and hank and ben looked at their handiwork and they were glad

8/14/2019 And Hank and Ben Looked at Their Handiwork and They Were Glad

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Don Coxe Conference Call for 2008-09-05 And Hank And Ben Looked At Their HandiworkAnd They Were Glad

BMO Capital Markets Client Conference Call for September 5, 2008

Don CoxeChicago

And Hank And Ben Looked At Their Handiwork And They Were Glad

Thank you all for tuning in to the call, which comes to you from Chicago. The chart that wefaxed out was the CRB futures and the tag line is And Hank And Ben Looked At TheirHandiwork And They Were Glad.

As the chart reveals, we had a fast run up from the first of May to mid-July in the commoditiesand then came the massacre of Sunday the 13th. And weve had a plunge to the CRB. And the

CRB breaks its uptrend line if we get down to 350. Were at 374 at the moment.

So I dont have to tell anybody on this call that whats happened in the last nearly two monthshas been pretty devastating. And its been against a backdrop of bear markets in equities aroundthe world. And they arent confirmed bear markets in North America unless they break throughlower levels. And the breakdown levels would be 1210 on the S&P and we would get abreakdown on the Dow at 10,850. We get a breakdown in the Transports at 4650. We get abreakdown in the TSE at 12,000. And the FTSE at 5150 and its only, not even 200 points abovethat.

So, lets talk about this, what they did, why they did it and how brilliantly they did it, because

this is the most massive intervention of government into the capital markets or the financialsystem since Roosevelt closed the banks back in 1933, briefly.

Well, one of the things that we have to address in this is, first of all, why they did it and then howthey did it. But we have to look at also, what are the chances that their intervention in factchanged the fundamentals enough so that weve got the commodity story right off the table foran extended period of time. And in looking at that, Id like to take you back to where we were inthe first week in July. And that seems like eons ago and thats why Im going to take you throughit. Because its hard for some people to recall just how much we were up so recently.

Back then, gold looked like it was going to break through the 1,000 mark, which it had done

briefly at the time of the Bear Stearns bailout. But this time it was also being fueled by the bigsurges that occurred in CPI from spring. CPI was now in the US and of course thats thenominal CPI, not the adjusted CPI or the core but thats what all sorts of things are tied to,including Social Security and indexed wage contracts. And we were at a 15 year peak for that.And with a 2% Fed funds rate, this was putting enormous pressure on Ben Bernanke. Hedalready had one or two dissenters on his board. And so he was faced with the fact that he mightbe under pressure to actually raise the rate. Oil was above a hundred and forty bucks a barrel.Corn was at seven and a half and soybeans were above fourteen. And although cost pass


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throughs were being resisted in the system, food inflation was threatening to break out really bigtime.

The Dollar looked like it was going to break down anew, it was down at 70 on the DX anddespite spreading recessions across the Eurozone, the Euro was threatening to burst upwards

through a buck sixty. The bank stock index, the one we use, the BKX had fallen in six monthsfrom 90 to 50. And all those bank equity deals with sovereign wealth funds were way underwater.

But Bernanke had another problem, which was that the Feds balance sheet was being degradedby the day with this extraordinary policy of swapping Treasuries for CDOs according to thebanks models for the prices of these ones that they couldnt sell. And this was a huge change inFed policy from what securities were required up until then, youd have to use Treasuries for thepurpose.

Meanwhile, the policy of course, the problems had spread across the world. The ECB was facing

the same kind of degradation problems on a smaller scale in its balance sheet, because banks inthe regions particularly in Spain, but also smaller German mortgage lending banks werepacking up their illiquid mortgage products and borrowing from the ECB at rates that once againput the ECB in a position that their balance sheet could be in trouble.

But out there also, the screams were coming thatthe Wall Street Journal was leading thecharge, saying that $140 oil was due to what was happening to the Dollar and that the Fed had toraise interest rates to protect the Dollar and therefore get oil prices down.

Now, the most immediate problem of course was that Fannie and Freddie were on the edge ofcollapse. And that meant that hundreds of billions worth of their paper held by government funds

abroad, including a hundred billion by Russia, was at risk. And it also meant that the bigexposure that banks have to Fannie preferred stocks and other equity securities was in troubleand the banks didnt need anything else to go wrong.

