Nesbitt Burns Institutional Client Conference Call for August 17, 2007
Don Coxe
Chicago
“All Financial Crisis Exit Roads Lead to Gold”
Thank you all for tuning into the call, which comes to you from Chicago and
it’s a big day today. For those few who may not know this, the Federal
Reserve cut the discount rate by half a point and also announced that they
were prepared to lend money out up to thirty days, whereas the discount
window was usually only an overnight affair. So we’ve had a roaring stock
market so far this morning, so there must be a lot of happy people on the
call which comes to you from Chicago. There’s panic buying at the Board of
Trade and at the Merc today.
The chart that we sent out was of gold and the tag line was “All Financial
Crisis Exit Roads Lead to Gold”. So, between now and the last call, of
course, what we’ve had is from time to time, financial panic selling and
this morning at the opening we had financial panic buying. And I guess the
first question all of you wonder about is does this mean that the sell-off
in stocks is over? And I cannot tell you that.
No, what it means is that one aspect of what has been creating the squeeze
is probably over. And so I want to distinguish between the various things
that caused the panic selling at times and the market correction, where we
did get down ten percent, and the kinds of concerns that are going to
prevent this from being a brand new bull market.
When you have a problem of destruction of actual value of assets in the
system – financial assets – then what you have then is a financial-driven
bear market. And at some point what that does is becomes a
liquidity-driven bear market. But, what you have to do is get interest
rates down to a level that the overall assets of the balance sheets within
the banking system are valid enough to support a sustained economic
recovery.
When the problem is fundamentally liquidity, or – as in the current
situation - where we don’t know what over a few trillion dollars worth of
derivatives are worth, because they don’t really trade in the market and
aren’t priced for the market, then this is a different kind…of
financially-driven bear market. And what the Fed has chosen to do here
surgically and give Bernanke credit for this, which is, what he hasn’t done
is expand bank credit. What he hasn’t done is start printing money, which
is ordinarily what happens in all of these things.
The cycle for financial bear markets and financial crises, and I have been
through them all, coming into the business in ’72, so the pattern is this:
first of all, the financials start to underperform the stock market. And
then stocks start to fall and now the financials really start to fall and
lead the market down. And at this point the deep cyclical stocks get
pulled along with it. Then we find out some important financial
institution or institutions are in serious trouble and they become the
epicenter of it, leading to a panic or crisis mentality at which point all
stocks are getting hammered and financial assets generally get blasted.
And meanwhile during all of this process, the Dollar has been weakening
against other currencies. Then finally, with the system in real trouble
and financial panic spreading around the world, central banks intervene,
the Dollar gets devalued. And in the process, what goes up the most is
gold. Now that’s sort of the pattern. Gold tends to outperform on the
upside during the sell-off and then it takes a big move up, after it’s
over.
Now what gold did this time was uncharacteristic. And those of you who’ve
followed our work know that we turned very, very bullish on gold – not
having been bulls on gold – and we did it because what we could see was
unfolding here was a situation where the American Dollar was going to have
to come down and was going to break its long term support level. And that
all of this was going to mean that we had higher inflation, we were going
to have higher interest rates, particularly at the long-term, and we were
going to have a backdrop that was gold-friendly.
Well…since we turned so enthusiastically bullish on gold, gold has been…a
non-event. Now, being a non-event was a good thing since the stock market
peaked in mid-July, because gold didn’t go down. So in that sense, it was
a good asset to own, a store of value. A store of value is something that
supposedly holds its value when other things are falling apart. So in that
sense, even though gold failed to fulfill our enthusiasm for it, at least
it didn’t go down, as everything else was.
And until we reached the stage yesterday where what we had was commodity
liquidation. So, let’s go back and look at what was different in this
cycle in terms of where the selling came from. This is the first cycle in
which maybe forty or fifty billionaires, who ten years ago were paying off
their student loans, were the focal point of both the excesses in the bull
market and the panic aspects of the bear market.
