BUYER BEWARE by Theodore Butler [01/30/2007]

Most men treasure personal reputation as their most valuable possession. I know I do. With reputation comes responsibility, especially if you put your words in print for a wide audience. The last thing I want to do is to write something that would cause damage to the reader, particularly in financial matters. You dont get a positive reputation by tearing other people down, or by making unsubstantiated claims, or by stealing someone elses thoughts. You earn it by introducing and explaining ideas that help people.

Lately, I have been thinking once again about investment pool accounts and certificate programs for unallocated silver (and other precious metals). Although I have written about such accounts frequently in the past, I still get questions from readers. So let me be clear. My new thoughts lead me to believe that at some point it must end in disaster for both the buyers and issuers of these programs. I will try to explain why and convince you to the best of my ability to get out of these programs now.

What is a silver pool account or a certificate program for unallocated silver? In simple terms, these are purely paper promises or bookkeeping-only entries that are sold as an alternative for owning the specifically earmarked real silver of segregated or unallocated type accounts. For illustrative purposes, an example of a pool type account would be and for unallocated certificates the Perth Mint of Australia But they are not the only examples. Most people who buy this paper form of silver are not aware that there is no specific silver backing up these accounts, only a promise of some type by the issuer. If a problem develops either in the silver market (a shortage) or with the issuer (insolvency) the buyer could end up high and dry. The buyer pays full cash value for the silver, yet may not get the silver or the value of the silver.

I consider pool accounts and certificate programs with no serial numbers of bars on a par with the great failed experiment of leasing and forward selling of gold and silver by mining companies. Long-time readers may know that this issue was what prompted me to first write on the Internet, 10 years ago. To my knowledge, I was the first to write of the stupidity and manipulative effect of leasing. One great thing about the Internet and the printed word is the time record created.

For newer readers, leasing transactions failed because they didnt pass the test of common sense. Great quantities of physical central bank gold and silver were dumped on the market through leasing. This artificially depressed the price (to below $300 on gold). The mining companies obligated themselves to pay back years of production at those depressed prices. It was an accident waiting to happen when the price rose and the transactions were unwound. Leasing participants were too concerned about transaction fees and cheap financing to step back and look at the big picture. They convinced themselves they were hedging, even though legitimate hedging never involves the physical short sale of a commodity or obligates years of production.

The disaster did occur, as it had to. Gold prices rose when the dumping stopped and gold was bought back (the silver has yet to be bought back). The cumulative losses to date in gold from this wacky experiment are in the tens of billions of dollars and there is still a significant portion left to be closed out. Thats tens of billions of dollars in losses from an idea that shouldnt have passed muster.

Although it seems clear in hindsight just what a mistake this forward selling was, at the time it was an accepted practice that almost no one spoke against. I have a confession. Back when I publicly started writing about leasing and Barrick Gold and others involved in this nutty practice, I would sometimes wait for the process server to knock on my door with libel lawsuit papers. (Yes, there were many days Ive waited for COMEX related papers, as well.)

What does leasing/forward selling have to do with pool accounts and unallocated silver storage? Quite a lot, in my opinion. For starters, they both sound good, until you think about whats really involved. A transaction must be examined from the perspective of all parties to see if it makes sense, or even if it is legitimate. For the buyers of silver (or gold) in a pool or unallocated account, the great allure is that it is cheaper and easier than buying and storing real silver. Cheap and easy are powerful incentives, and, all things being equal, they win every time. And in todays modern world, technology enables us to do many things cheaper and easier (like e-mail and online shopping and securities trading), so were not always suspicious of things cheap and easy.

Are all things equal between pool accounts and owning the real thing? Do you save enough to justify it? I dont think so. (The real thing is actual metal segregated and held in your name by a large and reputable third party. Thats generally not the dealer you bought the metal from. In the case of 1000-ounce bars, professional storage identifies them by serial numbers.)

