What Went Down When Silver Went Up

While people were rushing to sell the family silver and standing in line with bags of coins, forces greater than the Hunt brothers were curbing the little guys' profits.

It is early 1980. The nation's economy is in a recession. Inflation is continuing to rise. And the prices of gold and silver are skyrocketing.

With silver in alloy form widely held by Americans, who are hurting from the recession and squeezed by the chronic inflation, hordes of people are descending upon silver dealers, bringing with them their silver coins, tea services, baby spoons, and anything else with silver in it. They are getting in on the action, selling while the price is high.

But what they find at the silver dealer is that the price they are getting for their coins and scrap is substantially lower than the price of pure, refined silver bullion making the news. At the height of the bull market, with silver having soared to 715 percent above its price at the start of 1979, US silver coins are being bought at discounts of as much as 25 percent below melt value. But then the price of silver crashes, and in the aftermath silver coins come to command a premium of more than 70 percent over melt value.

In contrast to the wild gyrations in silver premiums, gold coin markets are remarkably orderly during this tumultuous period. The price of gold bullion has surged to a level 269 percent above its 1979 open, but the major bullion coins—the Austrian 100 Corona, the South African Krugerrand, the Mexican 50 Peso, and the Canadian Maple Leaf—are trading at relatively stable premiums in relation to the price of gold bullion on world markets.

Seeing the stability of the gold market and experiencing the swing in silver alloy prices from discount to premium, some upset investors suspect a plot among silver coin dealers. They must be conspiring to buy at a discount when bullion prices are high and investors are seeking to sell their silver coins, and conspiring to sell only at a premium when bullion prices have dropped and investors want to buy coins.

If fingers are to be pointed in this story, however, it must be toward Washington, D.C. It was not the corner coin dealers who cleaned up in the market in early 1980 but big-time, well-heeled multinational firms—aided by the commodities futures markets and government intervention that kept dealers from responding quickly to consumers' and small investors' desire to get in on the action. The true story of the silver market in early 1980 provides a case study of how government meddling in markets prevents temporary dislocations from smoothing themselves out.

BEHIND THE SCENES

What happens in the silver market has a lot to do with the peculiar nature of the silver-supply situation. More silver is consumed each year than is produced. The difference is made up from aboveground supplies, most of which are in the form of alloys. The most common form of silver alloy is coins. Under normal conditions, when supplies of silver decline, the price will rise. Higher prices encourage holders of silver coins to sell them to take a profit. The coins are melted and refined into bullion, which relieves the situation.

Because so many Americans hold silver alloys, it is not surprising to find in this country a well-developed silver-recycling industry. Of course, it takes time and money to refine silver coins into bullion. Normally, brokers pay a price for the coins sufficiently below their melt value to cover the cost of refining and of financing the transaction. And, to protect themselves in case the price of silver bullion falls between the purchase of the coins and the sale of the bullion, the brokers sell equivalent quantities of bullion for future delivery on the commodity exchanges.

But during the boom, silver brokers had only severely limited access to that avenue. In a measure ostensibly designed to protect speculators from major losses in active markets, the commodity exchanges impose daily limits on the price changes of contracts for future delivery of the commodity. No trades are allowed at prices above the upper limit or below the lower limit. (No limits are set for contracts for the current month's delivery). Contrary to their stated purpose, however, these limits offer little protection to the speculator; when their effect is to halt trading, they actually prevent losing speculators from liquidating their positions.

Normally, these limits are sufficiently large that they only rarely come into play. But in extremely active markets—such as the 1980 silver market—they do sometimes completely halt trading in a commodity for future delivery. In this case, with silver moving so rapidly, the limits prevented trading in all but spot month contracts. With the spot price gyrating as much as $5 and $10 per day, futures' trading was locked out day after day. Silver brokers could not use the futures market to hedge against the possibility of silver's price falling while their coins were tied up in refining.

Furthermore, under pressure from the US Treasury, the exchanges imposed new rules requiring that 35 percent—rather than the usual 25 percent—of the value of contracts be deposited before a trade could be made. And, crucial to what was to follow, the Treasury issued a "request" to domestic banks to refuse to lend money against gold and silver. (Requests from governmental authorities of highly regulated businesses like banks take on the character of threats; they are nearly always met.) So dealers could not take bank loans, either, to finance their inventories.

The combination of these actions made it impossible for the silver broker/refiner to do business in the normal fashion. Unless he had access to unlimited funds from private sources, the willingness to take on substantial risk, or the capacity to hedge on foreign markets, he was shut off from normal hedging procedures. Almost no dealer had these resources at his command. In fact, the only ones who did were certain multinational firms that could obtain financing from foreign banks (or domestic banks willing to ignore the Fed's directives out of respect for the firm's size) and could sell on the London futures market, which trades huge-sized contracts.