Because these are the people who got these PhD’s in Maths and Physics to
work with their counterparts in investment banks in PhD’s in Maths and
Physics, to design products which could only be understood by those who
were in the Inner Temple of the new, secular faith, which is that you could
create risk-free assets purely on computers. And therefore you wouldn’t
have to muddy yourself down in the sweat of the stock exchange. What you
could do is trade these things between investment banks and hedge funds and
you could price them in a way that hedge funds could show very low
volatility and therefore that the pension funds would give them more and
more money to manage, because they’d achieved the amazing thing of not
going down, not having big volatility and having a whole set of assets
which even when they reported them, nobody in the pension fund community
would say “Well I wouldn’t own that in my portfolio.”
So what we got here was a disconnect between the hubris of the
mathematicians and the new young billionaires and what was actually
happening in the open market. Well, anytime you have the elites prospering
mightily at the time that the rest of the population is feeling concerned –
and particularly that they’re starting to see their mortgages foreclosed –
because another thing the elites did was designed very complex mortgages.
Mortgages used to be very simple, they’re handled by banks. All you needed
to know was the interest rate and what your monthly blended payment was.
And you had to have a down payment to get one. And if you got in trouble,
you could talk to your friendly banker and they could stretch it out.
Aaaah, not in this era. In this era, once again, a set of mathematical
geniuses created products which could be distributed by a whole new set of
people. And these people said “You don’t want to deal with an unfriendly
banker, we can give you mortgage approval in sixty seconds! And the great
value of the technology is you can get a product that has a teaser rate and
don’t worry about the interest rate going up at the end of the period
because Alan Greenspan himself has said you want to take adjustable rate
mortgages because we’re going to make sure there’s no inflation and
interest rates never go up.”
So what happened was the least sophisticated of buyers on the one hand and
the most sophisticated - in other words the bookends of the market - got
these products. The least sophisticated, because they could go in way over
their head. They didn’t have to have an income, or a job, or assets. And
by adding together the basic mortgage plus piggybacks and all these things,
they could own a house without any money down!
And the most sophisticated, because they wanted to be buying homes in Long
Island and Greenwich without any money down and so they were able to get
mortgages that wouldn’t have passed the smell test in earlier cycles.
Well, when you have excesses eventually the market prunes them out.
And what happened in this case was we had a crisis of the elites. And it
was their desperate position to try to unwind what they were doing.
Because they had found a new source of financing, which also makes this
cycle different. This was a cycle financed by the cheapest money in the
world, from Japan. The Yen had not been an international currency in past
cycles to any significant degree. The only time it had been briefly one
was in 1998, but that was a very short-lived one.
When we think of things like the Crash of ’87, it wasn’t the Yen, the
entire crash and the Ted spread crisis, was within the Eurodollar market.
So this time what you had was it was the Yen that was supplying the new
geniuses with their money. And what they were able to do, was borrow money
at 1.65% and put it out at 9 to 13%. And you know you can make a lot of
money if you can borrow almost unlimited amounts at that rate and lend it
out at that rate.
And you get that rate because of the complexity of the financial products
there so that people don’t really know what they’re paying. And then you
can be certified as a genius! And so what would happen is the system was
working very well. We were adding billionaires at a rate of about one
every couple of weeks. And pension funds were rushing to get out of the
grubby investments that were marked to market every day and get into these
low-volatility, low-risk things that only went up.
So, in general, whatever is the thing that the big banks and the big
investment banks and the pension funds are rushing into most in each cycle
is where the trouble is going to occur.
So, this entire “crisis” is one in which the unwinding of the excess
leverage, because that was the other feature in this. These people were
allowed to borrow three, twelve, in the case of Bear Stearns’ supposedly
brilliant mortgage fund, they were levered up eighteen times. Lehman was
having hedge funds that they were lending out to thirty times their money.
