Buying Gold as Banks Become Insolvent

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The FDIC maintains what it calls the “problem bank” list. Before the “Great Recession” of 2008, the list was relatively small with no more than 100 banks making the list. Since 2008, the list has grown to unbelievable length — 651 at the end of 2012, representing over $230 billion in deposits.

Given that number some individuals have decided to invest in gold as a hedge against bank insolvency. So let’s talk about how bank insolvency occurs, how it can affect you and what your options are.

What is “bank insolvency”?

“Insolvency,” is a fancy term for bankruptcy — meaning that the bank’s debts are greater than its assets. However, it is possible for an insolvent (or bankrupt) bank to recover over time if they earn a higher rate on their assets (e.g. loans) than they must pay on their liabilities (e.g. customer deposits). Over a few years the profits earned can be enough to cover the debts without any outside intervention.

What happens when a bank becomes insolvent?

Clearly, an insolvent bank can cause financial problems for customers and businesses that have entrusted their funds to the bank. When banks become insolvent, teams of government representatives and regulators — often led by the Federal Deposit Insurance Corporation (FDIC) — step in to take over the insolvent bank.

Sometimes banks will be restructured, other times sold. Keeping the bank open and operating with minimal disruption is a top priority. If the team of regulators and representatives fails to quickly and quietly recover the bank, customers may begin to panic resulting in a bank run.

Since deposits are generally insured, at least up to a certain amount, people do not need to worry about retrieving their funds. However, a domino effect can occur with both large and small banks failing, especially if people stop paying off debts in addition to pulling out their deposits. This creates a banking panic from which widespread financial turmoil may result, as was seen after the bank runs during the Great Depression.

gold_pile_RB_whiteHow likely is this to impact you?

It’s difficult to say, but keep this in mind: In normal economic conditions, a dozen banks may fail in any given year. We already know that a few failing banks do not impact the economic system as a whole but each additional bank that fails can tip the balance.

What if your bank fails?  Are your deposits safe? 

It’s worth learning about the basics of investing in physical gold as a hedge against bank failures.

Buying physical gold means you own your financial assets and you keep them safe either at your own home or in a safe deposit box. Gold is an asset you can hold in your hand, so if your bank fails, you have what you could call a gold insurance policy.

Remember, those 650 problem banks — 9.2 percent of U.S. banks by the way —with over $230 billion in deposits? At the same time, the FDIC, the government agency that protects your deposits, had only $33 billion in its insurance fund.

With more banks inevitably on the brink due to bad loan portfolios, some people believe buying gold or silver might be a smart way to limit your risk.

Why Buy Physical Gold over Paper Currency

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Paper Currency vs. Physical Gold

Historically, gold’s value has risen more consistently than paper currency. Why?  Physical gold holds intrinsic value. It’s scarce unlike paper money and governments cannot create more gold like they can print paper currency — an event that often occurs during times of financial volatility and is happening now in the U.S.

Gold’s value rises because it is so scarce and nearly every other form of paper currency eventually becomes worthless.

History of Gold as Money

The use of gold and precious metals as a form of currency began in Egypt in 2500 B.C. The Egyptians used metal rings for trade.  About 1800 years later, the Lydians began using metal coins, a tradition passed down to the Greeks, Romans and other Western peoples. These early gold coins were commodity money because they intrinsically held value.  The Chinese then developed representative money, which, true to its name, represented value but had no intrinsic value itself.

Fiat Currency

Representative money can be traded for its value of gold, silver, or another agreed upon commodity such as tobacco or beans. Today, we use fiat currency, which is similar to representative money, except that it is not necessarily backed by the value of gold or other commodities.  Because of this, governments, including the United States, can create as much or as little fiat money as they see fit to support their country’s economy.

Fiat currencies are government-created legal tender (e.g., the American dollar) and businesses and the public are required to accept them in trade for goods and services. The only real value of fiat money lies in the fact that people trust the government will continue to require businesses to accept the currency and to maintain good policy that keeps the value of the currency stable. Once a government stops considering a currency legal tender, it has virtually no value.

Governments can create more fiat currency without having more commodity to back the increase. This usually happens in times of economic volatility, such as during the recent economic crisis.  Printing more money can cause inflation and ultimately decrease the value of the currency. Here in the U.S. the value of gold generally increases while the value of the U.S. dollar decreases.

Safe haven Gold

In these times of economic and political trouble, it is important to look back through history and review the value of gold against other currencies.

While fiat currencies tend to decrease in value, diminishing all you have worked hard to earn and save, physical gold generally moves in the opposite direction —  increasing in value.

Gold and other precious metals are considered a safe haven against a decreasing dollar and increasing inflation, a way to protect financial portfolios and potentially earn value into the future.

Gold Soars Beyond $1,400/oz.

gold_pile_RB_whiteThe gold market is set for its highest close in more than two weeks, currently at around $1,413/oz.

Weakness in the dollar and in U.S. economic data, as well as an increase in Asian gold holdings, supported the price of gold today.

The tug-of-war between physical and paper gold continues, but physical appears to be winning. In China, India and Singapore, demand for physical gold has more than offset outflows from exchange-traded funds.

According to the founder of GoldForecaster.com “once the sales from the SPDR Gold ETF ceased, the weight of Asian demand would turn the gold price around.”

“If there are no more sales to come, then the record short position on Comex will prove a driving force to send the gold price higher as these shorts are closed and as the major banks and hedge funds go into the market to buy their gold back,” he added.

Also adding to gold’s good day was yet another sharp drop in the Japanese Nikkei Stock Average (down 5.2% overnight) and disappointing U.S. GDP data. Unemployment claims were also higher in the U.S. than expected.

Weak economic data signals the Federal Reserve should continue its quantitative easing program, which devalues the dollar.

What this means for you: The U.S. economy remains weak while gold demand is on a record pace.

Quarterly Record for Indian Gold Demand

World Gold Council reports world’s largest gold buyer headed for record

With gold prices coming off a two-year low, Indian imports of the yellow metal ballooned between 300 and 400 tons in the second quarter of 2013, according to the World Gold Council.

India’s demand for gold was nearly equal to half of all shipments in 2012.

“This report leads us to conclude that Asian markets will see record quarterly totals of gold demand in the second quarter,” managing director of research at the World Gold Council Marcus Grubb said.

“…It is quite likely that the gold previously held in ETFs will find a ready market among Indian, Chinese and Middle Eastern consumers who are taking a long-term view on the prospects for gold,” Grubb added.

Lower prices and offloading of exchange-traded products are cited as main reasons for the boom in demand, which has been ravenous enough to cause shortages for almost any institution dealing in gold coins — even the U.S. Mint.

What this means for you: Strong Asian demand supports the physical market in a time when ETFs are experiencing a mass exodus. With exchange-traded funds only partially backed by physical gold and actual physical gold being snatched up, doesn’t something have to give?