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Pollitt & Co. Inc.

11 King Street West, Suite 1950, Toronto, ON. Tel: 416.365.3313625 Boulevard Ren Lvesque Ouest, Bureau 930, Montral, QC. Tel: 514.395.8910

Whither the Feds Gold

The idea of revaluing the USs official gold from $42.22 to the

current market price popped up earlier this month in the

Washington Post. If the Treasury's bling were valued at thespot price, we'd be sitting on a literal gold mine of nearly $288

billion, the article pointed out. CNN later asked why doesnt the

Treasury and, by extension, the Fed realize those gains on their

balance sheets? The idea that a revaluation of gold's official

price might solve all the USs problems in particular those of

the Federal Reserve is not so cut and dried. Before we get into

the details, lets discuss the specific problems a revaluation is

supposed to solve.

The Federal Reserves balance sheet has deteriorated. Prior to

the credit crisis, the Feds assets consisted almost entirely of

low risk government debt. Since then the Feds balance sheet

has become a repository for the bad assets that no one else

wants to hold. The majority of the Feds assets are currently

made up of loans to private institutions and mortgage-backed

securities. The former include loans to shell companies that

have bought the worst of a bankrupt Bear Stearnss and AIGs

securities not the safest of investments.

Not only has the quality of the Feds assets declined, but the

quantity has exploded. Just over a year ago it reported assets

worth $900 billion. Now it holds $2.2 trillion. This represents a

huge increase in leverage. Before the crisis, the Feds capital

ratio its percentage of capital to total assets stood at 4.5%. It

has since fallen to 2.5%. Where before it had leveraged itself

around 20:1, it is now leveraged 37:1 (see Fig 1).

With share capital of around $50 billion, it wouldnt take a largeloss to wipe out said capital and render the worlds largest

central bank insolvent. About $110 billion has been lent by the

Fed to support the questionable assets of Bear Stearns and

AIG, so a 50% loss on these assets would do the job.

The Feds deteriorating health is problematic. US dollars are a

liability of the Federal Reserve, and as the Fed increases its

odds of insolvency, people lose confidence in holding those

dollars, spending them as quickly as possible. Inflation, a

decline in the dollars

purchasing power, is the

result.

Now back to the idea ofrevaluing gold. According

to ex-Fed Governor Lyle

Gramley and Peter Stella of

the IMF, changes to the

way in which the Fed

accounts for its 261 million

ounce gold stock might just

save the day. The Feds

gold is valued at a mere

$42 an ounce, far short of the $1100 market price. Marking its

gold to market would result in a rise in the Feds gold stock from

$11 billion to $283 billion. The Feds resulting capital gain acool $272 billion would easily cushion any writedown on its

Bear Stearns/AIG or MBS investments. Fed leverage would

tumble from 37:1 to a conservative 7:1. Solvency assured, there

would be no reason for dollar-holders to lose confidence, and

therefore the inflationary threat would be eradicated. Voila!

Unfortunately, the revaluation story is not entirely correct. The

Feds gold stock does not actually consist of physical gold.

Rather, the Fed holds certificates to gold held on its behalf by

the US Treasury. Due to the rather odd fine print on those

certificates, any capital gain earned from an increase in the

official gold price would at this time appear to accrue to the

Treasury and not the Fed.

A bit of history will help explain this strange relationship between

the Feds gold and the Treasury. Until January 30, 1934, the

Feds then 195 million ounces gold stock, valued at $4 billion,

was comprised entirely of physical gold. The Gold Reserve Act,

passed that very day, forced the Fed to transfer all of this gold to

the Treasury in return for $4 billion worth of gold certificates

paper claims to gold. Oddly, these certificates were not payable

in a fixed quantity of gold. Rather, a $10,000 gold certificate

simply promised to pay to the bearer $10,000 worth of gold.

The very next day January 31, 1934 the official price of gold

was increased by the authorities from $20.63 to $35 per ounce.

The Fed still held $4 billion worth of certificates convertible into

$4 billion worth of gold at the Treasury. But the $4 billion worthof gold promised on the face of the certificates was now

equivalent to 115 million ounces, far less than the day before

when these same certificates could lay claim to 195 million

ounces. By tweaking the gold price, the Treasury had effectively

confiscated some 80 million ounces of gold from its bureaucratic

cousin, who earlier had confiscated it from the public. The

Treasury didnt sit on its new gold. It printed up new gold

certificates using its 80 million ounces as collateral, brought

them to the Fed, and had the Fed issue it $2.5 billion in newly

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printed currency.