So what they did and this is why you want in a crisis like this, you want a Goldman Sachs ex-CEO at work. People sometimes sneer about the fact that Goldman seems to just get all these bigappointments. But what it means is youve not only got somebody that really knows the markets,but somebody whos access to information is terrific and who really understands how you canintervene in the markets successfully. Because if youre going to do a strategy like this, its gotto work.

So what they were able to get information on, with help from the Commodity Futures TradingCorporation, was the change in the make up of who was driving this huge rally in thecommodities. And there had been a change since May in the speculative investors had a muchbigger share on the buy side. And these were levered speculators lead by the hedge funds.

So what they did was basically said All right, weve got to bail out these over-levered banks,weve got to do something to get the bank index rising so that we can create equity in thebanking system that they can do re-financing. So well go from taking all the pressure on


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leverage off the banks to putting it on the commodities. And were going to focus particularly onoil, gold and the grains. Because if you could take those out, you would also take out theinflation scare. So you get a psychological effect, plus the real effect of the leverage beingunwound in the private sector in a way that was deemed deleterious to the financial system.

And they did it and it worked.

And leverage was being unwound dramatically. And of course by doing it Sunday night, that wasbrilliant because the hedge funds who were short the financials and long the commodities werein the position that the commodities were already going down because they trade around theworld. But the available supplies of bank stocks were very small in foreign markets. So that bythe time that New York opened on Monday morning, what you had was massive bids for thebank stocks gapping upwards. And that just reinforced the need of the hedge funds to unwindtheir positions. So we had a true panic.

And this was bigger by far than what had happened when the Bank of Japan had made that

massive adjustment to its balance sheet a couple of years earlier in the merry month of May,which was the quickest downdraft wed seen in this commodity bull market.

Nothing like this had been done efore and they got help from the SEC. In other words, they gotall their troops in line. Chris Cox no relation to me came up with an unprecedented ruleagainst short-selling of Fannie, Freddie and of selected bank stocks.

So you had a situation where, when these stocks were rallying, itd be difficult for those whowerent caught in a levered position but said Ah these stocks arent worth these prices, thatthey couldnt move in and supply the stock to meet the panic short-coverings. That was,therefore, what you had a situation where all the regulatory authorities in effect moved in at the

same time. And it was enough to blow the system apart and to change the game.

They also had somelots of help on their side from deteriorating economic numbers and theywere coming in day after day so they would have undoubtedly talked to their friends at centralbanks abroad and the Bernanke people would have been able to get all sorts of help on that. Andremember that with central bankers, theyre real group, their real collegiality is with other centralbankers. They find themselves regularly in an position of an adversarial relationship to localpoliticians and interest groups, so the people that they can talk to most comfortably are the kindof people that they do social events with and they have meetings during the year around theworld. They know each other. They trust each other. They consider themselves the true globalelite group. And therefore Im quite sure that they got all the information that they needed aboutpositions around the world and that this intervention was going to work.

Well, if, in that kind of situation there was no new source of buyers to stop the descentand thisis also against a backdrop that we had of bear market conditions for equities generally. And whathappened then just fed on itself. And as oil in particular went down and as gold broke down, thenwhat we had with the grains was that the rain stopped. Terrific weather returned to the plains.And so, the USDA started coming in with better reports about the outlook for grains.


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How long can the pain last? Well, I dont know the answer to that, but if we start with the bigone, which is oil, oil is in the position that the slowing down of consumption across the OECD ata time that OPEC is producing flat out and the Saudis add an extra million barrels a day ofproduction, that near term supplies are generous and that oil is so gigantic, because youve got 85million barrels a day coming out of the system. So if the sentiment changes and then what youve

got is it just keeps hammering it.

We saw the sell off that had taken oil all the way down to fifty bucks. And although I dont seeanything like that on the horizon, what it did mean was that the sentiment that said oil priceshave nowhere to go but up changed dramatically. And it didnt help that we had the number ofpeople out there forecasting $200 oil, which would have meant that oil prices would havequadrupled in less than two years. And its pretty hard to make that case, because that kind ofratio in that kind of time for something which is in daily supply on this scale would involvesomething where youd still have to see really strong growth in demand. And an OECDrecession is not a time where youre going to get that.

And, of course, overlying all of this was all the discussions about what was going to happen toChina after the Olympics. And the viewpoint was that China was going to slow down. So youtake out the big marginal buyer for energy and metals. And we wont know, of course, howmuch of a recovery after the Olympics China is going to have. So this is one where both sides ofthe case can say Well, just wait, youll see. But given that the Chinese stock market has beentrashed this year, that argument doesnt look good. However Ill remind you that for the firstthree years of the commodity bull market, just about the worst stock market in the world wasChinas.

