Thus, to avoid a Supercut in the amount of $400 million, Mr. Buffet has to figure out an exit strategy that (a) dribbles out the silver over time, so that the market is not noticeably affected, (b) dispenses with the "overhang" discount of 20%, and (c) safeguards the value of Buffet's silver against market loss. All these goals can be accomplished by making a deal with Barclay's. Of course, I have no idea whether Barclay's paid a visit to Mr. Buffet and suggested such a deal, or whether Mr. Buffet called Barclay's and talked them into creating a Silver ETF. Someday we'll probably find out whose idea it was.
Here is how I figure the deal would be constructed. To begin with, Mr. Buffet would consign, rather than lend, his silver to Barclay's, since such a loan would encumber the silver and perhaps make it less acceptable to the SEC as an ETF capital reserve. Instead, he would ask for, and obtain, a put on all 130 million ounces, thus protecting himself against loss and shifting the entire risk to Barclay's. (Of course, at today's rock-bottom prices, there isn't much danger of a fall in the price of silver, so the risk is minimal.) The put would probably be exercisable, in Buffet's discretion, as to any amount of physical silver in the ETF vault at a price of $9 for the first year and $10 after that, for some specified number of years.
Thus the put safeguards Mr. Buffet's silver against market loss, accomplishing goal (c) of the three goals set forth a couple of paragraphs above.
What about (b), the goal of getting rid of the overhang 20% discount? This discount should self-dissipate when the investing public realizes that the ETF is not going to dump the 130 million ounces on to the market. The 130 million ounces, which Berkshire-Hathaway has consigned to the Silver ETF, is part of the ETF's capital. An ETF does not sell any part of its capital to the public; it simply acts as a trading facilitator. If the public in a week is a net buyer of shares, the ETF replenishes its silver inventory by a purchase that week of spot silver on the Comex.
Finally, as to (a), Mr. Buffet simply has to tell the Silver ETF when he wants to sell a number of ounces out of the 130 million, and the ETF then "buys" those ounces from its inventory instead of from Comex. This way the entire 130 million ounces can be trickled out by the ETF over time. Mr. Buffet will have saved himself a $400 million Supercut.
In order to keep our reasoning simple, let us suppose for the moment that no one has thought of creating a Silver ETF. Assuming, also for simplicity, that silver is now selling at $10 per ounce (a bit higher than its market price of $9.70 as I write these words); what would Mr. Buffet's exit strategy be? The first thought that would enter anyone's mind is that he could leak it out into the market slowly and by stealth. But the problem with this approach is that Berkshire-Hathaway is a public company. At most it might have a three-month stealth period which comes to an end when the company has to file its quarterly report to the SEC. But even within the three-month stealth period, word would probably get out that Buffet was selling and the price of silver would abruptly fall. As a result, the proceeds to Berkshire-Hathaway from the stealth sales would be a pittance compared to the huge mark-down of its silver portfolio resulting from the market decline.
(If you are asking why the price of silver would abruptly fall when the market has already discounted the Buffet horde by 20%, read on. Otherwise, skip this parenthetical paragraph. Since the market doesn't know when Mr. Buffet might decide to sell, the 20% price discount on the market attributable to the potential sale of the Buffet horde represents the average value of a time-indefinite overhang. It means, in effect, that since Buffet could sell tomorrow or ten years from now, the market has to choose some average time in which to quantify the discount. Clearly the figure of 20% would go higher if the market knew that the horde will be dumped in a shorter-than-expected period of time. Thus if Berkshire-Hathaway were to announce tomorrow a secondary offering of its horde of silver, we'd see an additional discount in the price above the 20% overhang, as the next paragraph spells out.)
Instead of absorbing the Chinese water-torture involved in dribbling out his silver, suppose Mr. Buffet decides to dump it all in one fell swoop. He would do this by finding a Wall Street underwriter who will retail the silver to the public in the same way that a secondary offering of stock is retailed to the public. Let's say the underwriters offer 10,000 units of silver to sophisticated investors, a unit consisting of 13,000 ounces of silver. What would be the offering price of a unit? It would have to be priced below the market to be attractive to large investors. Assuming the market price of silver is $10, the units might have to be priced at $9 per ounce in order to clear the market.
To sum up, if Mr. Buffet's silver horde would be worth $12 per ounce except for the "overhang" discount discussed above, and if he dumped it at $9 per ounce, he would be getting $3 an ounce less than his silver would normally be worth. He'd be taking a 25% "haircut." This haircut translates into a dollar figure of $400 million.
My Ellery Queen solution, for what it's worth, is that there is a secret contract between Barclay's and Berkshire-Hathaway whereby Berkshire will consign its entire 130 million ounces of silver to Barclay's. For this solution to make sense, we have to figure out why such a secret contract would benefit both contracting parties.
As far as Barclay's is concerned, this posited contract with Berkshire-Hathaway is the only way to make the ETF happen. Barclay's simply cannot go into the public market and buy the silver, for the reasons we have just seen. It is very likely that the only possible source for the requisite amount of silver is Warren Buffet's treasure trove. Accordingly, we can suppose with some confidence that the deal between Barclay's and Buffet was finalized before Barclay's even submitted its application for a Silver ETF. Thus for Barclay's it was either Buffet's way or the highway.
But how does the deal benefit Mr. Buffet? This is a more interesting, as well as a trickier, question. Let's begin by acknowledging that he did not achieve his reputation as the world's shrewdest investor for nothing. We can safely assume that he would not have made any deal with Barclay's unless he would profit handsomely from it.
Thus we are safe in imagining that when in 1997 Mr. Buffet started buying 130 million ounces of silver, he must have been thinking about an exit strategy. He knew that by accumulating so much silver, it would overhang the market. The market responds to any significant horde by discounting its potential sale. My estimate is that ever since Berkshire-Hathaway's announcement in 1998 of its accumulation of 130 million ounces of silver, the price of silver on the open market rapidly shifted to about 20% lower than it otherwise would have been. This 20% represents the market's "discount" against the eventual day when Berkshire-Hathaway decides to dump its entire horde on the open market. (I'm not saying that the price of silver went down by 20%; all that was needed was for the market to become sluggish for a number of months until it had "absorbed" the potential loss resulting from the impending and eventual dumping of Buffet's horde.)