show up at an executive board meeting sporting a 41% error on a forecast I made just a few months ago, all I hear is people all demanding that I be fired or killed for bringing the company to the edge of bankruptcy and ruination, which of course I seize upon to show that precision economic forecasting is a ridiculous exercise everywhere you go, especially since economics is, just as the Austrian school of economics always said it was, human behavior with a huge random element, which is not even to mention Taleb’s Black Swan Hypothesis of unforeseen catastrophic events making a complete mockery of using bell-curve probabilities to forecast long-term expected results.

It’s like expecting, but not getting, what you would expect from the statement from the Federal Open Market Committee after their recent meeting, which apparently showed that they are incredulous of the generally low level of intelligence of Americans, which they demonstrated when they said, “As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year,” which I figure would be $238 billion a month for the remaining six months of the year, which would normally make my heart start fibrillating with fear at the inflationary implications of such irresponsible monetary policy.

My snotty interpretation is that by saying “as previously announced” they mean, “we say again so that you can’t say we didn’t tell you that you morons are sitting there while we at the Federal Reserve are going to buy up the losses of our friends at a rate of $12,500.00 for every one of the 100 million non-government workers in the USA, which is admittedly a lot of money at $12,500.00 each, but which is almost certainly grossly understated so that we are going to keep coming back for more and more and more! Hahaha! Suckers!!”

Whether or not they meant that, it turns out that I was right, and this is all part of some nefarious plan, as they later slipped in, almost as an afterthought, that “In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn,” which made my eyes pop out painfully when I realized that this means that we are suddenly talking about buying up almost $350 billion a month in worthless assets and handing over the cash to the lucky current holders (who are making out like bandits!) of those toxic assets, which means that these guys will suddenly have a lot of cash in their pockets looking for a home, and the prices of something, or some things, are going to go up as this $350 billion of new cash Per Freaking Month (PFM) gets plowed into “investing” in some asset or another.

This is where some people think it gets tricky, but it is not. This is, in fact, the easy part, as all you have to do is buy gold, silver and oil when your government is acting so impossibly stupid.

At least, that is the lesson of the last 4,500 years of history! And like the saying goes, “The race is not always won by the swiftest, nor the battle by the strongest, but that is the way to bet!” which is just another way of saying, “Whee! This investing stuff is easy!”

Until next time,

The Mogambo Guru
for The Daily Reckoning

Freezing of Landsbanki: Iceland to be Versailled

UK freezing of Landsbanki assets 'as damaging to Iceland as Treaty of Versailles'

The bitter state of relations between Iceland and Britain over the collapse of Icesave has emerged in official documents warning the UK that it was inflicting damage equal to the Treaty of Versailles.

Unions and firms call for people's bank

Unions and firms call for people's bank

Northern Rock would form foundation of state-backed 'Post Bank'

Unions and business groups are calling on the government to use Northern Rock as the foundation for a state-backed bank, that would also operate through the Post Office branch network.

The coalition published detailed proposals it said would give a boost to the post office network and prevent further closures. A "Post Bank" would revive and protect post offices, support communities and help smaller firms, while the banking system was still in disarray, it said.

It presented a number of options, ranging from using Northern Rock as a foundation for a mutually structured people's bank, to buying out the relationship between the Post Office and the Bank of Ireland.

The business secretary, Lord Mandelson, has backed the idea of a people's bank offering financial services through the network of about 12,000 post offices. But the government has other plans for Northern Rock, the lender it bailed out last year, and is widely expected to work towards a sale before the general election, possibly as early as the autumn. The coalition said about 120 small business were closing every day during the recession as banks cut off lending lines in order to restore their balance sheets.

UK banks still face about $200bn (£122.5bn) of losses linked to the credit crunch, according to the IMF.

"There's never been a better time to set up a Post Bank," said Billy Hayes, general secretary of the Communication Workers Union. "In order to ensure a viable future for post offices across the UK we urge Lord Mandelson to endorse this vote-winning initiative and to urgently take the necessary steps to introduce a Post Bank."