So, its a funny kind of stock market. And I dont understand it well enough to make anyauthoritative comments. But, its stock market looks like so many others. Its in a bear phase.

Meanwhile, what weve done is driven interest rates even lower in open market instruments.Youve got the US ten-year now at 3.58. And at a time youve got CPI well above 5%. So thisreinforces this global phenomenon of negative real yields on bonds. And that is a warning of twothings. First of all, its an inflation warning. If we learned anything from the 70s, it is that theonly way you stop inflation from going up without a very deep recession is by having high realinterest rates.

So to have negative real rates everywhere and particularly in the US, given its role in the globaleconomy, means that the fundamentals for paper money are deteriorating.

Now the fact that the Dollar was rallying like this against gold and against other currencieswould say well the market is predicting that inflation is about to collapse. That it was just aninflation bubble. Hard argument to make. Because again, citing the 70s, one thing that did nothappen was that recessions collapsed inflation. Yes we know its different this time because wedont have powerful unions that get big wage increases even during recessions. And so thereforewere not getting the cost pass throughs. But, I still am of the view that negative real interestrates is a high risk strategy. It may be one that needs to be followed by central banks around theworld, but what it means is when we come out the other side of this recession, first of all the


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recession cannot be deep, when you have that kind of liquidity. And in addition, we come backto the demography, which is so much different now than it was before. Were now at 6.1% USunemployment, but remember, it wasnt that long ago where the Phillips Curve people told usthat if unemployment rates ever fell below 6%, it was inflationary.

So, yes, were up from 4 , but this is not, again, the kind of recession where youre going tohave massive unemployment because of course weve got all kinds of shortages developing nowin skilled workers. And if the Republican convention is any sign of whats coming, were goingto have huge demand for anybody tied to metals, pipes, oil, seismological work, these kinds ofthings. And thats going to mean that theres going to be a big push from that side. The kind ofpush, of course, that Alberta experienced with the opening up of the oil sands.

Now theres lots of other unemployment you can talk about but remember the improvement inthe US trade deficit shows you that the manufacturing sector other than autos has been doingsurprisingly well. Its been the biggest contribution to US GDP growth.

Ive been telling Midwest audiences for two years that one of the big surprises was going to bean industrial renaissance in the Upper Midwest - ex autos - simply because the overvaluation ofthe Dollar was gradually being taken out and any companies that managed to survive the grossovervaluation of the Dollar must be really well run and they would really benefit if the Dollarcame down. That doesnt mean the Dollar has to collapse but its quite clear that this recoveryoccurred with the Dollar at the 75 or lower range and this was quite enough in itself that evenwith slowing across the OECD and slowing among the USs main trading partners that what youhad was surprising improvement.

Finally in commenting on the politics that weve seen developing in the last two weeks. Wereback in the election campaign being a toss up.

Obama got a tremendous bounce out of the fabulous performance the Democrats put on at theirconvention with all that help from Bill and Hillary. So the Democrats are united and they haventbeen united for a long time. And the Republicans who were totally disunited as of a few weeksago because McCain was not popular with large segments of the Republican party, the CountryClub Republicans in particular, and the very conservative Republicans who felt that he had neverbeen a true conservative.

So the Republicans were facing an electoral disaster. The Congress was going to go hugelyDemocrat and there could have been a landslide at the White House level because you had thisextraordinarily attractive Barack Obama at the top of the ticket and of a united party and it wastime to punish the Republicans for Bush.

Now how could all that change in a hurry? Well, what we saw of course was that the choice ofGovernor Palin turned out to be an inspired choice in that it changed the pieces on thechessboard. Its united the Republican party.

Now the only ones who are sulking a bit are the old-style country club Republicans who stilldont like McCain that much and certainly dont like the idea of a conservative evangelical. But


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in the overall scheme of things they arent that big. And so I think its interesting that weve onlyhad one tracking poll that came out after Governor Palins speech and that was CBS news. Theyonly surveyed a few over 700 voters but they show a tie. The other polls that have come outshow that Obamas lead has been cut to 3 or 4 points.