Now, if you’ve got a two percent spread, even, and you’re able to lever up
thirty times, you know you can get really rich, really fast. And you can
really look like you have solved all the world’s problems for yourself and
you’re going to be rich at a very young age and not to worry about it.
Your investment bank is going to keep the process working for you.
So what we had here then was a situation where the major investment banks,
collectively, their stocks started to really go down badly. Bear Stearns
was, of course the one that was most deeply in it, but if you look at the
chart of Goldman Sachs as it was at the close yesterday…if that chart was
at the end of a hospital bed, you’d be ordering flowers.
And this was the company that was the cover of The Economist, in March or
April. And this is going to be one of those magazine covers like “the
Death of Equities” and “Death of Bonds” covers in the past, that people are
going to go back to, because The Economist, those maudlin college wits,
came out with the most adoring cover story about how Goldman could manage
risk. They said nobody really knows how they do it, but they never seem to
lose and it’s magical and all the stock does is go up and everybody that’s
associated with the firm gets rich.
So, what happened of course was that all of these institutions got caught
by Basel Accord Rule Number Two, which is that you have to have enough free
equity to still be a player. And that equity has to be subject to the
valuation rules used by the Basel Committee. So, what you can’t use in that
is stuff that is only valued between your people and their mathematical
equivalents in the hedge fund community or the investment bank, depending
on which side of the transaction you’re on.
So, what then happened was we got a crisis where you start to worry about
the viability of the system and that’s when the panic came in.
Remember what I told you last week, bull markets are about the income
statements. Bear markets are about the balance sheets. And that’s why the
financials get into trouble and do worse than the rest of the market and
why you don’t want to own them in this market. Because as soon as you
question the valuation that they have for the assets on their balance
sheets, you literally don’t know whether they’re viable.
And this time the crisis focused on one that wasn't officially a bank which
is CountryWide Financial. And it's merely the biggest mortgage lender in
the United States. And in retrospect, we should have realized that that's
where the trouble was going to occur, because this spring Countrywide
Financial - which is both a mortgage lender and it has its own bank - chose
to take its bank out of the federal reserve system and make it a thrift.
In other words, it moved into a nearly extinct category - savings and loans
- where it would be supervised by Othio.
Now Othio sounds like a minor character in a Verdi opera. Othio was
actually a minor character in Washington that supervises the few remaining
thrifts. There has never in history been good supervision of the thrifts
by Washington. So what they were clearly doing - and they said this - they
wanted to get away from burdensome Fed and controller currency regulations.
And at the same time the CEO was cashing in 320 million in stock market
profits.
If I had seen that at the time, I would have probably recommended to all of
you to go out and immediately short CountryWide Financial, but I must admit
it wasn't something I was following. But that was the signal that this
organization was going to change its spot from being simply the best
performing stock in the S&P over 20 years and it was going to be taking on
an unreasonable measure of risk late in the cycle for bad mortgages.
So, that's where the crisis focused and I believe it was its problems that
forced Mr. Bernanke to cut the discount rate and to provide money for
depository institutions, which means he can help Countrywide Financial
directly. Even though they are not part of the federal reserve system.
Now gold we said in every single case was the thing that you made money on
during crisis. It was the thing that either wouldn't go down or would
start going up during the crisis. And then once it was all over and the
Dollar had been devalued and interest rates were lower and you have a
steeper yield curve, gold would go up significantly.
Well I must admit that I'd like to have seen more than that $10 an ounce
move in gold today. But I think the market is taking the view that this is
- since all it does is increase liquidity, it doesn't lower the Funds Rate
it doesn't mean an expansion of the money supply that this isn't
necessarily the kind of thing that will lead to a substantial Dollar
devaluation. Now the DXY is down 51 basis points today but it's still at
81. And the Euro isn't even up a full cent. The Canadian Dollar is the
star currency as it was yesterday. It's up 1.3 cents
Meanwhile the Yen is holding on to its very low level. It's at 113 and
three-quarters. And what that is telling you is that this story is not
over yet. Because what you would expect here - in a move like this - is
that the Yen would move up in value because of the depreciation of the
Dollar. And what happened was the Yen actually fell off and now it's
coming back.
