Gyroscopic Investing

The notion that GLD (or IAU or SGOL) intrinsically corresponds to some amount of gold seems fundamentally incorrect to me.  In this thread, lets collect some plausible nightmare scenarios.  Be creative.  Think "worst case". 

The potential vulnerabilities seem to be that since a share of GLD is not the same as 1/10th of an oz of gold, GLD's price can vary independently of the actual price of gold, trading in GLD can be suspended for indefinitely long periods of time while trading in actual gold continues, the monetary value of a share of GLD can ultimately be decided by a court, one or more of the authorized participants might engage in a massive fraud (this one's easy - an AP exchanges a tonne of gold plated tungsten for shares, sells the shares and then goes belly up - the "backing percentage" is now off by a tonne), etc etc.

Here's a nightmare scenario I'll freely admit I'm not entirely sure is actually feasible:

1) Gold explodes to the upside.
2) JP Morgan acts to control the upside explosion (because they're so short gold, movement up is bad for them) by taking an even larger short position on COMEX, and by madly borrowing shares of GLD/IAU (same mechanism as shorting GLD/IAU) which shares they trade for actual gold from GLD/IAU, which gold they sell on the open market hoping to control the price explosion.  This effectively amounts to shorting GLD/IAU - but in a way that no one has to openly report (!).
3) Prices KEEP going up, and eventually even JP Morgan runs out of money (effectively a short squeeze).

Now what?

They obtained actual gold (which has already been sold on the open market) from GLD with borrowed shares and the "backing percentage" quoted by GLD reflects the "borrowing" as SALES.  Anyone holding GLD in such a way that it can be lent (think very very hard about whether your shares of GLD can be lent by anyone) suddenly realizes their "shares of GLD" don't correspond to gold, but to an amount of "cash" somebody put up as collateral.  The market panics.  Perhaps everyone dumps GLD and AFTER its price collapses the government finally steps in and freezes trading (which, not coincidentally, helps JP Morgan).  The actual price of gold KEEPS going up.

The net result might be physical gold trading at $5,000/oz and shares of GLD frozen reflecting a gold price of $500/oz.  After several months winding through the courts (during which time the price of gold KEEPS going up), the court decides the only "fair" solution is to liquidate the ETF at its frozen value (affecting ALL shareholders, not just those whose shares were lent) and sell the actual gold to help pay for the obligatory JP Morgan bailout (because they are, of course, too big to fail). Another possibility is the court dilutes the shares by an amount corresponding to how many shares JP Morgan "borrowed".  I don't think it's inconceivable that they could borrow 50% of the total outstanding shares, meaning all shareholders would take a 1/3 hit.  In the first case you're getting less than 10% of what you think is the value of your GLD.  In the second, you're getting 2/3.  The point here is the value you receive might be, somewhat arbitrarily, decided by a court - not by the gold market!

Anyone else have a nightmare scenario?

In general I am not too concerned about fraud etc. To my mind there are two great risks in gold ETF's. First in a really serious emergency the financial markets might be closed. This happened at the outbreak of the First World War. All of the great powers abandoned convertibility for their currencies and the London Stock Exchange closed. It remained shut until 1915. Secondly gold held in an ETF is an easy target in the event of some great emergency for governments looking to expropriate. I have stated on other threads in the past that I think the odds of large scale gold confiscation in this country are slightly below negligible. But you asked for a worst case scenario. If we got involved in full scale war with China or were struck by a massive currency crisis I could see the government doing things that they would not do under anything other than extreme emergency conditions.  Gold in an ETF would be highly vulnerable to state confiscation.

What about just shorting GLD?

Yes, you are supposed to borrow the shares.  But even assuming the best case, there are now two owners for every shorted share (the original owner, and whomever purchased the shares from the shorter).

Last time I saw a report (mid-August) GLD was short a bit over 5%.  That means, at the least, were GLD to suddenly close, 5% of people that think they own GLD do not.  Or else everybody that owns GLD owns 5% less than they thought they owned.

Worst case, a big player goes massively short GLD and is unable to obtain the shares before settlement so they are 'naked.'  Most likely this will happen during or shortly after a big run up.  If the price then goes exponential...

You could do what Clive has suggested and buy the 3xGLD with 33% of your gold allocation and then place 67% in STT.  It provides the same return as 1xGLD except you only place 1/3 of your pennies in it.  Or get even more crazy and buy deep-in-the-money three month call options with 10% and keep 90% in STT.

Also, I'm not sure I buy the whole JP Morgan has massive shorts on silver and gold.  Even if they do it is likely part of a hedging or arbitration strategy.  I highly doubt that the traders that have been holding pure shorts for the past decade would still have a job.

Gosso wrote:I'm not sure I buy the whole JP Morgan has massive shorts on silver and gold.  Even if they do it is likely part of a hedging or arbitration strategy.

For silver, at least, it's a matter of public record.

they claim (because their position size is larger than allowed by nymex/comex rules) that it is because they hedge clients who are producers.  (that is the only way the size of their position is 'legal'.)