I think the tracking poll should be taken seriously because of the other announcement which wasa surprise which is that Senator Obama agreed to appear on Bill OReillys show last night. Andtheyve taped sections of it for broadcast next week. The Democrats refused to even have theirdebates on the Fox news because they regarded that as a Republican channel. They of courseappeared on all the others because their friends run those.

The fact is that he chose to do this, which was an amazing thing. I saw the first interview lastnight and I thought Obama came across very well, but this was a shock to the Democratic core.And I dont believe that he would have done that if their own polls hadnt shown that GovernorPalin had produced a big swing. And he had to come out there and come into the lions den as itwere and show that he really was up to the job, because the key thing that was getting the big

response out there was the question of whether he had any real experience.

Wrapping it upwere going to have more turbulence and the backdrop of bearish equitymarkets and disappointing economic numbers is not the stuff of big rallies.

Oil is quite likely going to break $100 and thats going to be a big psychological effect oncommodities generally, but if you accept that were not going into a deep global recession andyou accept the fact that most commodity companies have very powerful finances and are makinglots of money and havent done dumb things and if you accept the fact that everything thatsoccurred geopolitically in the world suggests that unhedged resources in the ground in politicallysecure areas of the world are actually growing in value as we speak.

But the long term is a series of short-term forecasts and I have never been very good at short-term forecasts, but Ill reiterate that the long term forecast actually gets better under this.

The next issue of Basic Points will be out next week. We go into detail on how we see thesechanges but our bottom line is that with any longer term viewpoint - and that is anything a yearor more - youve got to believe the underlying value of these companies relative to their stockprices is better now than its been for several years. But pain now is more felt than the possibilityof lack of pain later.

So I cant give you perhaps the consolation youd like, except to say that I couldnt disagreemore with those who say this proves that the commodity boom was a bubble, like the techbubble. And I dont know when the day will be that well look back at the prices of these stockstoday and say why wasnt I backing up the truck?

Thats it. Any other questions?

Operator: Mr. Coxe, you do not have any questions registered at the moment.


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Question 1 (Bill Mascovich): Just thinking that another big shoe is about to drop. In particularMerrill Lynch took that write off on those CDOs. I cant remember if it was 30 billion dollars at5 cents on the dollar. Other people must have to own - have to own similar securities - the samesecurities. I dont believe theyve marked them down yet and thinking that going into the end ofthe year audit committees and etcetera boards. What do you think of the likelihood that were

going to see additional massive mark downs in some of these structured synthetics?

DC: Good question. Thank you. Remember when I talked about the goals that Bernanke andPaulson had. A central goal was to create equity within the banking system so that the bankscould float more equity. Given the fact that all those sovereign wealth buyers had lost heavily ontheir investments and they had been reassured at the time by the bankers that, Oh this is just ashort term selloff. The housing market is going to turn and we have done very careful revaluationof the structured paper on our books and all the bad news is out.

Its going to be hard to come back to them. So therefore the idea was well get their stock pricesup by forcing the people that are shorting them to cover their shorts, but what we havent seen is

theres been a rush of anybody to take advantage of the opportunities created.

So I dont know when well get back to the situation that we were in in the first six months ofthis year where each week we had scary news about the fundamentals of the US financial systemand that was driving down the stocks. Everybodys been distracted by the fact that the stocksthemselves seem to been doing well but they didnt get up to the kind of levels and couldnt findthe big buyers stepping up to float new equity.

So the leverage in the banking system remains excessive. And as you say once they startreflecting actual market transactions on this stuff then were going to be back in the soup. And soultimately what this is going to do is get people looking at investing in companies that have real

balance sheets, real income statements and you can believe their earnings statements and theyrein no danger of going bankrupt. So I dont know when that will be, but your point is an excellentgood one that the yearend is no longer off far in the distance that we can not worry about it.

So seeing the selloffs that are occurring in these stocks today, not big, but its across the system.And the BKX today is down just a little bit more than the Dow. Yeah its going to happenbecause the housing market has not improved and the other big, as you talk at SHU, is thecommercial mortgage backed securities. Theyve been taking small haircuts on those but I justbelieve that theres so much product thats coming on stream in the cities that hasnt beencompleted yet - big buildings and what youre going to see is huge impact then on that part oftheir portfolio and the leverage loan part of it - the collateralized loan part of it we havent talkedabout it yet. Well you can see in the KKR Fund and these others that theres all sorts of lousypaper thats still sitting in the system that they cant sell to anybody.

