Interesting readNear the end he talks about gold...but a good read throughout.
One additional point... he is a friend of Ned Goodman as mentioned below.
I expect physical demand for gold in India to be very robust over the next 3 months... this will drive the price over $700us and will continue untill the price in Rupees slows physical demand..
Hovering around $700 Cnd is it a good time for Canadians to buy gold?.. Gold will go up in US dollars but where is the Cnd dollar going in relation to the Us dollar?
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Nesbitt Burns Institutional Client Conference Call for August 23, 2007
Don Coxe
Guelph, Ontario
“The Big Banks: Where Yesterday’s Bad Ideas Silt Up”
Thank you all for tuning into the call which comes to you from Guelph, Ontario. And the chart that we faxed out was the comparison of the performance of the BKX, the bank stock index to the S&P and our comment was that the banks are where yesterday’s bad ideas silt up.
And so, we’re getting to the next stage of what is called the global credit crisis or various other terms. But this is one of these times when most of you on the call are feeling better, maybe you’ve slept better, because we had a fabulous day yesterday in the markets. And we’re having a good day today, although it’s a little more mixed. But the story still is that people are trying to figure out how serious this is going to be and should they take advantage of rallies like we’re having right now to get out of stocks. The doomsters who claim to be vindicated by all this are becoming even more shrill and there of course is more bad news.
So what I want to do at the beginning of the call is sort out what is an aspect of this which we haven’t discussed in detail before, which is the nature of the problem within the asset-backed commercial paper market. Now, for most of you on the call, you’re probably very thoroughly familiar with how this market functions, but for those who’ve not – and I’ve had quite a few questions about it – I’d like to explain the characteristics of this market and why it’s the one that has blown up and why it is the one that’s blown up almost everywhere. Whereas, this whole thing began of course with problems in the US subprime market. And that’s very much a US factor. And then it spread through the problems of the banking system, with being stuffed with all sorts of lousy credits from private equity takeovers and creating new billionaires. But where we’ve seen this show up most dramatically is in the short-term credit market and particularly in the asset-backed commercial paper market.
And the demises of firms that have grown up like mushrooms in this decade in this area have been highly-publicized and have lead to the feeling that a much worse financial crisis is out there. So let’s look at that market.
First of all, it started off to a very considerable degree and it grew within the banking system itself. And the reason for that was that as a result of Basel Accord Number Two, in particular, that the banks in order to grow, and still pay out big dividends and buy back stocks, what they needed to do was create assets that weren’t on the balance sheet.
Now this has an Enron sound to it, but there’s nothing sinister about it. What they did was banks sponsored asset-backed commercial paper. Where products that they would have taken on their balance sheets themselves if they were prepared to expand that asset class, in other words, once they’d inspected, they’d approved the loans and everything, they put them off through what were called conduits. And that these were traded in the ACBM market and because of the provisions they had in them they could get triple A ratings on them and this market grew and grew and grew. Which meant the banks could then use this aspect of the market which was to a very considerable degree consumer loans of various varieties, let that market grow, but focus on their enthusiasm for investment banking. Where they needed to have lots and lots of capital. And where from time to time they could expect to take hits to their equity which would be the kind of thing that would put them at risk under Basel Accord rules.
So, this process worked beautifully as long as global liquidity was expanding at an amazing rate. And that everybody was able to turn over their paper. Now, alongside this, because the commercial paper market was growing so rapidly, new entrants came in and said “We don’t need the banks. What we can do is we can also go to the rating agencies and get ourselves triple A ratings by using the same kinds of techniques.” And so what you got was the Coventrees of this world and various other kinds of lenders. And it became an enormously profitable market in itself. Because once again, consumers were able to borrow freely and by having a trust arrangement, which is if anybody defaulted they automatically added new assets into it, they could get this coveted triple A rating.
And because there was so much triple A paper, the fastest growing asset class for most mutual fund organizations in this decade has been short-term money funds, money market funds, and they work on the basis that you must not break the buck, which is the one dollar price. Well, what went wrong?