As in 1934, it appears the benefits of a modern revaluation

would accrue entirely to the Treasury. At todays official price of

$42.22, the Feds $11 billion worth of gold certificates currently

lay claim to 261 million ounces of gold held by the Treasury. Say

the official gold price was increased to $1100. As indicated on

their face, the Feds certificates would still be worth $11 billion ingold. But these certificates would no longer lay claim to 261

million ounces of gold. Instead they would represent claims

equal to a measly 10 million ounces.

The Treasury would still have 261 million ounces in its vaults,

but whereas before revaluation all this gold was held in trust for

the Fed, now only 10 million would be held for the Fed. The

remaining 251 million ounces would be free and unencumbered.

The Treasury might choose to just sit on its new treasure trove.

But most likely it would proceed directly to the Fed without

passing go, deposit $276 billion worth of gold certificates (251m

oz. x $1100), receiving in return a massive $276 billion stash of

newly printed dollars.

So, in sum, the Fed would not benefit from revaluation since the

entire capital gain would be earned by the Treasury. Worse, the

core problem of inflation a revaluation was supposed to combat

would actually be exacerbated. Fed assets would grow without a

corresponding increase in capital, increasing the Feds leverage.

Furthermore, the Fed would have to issue $276 billion in new

dollars to the Treasury a massive one time increase in the

money supply. As the Treasury spent this hoard, ever more

dollars sloshing through the economy would ignite inflation.

And dont think the public would benefit if President Obama

suddenly had $276 billion to spend on their behalf. While

seemingly free, this stash would come at a cost. Like the kings

of old who secretly reduced the metal content of coins to fundtheir wars, the Treasurys $276 billion war chest would be paid

for by a raiding of the Fed, the dollar-holding public footing the

cost as their dollars bought less.

Nor would a revaluation help the Treasury out that much, since

in todays world of $1.4 trillion budget deficits, spending at $2.1

trillion, and total debt of $12.8, a one-time $276 billion bonus just

aint worth so much.

Lastly, the Treasury may want to avoid revaluation of its gold

stock because this would attract undue public, media, and

political attention to golds monetary role after many years of

being ignored, even trashed. It is very likely that the Treasury

has unofficially lent and/or swapped a significant chunk of its

gold to private counterparties. The re-marking of golds official

price to market would lead to speculation about golds re-

emergence as a reliable central bank asset. Golds market price

would surge. Since many powerful private institutions have

borrowed Treasury gold only to sell it short, it is doubtful that

either the Fed or the Treasury both populated with insiders

connected to these private institutions would look fondly on a

removal of the $42.22 price.

To conclude, there is an odd relationship between the Fed and

the Treasury and it remains unclear whether the Fed is really

independent. On paper an increase in golds official price would

hurt the former at the expense of the latter. The Fed will have to

find some other way to fix its ugly balance sheet. What does

seem clear is the first baby steps on the road to remonetization

of gold are being taken.

***

Speaking of gold, the metal recently rose above $1100. Gold

investors tend to be a contrarian lot. When they see the price of

gold hitting a record high, one half of their brain is gleeful, the

other half grows suspicious and wants to sell against the trend.

For now, the Pollittburo encourages your inner contrarian to

relax. Searches run on Google for gold price an indication of

mass interest in a given topic have yet to hit significant peaks,

a pattern played out on previous spikes in the metal in early

2006 and 2008 (see Fig 2). In other words, the masses arent

buying into this rally just yet. Perhaps all the more reason to add

to ones position?

The information contained in this report is believed to be reliable, but its accuracy and/or completeness is not guaranteed. All opinions, estimates and other information included in this report constitute our

judgement as of the date thereof and are subject to change without notice. Pollitt & Co. Inc. does not issue ratings or price targets on any securities mentioned within this letter, nor does Pollitt & Co. Inc.

maintain and publish current financial estimates and recommendations on securities mentioned in this publication. Pollitt & Co. Inc. discontinues coverage of the stocks highlighted in this letter. For

information on our policies on research dissemination, please see our website, www.pollitt.com.

Stock Rating Terminology:

Buy: The stock is expected to outperform its peer group over the next 12 months. Hold: The stock is expected to perform in line with its peer group over the next 12 months. Sell: The stock is expected to

underperform its peer group over the next 12 months. Our stock ratings may be followed by (S) which denotes that the investment is speculative and has a higher degree of risk associated with it. The

company may be subject to factors that involve high uncertainty and these may include but are not limited to: balance sheet leverage, earnings variability, management track record, accounting issues, and

certain assumptions used in our forecasts.

John Paul Koning Toronto, Ontario

jpkoning@pollitt.com November 23, 2009