So, a back of the envelope calculation as to what we should be at when this
is all over is about par for the Yen and about par for the Loonie.
Something like that. Because what we're going to have to have probably
because of the destruction of value in the United States - a country which
has a zero savings rate - with the amount of value that is being wiped out
through all of these Babel Tower structures that have been created - which
were designed to mask the risk and have it excreted from the cash markets
off into the skies - that as those towers crumble what you've got is a
destruction of actual value in the system as the towers crumble.
By the way I was kind of amused to see the Financial Times yesterday using
the same metaphor that we have been using about these towers in the sky.
Anyway, this is not over yet. In other words, as much as I'd like to
reassure you all - look your stocks have jumped - and some people are
already saying the bear market is over. It's not.
What we have though is that we have taken out of it the pure liquidity
squeeze aspect of it which was the kind of thing that in Canada where a
company couldn't roll over its asset-backed commercial paper. I hadn't
heard of them before. The name was Coventree.
I was amused because it illustrates, once again, the problems when you're
dealing with companies where clearly the people who are running the
companies don't have much of a classical background. Obviously they called
it Coventree because they couldn't get Coventry with a t-r-y because that
name had been used. But if they'd thought about it or known what a
coventry is - this has been the case for thousands of years and the old
religion which is where you get the term witch from - where they would have
their coven dances. A coven was thirteen people. The one in the center
was the witch or the God on Earth and those were the ones that eventually
got burned at the stake because the church eventually destroyed them all.
But they would dance around this figure in the center. That's why number
13 is unlucky. Because if 13 was your number it probably meant that you
were a believer in the old religion and could be burned as a witch.
So therefore one shouldn't have been surprised that this firm went bust on
the 13th of August. It's nice to see that some patterns hold true. But,
both in Canada and the US then, what you've had then is companies you've
never heard of before who have gone down the drain and who have created a
liquidity squeeze.
By the way to find out that two small mining companies who were raising
money to open new mines put their money with this firm. You know if I were
a stockholder in those companies which I was not, I'd want to drop the
management down a mine shaft because you've got enough risk in opening a
new mine and everybody knows that if you get a higher rate of interest on
short term deposits it's because there is some measure of risk there. And
there is enough risk in opening a brand new gold mine without having to
take a risk with who it is and to get an extra half of one percent - I mean
that is beyond idiocy.
So people like that don't deserve to be bailed out. And therefore I don't
think they are going to be bailed out permanently. Because we still
haven't done things like dramatically increase the money supply or lower
the Fed Funds rate in a way which means that money supplies will be
expanded.
So we've prevented a short term liquidity crisis from producing a market
crash but the fundamentals of the kind of thing which are going to require
further readjustment in the value of the Dollar will also mean
significantly higher gold prices before all of this is finally cured and we
can proclaim all clear for the next bull market.
We've been waiting for a 10% correction. We got it. But, this 10%
correction did not clear all the problems within the system. We've had this
question of the pure liquidity squeeze aspect of it taken out of it, but,
we haven't dealt with the basic problems which is that we've still got a
couple of trillion dollars of so called assets that we don't know what
they're worth. And those assets somehow or other are going to have to be
worked through. And the debts that are levered up on them have to be
worked off.
So more work to be done in solving the question of problems that were
created by a tiny number of rich elites. This wasn't like all past manias.
This wasn't something that the general public created it. And it's tragic
that the man on the street so called should be a loser out of all this. So
I hope that this system doesn't end where they get bailed out. Because
what we most need now is to destroy those elitists who caused the problem
in the first place. If they get off scot free, then we've delivered the
wrong message. If capitalism is the best system in the world, it's one
because it tends to punish those who push the system to the limits at the
expense of other participants of the system.
That has yet to come.
If there is justice in all of this - justice for average individual
investors, then that process will come. And along with it will be higher
prices for gold. That's it. Any questions?