Well first of all, in the case of Coventree and the others, they paid a premium interest rate above what those that were sponsored by banks paid. Now, Coventree and the others could say “Well, we had arrangements with banks as back up lines of credit.” But the exact nature of those lines of credit is now called into question, because, in Canada at least, the big banks are saying “We don’t have a responsibility to bail them out when they can’t roll over their assets.”
But some critics, including the very articulate and very successful Ned Goodman – who, I have to explain, is a personal friend – is extremely critical of the Canadian banks on this, saying that they should be stepping up to the plate and threatening lawsuits. Without trying to take sides, because obviously I work for BMO Capital Markets, the nature of the pledge to back up the lines of credit is going to be discussed if it does go to court. But the fact that they could pay more – and I was told yesterday at lunch by somebody who is extremely knowledgeable on this that it would be three to five basis points more than those that were direct vehicles of the banks themselves.
Now, there’s only two ways of course that you can pay out more than somebody else. You either take a bigger risk in terms of credit quality of the assets you have or you take a bigger duration risk than the ones that are your benchmark. Because otherwise the Milton Friedman principle that there’s no such thing as a free lunch applies. What I find amazing is that mining companies in Canada, small companies, most of them I’ve never heard of before have $273 million, at last count, in paper of companies that are having trouble paying up and you don’t know when you’re going to be paid up.
Now, what occurred was that, first of all, questions were raised about the quality of the assets that they had, and they apparently could deal with those. But there’s no question that they have some assets that are longer duration. And in the case of the bailouts that are being done and in the European varieties of this what they’re doing is converting them from firms that have to pay up on demand to firms that may pay up in thirty days, sixty days or ninety days.
Well, you can’t use that kind of paper to back up short-term covenants. And you can’t show it as cash on your balance sheets. And the irony is that all of this could work through, without any actual defaults in terms of the assets themselves. In other words, they may in fact, everything they have in their portfolio may turn out to be money good. But if they are supposed to be alternatives to pure cash, then that means they have to be instantly available in cash and that is not happening.
So, this illustrates what makes this liquidity crisis different than all the ones before it. Because to have an asset class that’s at the center of it, where it’s a question of whether they can meet instant cash demands or whether they can if given a little time to it, there’s no allegations of fraud. All of this is a different kind of environment.
Now of course what happened in Illinois in the case of Sentinel was fraud. I was amused to see that one of the German ones that went down was from the Sachsen Landesbank. And this was one of the many state backed Landesbank as they called them, which were set up after World War II. Germany, which is the most overbanked country in the world, these little state-owned and state-backed banks were there to supply credit outside the banking system itself. And they were the equivalent of Canada’s…what they used to call the Industrial Development Bank, where I did my legal articling many a year ago.
Well, what happened was two years ago the EU said “It’s ridiculous that they can borrow money in the market saying they’re guaranteed by each of these local states.” And so they had to give up on that guarantee. So that meant they had to find new ways to do things. And furthermore, there weren’t all that many credit demands because they could be met by the many, many, many, many, many big German banks. So the question is, they were all dressed up with no place to go and they didn’t have a sponsor so what they did is they created these new entities mimicking the banks elsewhere. And what they did, a lot of them, of course, is invested in American mortgage-backed product.
And so we’ve commented I believe, before, on one of the little-noted aspects of the American trade situation in this decade, which is that in the case with Germany, what America did was imported Mercedes and Beemers and exported subprime mortgages. And that, you have to say, is a credit to American financial ingenuity. And there’s no question that a lot of the people who are driving Mercedes and Beemers in this country, made their money out of putting together packages of bad, toxic waste mortgage products and then having their firms peddle them off to Germany. So in that sense, you could say that this is you know, Yankee ingenuity at its best.
But, in the meantime what it’s done is put these people in trouble. Now in the case of the Sachsen Landesbank, they created a conduit, as it’s called, with a nice Anglo-Saxon name in it, Ormond Key. Which they used as the vehicle for short-term asset-backed commercial paper issuance. So I would say that this is…Sachsen, is the name of this Landesbank, but since all of the German elites have been railing away against Anglo-Saxon finance and economics, I find it amusing that the Sachsen Landisbank would use an Anglo name for a vehicle which it did to get outside the rules and constraints put on them by [hah!] the European Central Bank itself. Anyway, that one has blown up because they have too much really bad product in it.