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? Whats 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 dont charge storage fees? They make it on the float, or the use of the buyers money. Thats the only way they can make money. The issuer puts the buyers money at interest or into the business. Since no actual metal back ups 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.

Now some people who are aware of these circumstances claim they are content doing business this way, because there have been no known problems to date. I can understand that, but things can change and how could you know if they did? Others would say the Perth Mint also offers a guarantee from the provincial government. I understand that as well, but real metal holders dont need a government guarantee because unencumbered metal is an asset that is no one elses liability. A pool account or an unallocated certificate account, by definition, turns an asset that is no ones liability into an asset that is decidedly someones liability. Thats perverse.

In no way am I attempting to malign the reputations of or the Perth Mint or any other issuer of pool or unallocated silver accounts. On the contrary, I am trying to save them and their customers great potential harm and heartache. My motivation in writing about leasing/forward selling ten years ago was to alert all participants to the inherent flaws in those transactions. By not heeding the warnings, the mining industry went on to lose tens of billions of dollars that would have enriched their shareholders.

My motivation today is similar. The worst thing that could happen to a silver investor is to have bought at the right time and then discovered, too late, that he held the wrong form of silver. I am convinced that silver in pool accounts and unallocated certificates are the worst form of silver and that it is highly likely, if not near certain, that they will end badly for all involved. Thats because the issuers are at risk in a price rise. As the price rises, the buyers are accruing profits and the issuers are accruing losses. The issuers have to actually pay out the losses only as buyers sell at a profit or convert their pool accounts or certificates to real metal. But there is no way of measuring the issuers total liability to the buyers. As long as only a few buyers are selling out, or if there are new buyers coming in, the cash outlays by the issuers may be minimal. As long as pool investors think silver is a buy or hold, they will not cash out and require the issuer to pay out cash. This can allow an issuers financial condition to deteriorate as the price rises. The only real issue becomes when is this likely to reach a tipping point? The obvious, if imprecise, answer is when the price is high enough to cause people to sell while no new buyers appear.

What Ive just described is a classic Ponzi scheme, in which old investors are paid out with new investor money. The scheme can only last until new investors stop investing. Then it collapses. Do I think that any of the pool issuers intentionally set out to construct a Ponzi scheme? Absolutely not! Just as I didnt think that Barrick Gold would intentionally deprive their shareholders of many billions of dollars with their foolish forward sales. Just as I dont think some large trader at the COMEX woke up one day with the bright idea to intentionally manipulate the silver market with concentrated short sales. Thats not how things normally work in the real world. The way things work in the real world is that unintended consequences develop when people take questionable actions without thinking things through.

Pool accounts and unallocated silver certificates are a bad idea. They create unacceptable trade-offs. It costs a small amount of money to store and insure real silver. You cant do it for free. You can store non-existent silver for free, but thats a bad idea. Compounding the problem is the lack of public information. Ive read the annual reports of the Perth Mint, and I am concerned with the lack of financial detail and their reliance on leased metal. Pool operators like are private companies and financial data is not available. Worse still is the lack of regulatory oversight. If you think theres a problem with the silver ETF, you can at least petition the SEC, or Barclays, a public company. The CFTC may sidestep complaints about the COMEX, but at least they have to go on record. Who oversees the pool accounts and certificate issuers?

Investors should rid themselves of these pool and unallocated accounts while they can. There are too many good alternatives for holding real silver. Also, a deployment out of non-existent silver to real silver will help the price. The issuers should stop dealing in these potentially ruinous financial concoctions, which are not central to their basic business. It may prove temporarily painful but, in the long run, it may save these businesses. Ten years ago, very few envisioned what damage leasing and forward selling would do to the miners. Years from now, I think the same thing will be said about pool and unallocated silver accounts.

A Permanent Shortage Of Silver
Dumb & Dumber
Mission To The Moon
No Way Out
Thank You, Mr. Buffett
The Death of Hedging

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