"The government must choose between short-term profit and securing the long-term future of financial services at the Post Office by establishing a trusted and non-profit making bank run through the post office network," added John Wright, chairman of the Federation of Small Businesses.

The Post Office already offers some banking services and bill payments, although the "people's bank" would also offer debit card facilities, current accounts, savings plans, loans, business services and financial advice currently available in main city-centre banks.

Goldman Sachs banker arrested

Goldman Sachs banker arrested over claims he stole secret information

A former Goldman Sachs banker has been arrested in New York on allegations that he stole secret information about the bank's trading systems and uploaded them on to a German website.

How elites always destroy paper money

Daily Bell interviews James Turk: How elites always destroy paper money

Section:

From The Daily Bell
Appenzell, Switzerland
Sunday, July 5, 2009

http://www.thedailybell.com/index.asp?fl=

The editors of The Daily Bell are pleased to present this exclusive interview conducted by Scott Smith with hard-money commentator James Turk. Turk has specialized in international banking, finance, and investments since graduating in 1969 from George Washington University with a B.A. degree in International Economics. In 1980 he joined the private investment and trading company of a prominent precious metals trader. He moved to the United Arab Emirates in December 1983 to be appointed manager of the Commodity Department of the Abu Dhabi Investment Authority, a position he held until resigning in 1987. James Turk has written several monographs on money and banking and is the co-author of "The Coming Collapse of the Dollar," which has been updated for a paperback version entitled "The Collapse of the Dollar." He is also the founder of GoldMoney, a convenient and economical way to buy and sell gold online using the digital gold currency. See Scott Smith's "After Thoughts," below, for more.

Daily Bell: Thanks for sitting down with us. We've read your esteemed analysis for years.

Turk: Thank you for your kind invitation and the opportunity to share my thoughts.

Daily Bell: You are a regular contributor to the Gold Anti-Trust Action Committee. In May, Bill Murphy and Chris Powell, co-founders of GATA, traveled to London. How was their trip received across the pond?

Turk: It went very well. They were well-received by the British media and many fund managers and others in the City. Their trip is just another example of the yeoman's work that GATA has been doing over the last 10 years to create a free market in gold, one unfettered by government intervention.

Daily Bell: What is the rising price of gold telling us?

Turk: Gold rises in terms of national currencies whenever there is any kind of monetary problem. These problems include inflation, bank failures, currency debasement, exchange controls, etc. For decades the US dollar has been adversely impacted by one or more of these monetary ailments, so the dollar price of gold has generally been in an uptrend for decades. Or in other words, the purchasing power of the dollar -- and for that matter, other national currencies -- has been falling.

For example, a barrel of crude oil now costs 2.2 goldgrams, which is more or less the same price since the end of World War II. Crude oil only looks like it is getting more expensive when its price is measured in national currencies, and the worse the currency is debased, the more expensive crude oil looks. We can therefore conclude that the experiment with fiat currency -- currency not backed by precious metal and circulating simply because of government edict -- is an appalling failure.

Daily Bell: How did we get to where we are today in terms of the current crisis?

Turk: That's a very good question. The world is in this mess because of the misplaced reliance people have placed on government. They mistakenly think government can solve all the world's problems by passing laws or redistributing wealth. Government leaders and policymakers of course believe that too, or at least tell us that they do because this unthinking reliance on government by the masses enhances politicians' power, which ultimately is derived from people willing to do what government tells them to do.

In fact, everyone should instead be relying upon the free-market process -- namely, one that operates under a consistent rule of law instead of under the conditions of the way the 'market' now exists, which is being battered by the whims and capriciousness of politicians. Governments destroy free markets long before they ever understand how the market process works. But there is a second element to today's mess that goes beyond the misplaced faith people have placed on government.

There is an irrational belief in erroneous economic theories proposed by crank economists. Nothing has changed through the ages; people in effect still believe in alchemists and their flawed 'science,' although the alchemy is cloaked today in modern-day lexicon.

Daily Bell: How well is Ben Bernanke handling the current economic crisis?