So, of the two risks you can take, they took the risk of both duration, because here they were backing short-term commercial paper with long-term mortgages and credit quality, buying these computer-created creations which were the ones that of course are now…nobody knows what they’re worth.
So the ABCM market then is where too much of this paper that we can’t evaluate has silted up. And the banking system one way or the other is going to have to deal with it.
Now, when people tell me “Oh, this could be the worst credit crisis of all time. Worse than 1987.” and all this…it is not! And I was just telling a luncheon meeting in Toronto yesterday, what really is involved here is that at the root, it’s because nobody knows how to evaluate a couple of trillion dollars worth – that’s a rough estimate – of newly created financial assets which don’t trade on the markets and were not priced off the markets but were priced by the same machines that created them. In other words, this is a Michael Creighton type story where robots or manly creations run wild. And what’s happened here is that we have a Malthusian problem of the population of these clones or whatever you wish to call them. Which is, there’s too many of them out there and what they’ve been doing is multiplying like mad. And they are eating up the real food supply.
So, the way we’re going to get out of this will be population control for the man-created or computer-created products. And what probably is needed is for enough of a selloff in the markets to in effect create financial vasectomies on a grand scale so that the PhD’s and the PhDs who’ve created these things – I think in this case PhD stands for Procreators of Hidden Debts – that their population is diminished. And then we can get back to good old fashioned rules of credit and knowing what things are worth.
It is an ironic factor that this is a cycle in which the publicly distributed products have been buried under with all the problems of complying with Sarbanes-Oxley, and none of them have blown up – which may be a tribute to Sarbanes-Oxley – that the problems have been created in things that were created by financial institutions and that don’t have to comply with anything. Because they are designed entirely by computers and they are designed according to recipes created by the ratings services. So the ratings services computers talk to the computers of the investment banks and what they do is they manage to come up with something that meets all the criteria and then they get a triple A rating.
I vividly remember that there used to be about twenty-five triple A rated companies in the United States. As of the 1987 crash, there were seven. And now, there may be one or two at the most. And yet we’ve got all this triple A paper, which is not issued by government. How is that done? Well it’s done by these various creations – and although most of them have worked, like the trusts that have been used as consumer loans for a long time, auto loans and things - but, where it really got out of hand was on these collateralized debt obligations and those kinds of things, which are totally computer-created and never priced off the market.
So, I’m taking you through this to suggest that anybody who says “Wake me when it’s over”, I don’t know when that’s going to be. Because the problem is, that this is entirely a situation where the excesses were spawned as a result of mathematics and the use of computer technology. And they were spawned in these droids, clones, whatever you want to call them. George Lucas would be a very good symbol of what Wall Street has done here. In the sense that it’s these kinds of products which can’t be evaluated and you don’t know how big they are and how big they are in relation to investment banks, hedge funds and now we find to German Landesbanks and all of these. In other words, these things have multiplied across the world because there's no constraint.
So the only way that we're going to be able to constrain these PhDs from creating more hidden debts that cause problems later on, is to have enough of a blow out in the system so that the investment banks and hedge funds refuse to participate in this form of reproduction done across computer lines and according to advanced formulas. Because we need open and transparent markets and I don't know how long it's going to take to work through this but it's not going to end over night. There's too many of them out there and there's too much temptation to investment banks to create more of these things whenever they see that the public is now ready to buy them again.
Meanwhile what we have is people frozen in place. This is not like all past crashes where people don't have the money. People do have the money. They're not prepared to commit it though to something whose either financial background or duration is clear. And so you know before this is over we might have negative T-Bill yields which we had at brief moments during the depression. I'm not predicting that, but the T-Bill has actually been the asset class that has had the wildest price swings in the last three weeks. In the sense that the T-Bill yields have gyrated across the spectrum you would have thought it was some triple C junk paper in terms of the percentage variation in yields.
So all this then the banking system is in this in various ways. I mean it meets itself coming through the revolving doors of its office towers. And that is the big reason why we are skeptical about the US financial stocks.
