Re-Hypothecation and Precious Metal ETFs

"Unexpected this is. And unfortunate."
--Yoda (Return of the Jedi)

Zerohedge has been suggesting that the re-hypothecation issues faced by MF Global could spill over into precious metal ETFs such as GLD and SLV.

Further, ZH has posited a conspiracy theory that the metal ETFs were created to lure unknowing investors into instruments of paper gold and out of mining shares. Banks and other parties interested in getting control of the tangible gold supply chain could thereby acquire mining shares on the cheap. At some point, investors holding GLD et al will discover that they're holding worthless claims while the banks wind up holding the tangible gold assets.

Quite the Jedi Mind Trick...

While the conspiracy theory doesn't do much for me, the ETF re-hypothecation issue does. ZH builds its case around a lawsuit brought by a unit of HSBC on behalf of a client against the legal trustee of MF Global in charge of settling bankruptcy claims. The client (apparently using MF as his broker) was holding $850,000 in physical bullion at HSBC as collateral for underlying commodity contracts w/ MF. Following the MF bankruptcy, the client instructed HSBC to transfer the bullion to his Brink's account. Before the metal could be shipped, the MF trustee wrote HSBC claiming that the bullion was 'customer property' and not the client's.

In the lawsuit, HSBC is asking the court to rule on who is the rightful owner of the bullion.

If MF Global re-hypothecated physical bullion held in client accounts, then it is possible that the plaintiff no longer has legal custody of the bars.

The ramifications for ETFs like GLD are straightforward. These ETFs have gone to great lengths to demonstrate that the funds are actual in possession of physical metal, including publishing lists of bar serial numbers, positioning video cameras in the vaults that show the gold, and taking commentators on guided tours of the vault gold.

However, as the MF case demonstrates, measures that indicate metal on hand do not equate to ownership. The vault metal could be re-hypothecated or leased to someone else. When a counterparty somewhere in a daisy chain of trades fails to uphold its side of a contract, multiple parties might claim ownership.

Not exactly the situation that an investor wants with a 'safe haven' investment...

It is easy to file this situation under the general category of 'counterparty risk' that an investor takes on when buying any 'paper' form of a physical asset. I must admit, however, to being influenced by the re-hypothecation argument.

If you believe, as I do, that today's market prices are built on mountains of paper claims and leverage, then one has to question the validity of a security claiming to represent a physical asset that has no proof of clean title. As Zerohedge suggests, the metal ETFs can be seen as synthetic collateralized debt obligations (CDOs) that provide the illusion of investing in physical gold.

As such, I'm currently looking at lightening up my positions in GLD and SLV, and perhaps exiting them entirely--particularly if we see a relief rally after the recent carnage.

Am also getting the sense that Central Fund of Canada (CEF), while not perfect, is a more valid expression of physical bullion than either GLD or SLV.

position in GLD, SLV, CEF