Turk: About as badly as can be expected. In his epic "Monetary History of the United States," Milton Friedman explained how the Federal Reserve made the Great Depression worse by its bad decisions, dreadful mistakes, and mismanagement. I would add that governments will always get it wrong when fiddling with the market process. One only needs to look at the record of the Politburo of the former Soviet Union to understand that the market process is too complex to be driven by government bureaucrats and planners. So it is beyond me why people have this blind faith that the central planning czars of the Federal Reserve -- and indeed, the federal government itself -- will get it right in this current depression.

Daily Bell: We've pointed out that everyone is piling on the Fed these days. There may even be an audit. Is it possible that the monetary elite has decided to sacrifice the Fed -- and in doing so create an alternative structure?

Turk: It's an interesting point of view but I don't think anything will change. Governments have usurped the power to create currency. Money is power, and when you can create currency out of thin air as governments now do, they increase their power -- that is, until people stop accepting their currency.

The experience in recent decades has been one of more controls, more government interference in the market process -- not less. So the bottom line is that each individual has to protect himself and his family and be prepared for the inevitable collapse in the US dollar. The way to do that, of course, is to own gold and silver and avoid the dollar. I would avoid other national currencies as well because, after all, they are fiat currencies too and are backed to a large extent by dollars. So if the dollar falls into a black hole, the gravitational pull will drag other currencies along with it. The world needs to return to the basic concept that money is a product of markets, not a creation of governments.

Daily Bell: You're written that gold always wins -- that is, its price inevitably climbs higher as fiat currency is debased, which is a reality understood and recognized by government policymakers. If they know this, what exactly is their strategy these days, what are they trying to do?

Turk: Two things. First, they care only about themselves -- their "job" as a bureaucrat or a politician. Despite their rhetoric, they don't care about you or me. To politicians, constituents are simply an unavoidable annoyance that must be kept in line until the next election, which brings up the second point. Policymakers care only about keeping the fiat currency game alive until they have personally sufficiently milked the system to retire with a fat pension. They also have a short-term goal, which is to keep the system from collapsing until the next administration.

There are of course some notable exceptions, like U.S. Rep. Ron Paul. But generally speaking, the US does not have leaders today. There is no one willing to admit that the US is on the wrong road, even though polls show that a vast majority of Americans --around 80 percent -- instinctively understand and acknowledge that the US is headed in the wrong direction.

Daily Bell: Is it a managed retreat that hopes to preserve fiat money?

Turk: You could call it that. But it is more like politicians not wanting the ship to go down on their watch.

Daily Bell: Does gold remain undervalued?

Turk: Yes, which is quite amazing considering that gold has risen eight years in a row against the US dollar and appreciated during this period at an average annual rate of 16.3 percent. In fact, gold has risen by double-digit annual rates this decade against all the world's major currencies. But 1 ounce of gold still buys approximately the same amount of crude oil it purchased when this decade began. This performance is a testament to how badly the purchasing power of the dollar is being destroyed, which is quite ironic given that real estate in the United States is getting cheaper by the month. What is clear is that we are measuring this decline in real estate prices with a currency that is inflating. That real estate is falling in price while the purchasing power of the dollar is eroded by inflation simply shows how overvalued real estate had become at the height of that bubble.

Daily Bell: How about silver?

Turk: The gold/silver ratio is still way above historical norms. As bullish as I am about gold, I remain more bullish about silver. However, silver is more volatile than gold, so it may not be for everyone.

Daily Bell: Is the same general thing happening to silver as to gold? The same sort of manipulation?

Turk: Yes, because it would be too obvious for the price of silver to soar without gold soaring along with it. But the drivers behind silver are different. Silver really doesn't provide the same "canary in a coal mine" warning function about national currency that is provided by gold. Rather, banks are in the business of lending and they earn a lot of money by lending silver, while at the same time avoid the cost of storing it. The result is that a couple of bullion banks are short a massive amount of silver. The point is that it will be impossible for them to deliver physical metal against all of their paper commitments.