The Canadian banks on the other hand are in vastly better shape. And we're coming up to their earnings statements. They grow their dividends at a much better rate than the US banks and they by their very nature aren't as willing to get involved in creating products that don't meet the smell test. And one of the aspects of the smell test is that it's got human flesh in it, as opposed to that it's all created electronically.
So there's more working out to do before this will be all over. Yesterday at lunch with the market up a couple hundred points and lots of people sort of feeling good and sort of feeling well "Great! We finally got over this!" No, it's going to take longer. That doesn't mean that it's going to a much lower low than we've seen. But nobody can comment on it authoritatively until we know what the value is of assets showing on balance sheets of publicly traded corporations and the balance sheets of important hedge funds. And until we've got that in other words we go back to the old fashioned notion that what shows up in a balance sheet is a very good approximation to what you could get for it in a sale.
The irony is in a decade where the great enthusiasm was to clean up the system after Enron, what we did was created a parallel universe, an electronic universe, which had as its greatest core component the abolition of all transparency of all ability to look into what things were worth. And it was built on the kind of illusions that George Lucas would create on film, or that you'd get in a Lord of the Rings film where you have thousands and thousands of Orcs created by a computer storming across the screen. Only in this case it was billions and billions of dollars of short term paper.
So that's where we are at and that’s why it is I believe that in the US at least that the banks are going to underperform the market and the bottom will be seen when the bottom is reached on relative strength for the banks.
Now, on the dull old commodity side…I say dull old because the commodity prices have not really varied much this year and that's been one sign of why it is that the global economy can still be assumed to be in good shape. Because although commodity futures are as levered as any asset class, it's interesting that they've been actually an asset class which has been much better to be in than stock prices have been. I mean, the CRB index is only down 6% from its July high and only down 1% from yearend. But if you look at some of these commodity stocks you'd have thought that what it is that they produced, there was no demand for it and that they were cratering.
So the question people ask of me is "How is it that you can so cautious in your asset mix and still recommend a big exposure to commodity stocks?" And the answer is, what I want to own is something that is real, tangible, that is not subject created electronically and is absolutely needed by the most dynamic economies in the world. Economies that are not in trouble because of creating assets out of electronic impulses. And so, therefore, what I'm saying is I'd rather be tied to what are called old economy concepts here than new economy concepts precisely because it's easier to find out where the value is. And what's showing up is the real stuff has held up in price remarkably well through this period. What’s getting trashed is stuff that can be generated in infinite amounts by the PhDs.
So, going to the absolute opposite extreme which is, stuff in the ground or basic materials is the safest place to be. It also will be the most profitable to be once we've got through this period and we go back to the normal economic growth. So, it is a haven in bad times as an asset class and will be a great asset class coming out the other side.
Now meanwhile, what about gold? It's supposed to be the greatest haven of all. Well, it was up as much as five bucks today but now it's going back down and it's flat on the day. Gold can't make up its mind whether it's a commodity, whether the threat to the system is deflation or the threat to the system is inflation.
As before, I will remind you my view is that this cannot be resolved - what we're going through here - without massive reliquification of the financial system to drown these droids that have been created. And as I say a pledge - a birth control pledge of kinds - from the investment banks not to flood us with more of this as soon as the system turns around. And all of that is going to mean that we're going to have a drop collectively in the value of paper money as against the value of gold. Gold will rise in value against all currencies and that isn't happening at the moment. We're still just flipping back and forth between currencies.
The Canadian Dollar is on a roll today whereas the Yen has sold off sharply. So, for investors in gold the good news is it's a boring asset class, whereas most of the others have various kinds of excitement attached to them. It happens today that most of the things on my screen are green which means we're in one of these periods where the stock market is looking better. But I wouldn't be surprised if we gave up everything we gained in the last couple of days but it wouldn't change my view as to the essential view of risks and rewards which is that this is not the kind of debilitating financial crisis which is going to make everybody poor.
It is something that can be worked out because all it requires is massive injections of real liquidity to deal with the liquidity drains that have been created by these full fraudoui out there in the financial system. And maybe, maybe what we'll do is reduce the population of PhDs who are devoting themselves to creating illusions. Maybe they can go back to teaching in classrooms. I think America would be a better place if we had more real mathematicians dealing with real mathematical theory then besetting us up with these kinds of products that blow up.
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.