Q&A
Question (Steven Ottridge): Just a thought that's gone through my mind is
that we will go back to much more normal basic investing and so will the
institutions. People won't be able to come and say I've got this
convoluted way to make some money. They will be shown the door in a hurry.
I think we're going to go back to balance sheets, earnings and back to
normal investing.
DC: I'll say amen to that. Thank you. Next question?
Question (Arthur Gray): I certainly agree with you that the gamblers
shouldn't be rewarded. But I do think that the psychology of the country
is a lot different than Mr. Reagan went along with Volcker and say do what
you want to do. It doesn't look like anybody wants to be punished now. A
question is, I've read that European banks have pushed in three times as
much money as our Fed. Now won't that in the long run adversely effect the
Euro versus the Dollar?
DC: Yes, they've pushed in more money there than has been done here.
Because interestingly enough we've found out that a lot of this bad product
had filtered up there. They didn't know what they were buying. They were
really taken in by these new forms of shills and mountebanks that we've had
in this cycle.
The other reason I believe they did that though which was dealing with
liquidity squeezes, was because of the way that they have so many - you
have all these different countries. You still don't have one big free
banking system the way we have in the United States. And so what they were
seeing was you've got you know hundreds and hundreds of banks run by people
who speak different languages and everything else and what they were
getting was a seizing up in the system where there weren't liquidity flows.
Jean Claude Trichet has made it clear that his bias is towards further
tightening. What he couldn't allow then was a situation where a few
billion dollars of fears about subprime loans which would bring down a bank
that most people had never heard of - IKB - which they got together and
they got the German banks collectively to bail it out. He couldn't let
what was a pure liquidity squeeze bring down a system which because it's so
fragmented, is not subject to the kind of controls and reliquification that
the Fed has.
This is one of the advantages of the federal reserve system is that you've
got you know federal reserve banks in every state and that one way or the
other then you've got quick and efficient transmission processes.
This is the first time really since the Euro became a currency where the
system has been given a form of stress test. And because of all the high
publicity about the problems out of the US and because of the wrath of
Europeans at discovering that their banks had bought bad mortgage paper
from the US, what they didn't dare do was have a situation where some real
company that it was a real industrial concern couldn't roll over its
finances because of the squeeze.
So what they did was really a great job of re-liquification there. But in
the long run I would still expect that what they will show is greater
concern about money supply growth and a greater ability to control it I
think than the Federal Reserve will have. But it's interesting that we're
seeing that new mechanisms are being used by the central banks in this
cycle to reflect some of the changes at least that have occurred.
But I will give Mr Trichet full marks for what he's done to date because
he's made it clear that in his view the primary threat to the system still
comes from inflation. And what he's saying is he wants to be free to deal
with that with the money supply basis without having it totally constrained
with having to do with really the bad decisions of a few small players.
Nothing on the scale of the big players that we've got here in this
country. But I think it's because there's just a multitude of small
institutions over there that are part of the money transfer system that
forced them into it. I still think that the problems are overwhelmingly in
this country and that's why the Dollar has to be in trouble.
Thank you. Next question?
Operator: There are no questions registered for the moment, Mr. Coxe.
DC: Okay. Thank you all for tuning into the call. We'll talk to you next
week.
___________________________________________________________________
Don Coxe profile from the BMO websites:
Donald G.M. Coxe is Chairman and Chief Strategist of Harris Investment
Management, and Chairman of Jones Heward Investments. Mr. Coxe has 27
years experience in institutional investing, including a decade as CEO of a
Canadian investment counseling firm and six years on Wall Street as a
'sell-side' portfolio strategist advising institutional investors. In
addition, Mr. Coxe has experience with pension fund planning, including
liability analysis, and tactical asset allocation. His educational
background includes an undergraduate degree from the University of Toronto
and a law degree from Osgoode Hall Law School. Don joined Harris in
September, 1993. |