Daily Bell: You've written that it is reasonable to conclude that gold should comprise at least 10 percent of the world's money supply. And that because it is nowhere near that level, gold is undervalued. Can you elaborate?

Turk: For decades we have been using in commerce money substitutes -- that is, national currency, rather than money itself, gold. Consequently, few people today understand money/gold, which has created a prevailing bubble mentality. In other words, people view dollars and other fiat currency to be a store of value, rather than what they really are -- empty promises that are no more reliable in the long run than the hollow rhetoric of politicians. My point is that we are in a bubble, which is bigger than the Internet bubble, the Nasdaq bubble, and the real estate bubble. It's the bubble of mistaken beliefs that the dollar has a long-term future, when in reality, the dollar is on the road to the fiat currency graveyard. The consequence of this irrational faith in the dollar means that the dollar is overvalued and gold is undervalued. These relative valuations are an unnatural state and will correct -- I should say, continue to correct given gold's appreciation this decade -- by the price of gold rising a lot further.

Eventually, more and more people will recognize the dollar for what it really is, which will cause this dollar-bubble to pop. When it does, people will increasingly turn to gold, and this heightened demand will increase the value people place on gold. In the 19th century, about 40 percent of the purchasing power of the world's money rested in gold, with the balance in money substitutes -- that is, the various national currencies. By the mid-20th century gold's percentage declined to about 10 percent, and fell further to less than 2 percent in 1971 when the dollar's link to gold was formally broken by government edict. The reliance of money substitutes thereafter declined in the inflationary 1970s, so gold increased to about 10 percent again by 1980. It thereafter fell again, this time to less than 1 percent when Gordon Brown announced that the Bank of England was selling half its gold reserves. Gold's percentage today still remains less than 2 percent. I believe that the 10 percent level is a reasonable minimal target, which implies that gold will rise five times in real purchasing power terms. My longstanding price target for gold, first given in an interview in Barron's back in October 2003 when gold was in the $340s, is $7,000 per ounce by 2013-15. But given how badly the Federal Reserve is destroying the dollar probably means that my price forecast will be too low.

Daily Bell: How does the U.S. government manage the gold price? Can you give us the details?

Turk: The key is to understand that there are two gold markets, one for physical gold in which real, physical metal changes hands, and one for paper gold, which are simply promises to deliver gold in the future. The world's major physical markets are in Europe. Because the US government confiscated gold in 1933, there is very little physical metal traded today in the United States, which is principally a paper market.

These two markets are interrelated, but each responds to its own unique supply/demand characteristics. To execute trades on its behalf, the U.S. government, operating though the quasi-governmental Exchange Stabilization Fund, has enlisted a few bullion banks, which together have been dubbed the "gold cartel." The gold cartel operates principally in the paper market to "paint the tape." Though its intervention can occur any time during the day, there are discernable patterns. Its footprints are most noticeable after the physical market closes in London and Zurich and the US paper market takes center stage. The gold cartel also hits the market after the US market closes and before Asia opens when the market is notoriously illiquid, again to paint the tape with a low gold price.

The gold cartel uses only sparingly the physical stock of gold held in government coffers. It can create paper gold out of thin air, which is obviously not possible for physical gold.

The other technique governments use is propaganda. For example, how many times have they proposed to sell some International Monetary Fund gold over the past several years? And why are these proposals floated only when gold is threatening to run higher? Of course, propaganda is standard fare for governments. Remember when the sub-prime crisis was starting to unfold and Messrs. Paulson and Bernanke said the problems would be "contained"? Do you think they really believed what they were saying, or was it just propaganda? So with these questions in mind, let me ask you another question. If you hold paper gold instead of physical gold, do you really believe that your counterparty will make good on its promise to deliver physical gold to you when you ask for it?

The mountain of paper promises dwarfs the physical supply of metal, which explains why I have always recommended owning physical metal. And there are only two ways to do that. You buy gold and store it yourself, or you buy gold and have someone store it for you, which is what we do in GoldMoney. But if you choose this alternative, be sure that the company you use has the same governance procedures that we have in GoldMoney, and particularly real audits where the auditor goes into the vault and verifies the weight of metal really exists. In GoldMoney these audit reports are available to our customers upon request.