CHAIN REACTIONS

So what happened? Silver dealers were swamped with public interest. Retail dealers (those who deal primarily with the public) continued to purchase coin and scrap and attempted to move it through conventional wholesale channels. But with credit cut off and no means to hedge, wholesalers were in trouble. Many found out that their refiners could not handle the quantities they had been offered. Refiners began to drop prices (in relation to melt value), hoping that the declining prices would limit the amount of coin and scrap offered. But the refiners soon were filled up.

By this point, many dealers and small refiners were overextended. Some had all their capital tied up in scrap in the process of being refined and had no cash at all. They simply had to close their doors temporarily. When the refiners stopped buying, the wholesalers had to stop. And when the wholesalers stopped, the retailers had to stop.

Some refiners resorted to writing checks against their receivables. Checks from some small refiners bounced. Wholesalers who had deposited the bounced checks from the refiners could not then stop their own checks from bouncing.

Meanwhile, the public—still anxious to take advantage of the record prices—swamped the dealers. Long lines formed outside their places of business. Fights broke out among those waiting in line. Dealers who managed to find means of reselling silver and who could keep their cash flow going hired additional personnel and extended their hours. Telephone calls to dealers increased to the point that dealers took their phones off the hook. One dealer discovered that his competitors had been closed by lack of operating cash for more than a week; but he had not known it, because every time he tried to call them, their lines had been busy from unanswered incoming calls.

More and more dealers (both at the retail and the wholesale level) had to turn to those few firms sufficiently well financed and connected to find financing and to use the London futures market. These firms, few and far between, realized that they were in an exceptionally good position: they were the only ultimate buyers of any consequence left. Very quickly, then, they discovered that they could buy from dealers at larger and larger discounts below bullion value. They made almost unfathomable profits.

When the squeeze was broken and the price of silver plummeted, dealers no longer faced long lines of customers wanting to sell their silver coins. Instead, they faced lines of people wanting to purchase at the new lower prices. Those who had significant amounts of silver coin in inventory quickly sold out. But the lines of eager buyers remained. Dealers began to raise their bids to wholesalers on silver coin, but they could still not buy significant quantities.

Gradually, the higher quotes encouraged some to sell and discouraged some of those seeking to buy, and the market settled down. Within a few weeks premiums had dropped back into the 10–15 percent range.

RAKING IT IN

It appears that a substantial portion of the silver coin that was ultimately sold during the boom to a few major multinational firms was never melted at all. The firms simply sold bullion on the London futures market when they purchased the coin. When the market went bust, they repurchased silver bullion to cover their shorts. They then sold the silver coin, which they had purchased well below melt value, at prices well above melt value.

The whole episode was phenomenally profitable for such firms. Consider the following hypothetical figures, all based on actual market prices. When the spot price of silver bullion was $40, silver coin traded for about $27 per fine ounce. A firm purchases 1,000 bags of silver at a cost of $19,305,000. To eliminate its risk, it sells 715,000 ounces of silver for six-month delivery, at the futures price of $45 per ounce. That sale will yield $32,175,000 when it is consummated.

Now there are three things the price of silver may do during the subsequent six months: it can rise further, stay about the same, or drop. If the price rises further or stays the same, the firm refines the 1,000 bags. The refining would cost about $200,000. The firm then delivers the refined bullion against its futures contract. Under such circumstances, the firm's operating profit on the transaction works out as follows:

Expenses:
Financing (@ 22%) $2,123,000
Refining 200,000
Silver coin 19,305,000
Miscellaneous 50,000
TOTAL $21,678,000
Income:
Sale of bullion $32,175,000
Operating profit: $10,488,000

If, on the other hand, prices drop, the firm simply covers its future position by purchasing bullion for future delivery, and it sells its bags on the cash market. Suppose the firm decided to bail out at $15 per ounce. It would cost approximately $16.75 per ounce to buy bullion for five-month future delivery. There would be no refining costs; financing costs would be considerably less, because the transaction would be completed earlier. The firm's operating profit would run as follows:

Expenses:
Silver coin $19,305,000
Financing 707,700
Bullion 11,976,250
Miscellaneous 50,000
TOTAL $32,038,950
Income:
Sale of bullion $32,175,000
Sale of coin $12,400,000
Operating profit: $12,536,050

The firm's profits were locked in when they simultaneously purchased the coin on a spot basis and sold the bullion equivalent for future delivery. Their risk was negligible.

The net result of the government's intervention in the commodity and credit markets was mass disruption of the market process. The irony is that the government believed that it was necessary to protect the public, but in fact it created a situation in which the general public was unable to sell coins and scrap except at very low prices in relation to spot markets. Huge multinationals, on the other hand, were able to exploit the situation and make a killing.

R.W. Bradford is a financial consultant, publisher of an economic newsletter, and operator of a precious metals firm.