Daily Bell: How did the gold cartel come about? You seem to believe former Fed chairman Alan Greenspan was involved.

Turk: He re-lit the fuse after it had been dormant for a while. Under the classical Gold Standard, gold and national currencies were complementary. Each central bank managed its country's national currency so that it would always be equal to the purchasing power of gold. For example, the British pound had essentially the same purchasing power in 1914 as it did when Sir Isaac Newton invented the classical gold standard two-hundred years earlier. But this complementary role changed in the 20th century. It became adversarial. Governments began to chafe at the discipline imposed by Newton's invention. This is when Keynes called the gold standard a "barbarous relic." He advocated government control of currency so it could be managed as government saw fit. Rather than being a neutral tool in commerce as it was under the classical Gold Standard, currency became a manipulative force available to government planners.

Anyway, in the latter half of the 1990s, the gold price began rising because of the inflationary and easy-money policies followed by the Federal Reserve. The banks realized that they had a growing problem. They had been borrowing gold and there was no way they could repay the gold they had borrowed without driving up the gold price, which would worsen their losses.

Daily Bell: How did the Japanese yen figure into it?

Turk: During the last banking crisis in the early 1990s, Greenspan purposely steepened the yield curve so that banks could borrow at very low rates and use this money to lend at very high rates. This strategy increased bank earnings to help them out of insolvency. The consequence was that banks looked for anything with a low interest rate to borrow, and the yen had low interest rates because the Bank of Japan was trying to revive the Japanese economy after their stock market crash in 1990.

Daily Bell: Can you explain the gold carry trade?

Turk: Interest rates and asset/liability management are the keys to understanding the carry trade. A bank borrows a currency with low interest rates and uses that currency to purchase assets in a high-interest-rate currency. Thus banks have been borrowing gold at interest rates less than 1 percent, then selling the gold to obtain dollars that are used to acquire dollar-denominated assets yielding 5 percent of more. It is a lucrative trade as long as the price of gold does not rise in dollar terms.

Daily Bell: Has the gold cartel caused losses to the average investor? How about professional investors?

Turk: The answer depends on how you have approached gold over the past decade. Given gold's outstanding appreciation this decade, if you regularly purchased gold under a dollar-cost averaging program -- which is what I have been recommending for years and continue to recommend -- you have done exceptionally well. However, many trend-following professional traders have been getting chopped up and whipsawed by the gold cartel trading against them. So I do not recommend trading gold. I recommend accumulating it. Buy gold as your savings, but you are saving sound money and not some debased fiat currency.

Daily Bell: Will the gold cartel fail?

Turk: Yes, because gold always wins. The cartel will win a battle or two but it will lose the war. Governments always destroy the value of national currency; it is inevitable. Look at the history of fiat currency. I challenge you to come up with one fiat currency that has not been debased. Eventually all fiat currency is destroyed. The creation of currency needs discipline, which is something governments lack. They will always find some politically expedient excuse to create money out of thin air, and as a result, the currency eventually gets created to excess until it collapses. Gold imposes an essential discipline on currency creation, which explains why Newton's classical gold standard was so successful.

Daily Bell: What are the most important -- seminal -- articles of yours that you would encourage everyone to read? Where can they be found?

Turk: There are two I think that stand out. The first provides basic information about gold, which its title makes clear. It is "8 Things Everyone Should Know About Gold." You can read it here:

http://www.goldprice.org/james-turk/2006/09/8-things-everyone-should-kno...

The second article is entitled "The Barbarous Relic -- It Is Not What You Think" and is posted on GoldMoney.com here:

http://goldmoney.com/documents/barbarous-relic.pdf

This article explains why gold is money and, just as importantly, why the real barbarous relic is central banking.

Daily Bell: On behalf of all of our readers we thank you for sharing your views with us -- and for providing us with such fine articles.

Turk: Thank you.