So were going to get back into a real bad news situation where people are going to say, Yeahthe financial system continues to be in a mess and its this long in the cycle, but again theresonly so much room for headlines and what youre talking about is a page 16 story.

Thank you. Any other questions?


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Question 2 (Stephen Bartillo): The contrast between financials and energies has been reallystriking and weve sort of been wondering when there would be a reversal in that trend andthanks to the engineering of Ben and Hank weve seen somewhat of a reversal and werewondering whether thats just a swing trade opportunity. But I mean clearly the long run profitstory seems more compelling for energy and the commodities as you say. But if investors can

really find a reason to believe that the stated tangible book value of some of these quote unquotehigh quality global financial service companies are really what they are then they might startbuying a dollars worth of book value for quarters based on their book value. So are we seeing,in your view, a reversal of these two sectors thats more than just a swing trade? I know yourenot so sanguine on the financials still, but what is your view of this issue?

DC: Well, thank you. You see were not comparing apples to apples here because the financialsare hugely levered. They are hedge funds writ large. And therefore you know a 10% markdowneven if youve met the Basel Accord rules and you have 7% of free equity, that means in effectthat youre levered up something on the order of 12 times to 15 times. And so thereforewritedowns of the kind that Merrill had to take are absolutely devastating to your equity.

Nothing like that can happen to an energy company. As for the US energy stocks, theresabsolutely no doubt in my mind that these stocks are going to have a wonderful year next year.Because even if Obama does win the election, I dont think he can win the election without a realdeal being done on drilling.

The polls show that even among Democratic voters they want to drill. You saw that GovernorPalin got her biggest cheers and the audience got most energized when they started shouting,Drill, baby, drill and those expensive ads by T. Boone Pickens promoting natural gas and windpower. The answer thats being given is, Yeah, we need those too.

Well natural gas prices are only 7.27 at the moment. If theres any talk about starting to do thestyle of converting to natural gas powered vehicles, theyll start with municipal vehicles andothers, what youre going to have is that this policy which has been enunciated over and over bythe Republicans this week which was, Were sending hundreds of billions of dollars abroad.Weve got the resources here. Lets use what we have.

Governor Palin is in the position to talk about this knowledgably, as she did in her speech, wehave it here. Why are we sending this much money abroad to countries that dont like us verymuch?

So I do believe that the surprise will be that we will be developing more shale, gas and there willbe major drilling projects offshore. I have no doubt about it. Its not a matter of if, but when. Andif McCain should pull off an upset and wins the election, it will be sooner rather than later. As amatter of fact if McCain wins the election these stocks are going to gap up, because everybody isgoing to say who has the knowledge, the smarts, the cash to drill in a politically secure region ofthe world?


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In terms of identified supplies of barrels of oil seismically, US offshore now ranks just about atthe top of political secure regions of the world and yet theyre being held back by the wholeattitude which is that it would be bad for our beaches to have the drilling.

So I think this is a hugely good time to be buying the companies - the only thing about these

companies is youre talking about blue chip and red chip companies. Companies that have bigbalance sheets and good earnings. Even if oil falls to 80 bucks, theyre still going to makemoney. The integrateds will finally get an improvement in the crack spread and so theyll havethe cash flow to do these projects and its right here at home. So yeah, I think the energycompanies have to be one sector that youve got to feel comfortable about.

And if you look at the foods, okay weve got corn at 5.50 which is down considerably from itshigh. But if a year ago Id predicted 5.50 corn a lot of you might have stopped reading BasicPoints because youd say I was ridiculously optimistic. Corn is also one of the few commoditiesthats in contango. This years corn crop is at 5.50. Next is at 5.86 and corn in 10 is 5.84, whichmeans and youve got to understand that with the grains this is one group where the

participation, now that youve taken out the speculators, is overwhelming between producers andusers. And so the fact that weve got a contango here in other words that the selloff was doneprimarily at the front end illustrates again that youve got companies that are going to haveenormous cash flows.

So foods and fuels are going to be the first way out of it. And the gold story is simply that oncepeople realize that the rise in the Dollar was a force fed rally and that the financial system hasnot been cured. I look at it and I say, My gosh the arguments that weve had are just morecompelling now, but talk about whistling past the graveyard. But in this case whats under theground isnt corpses, its billions of barrels of oil.

Thank you. Anything else?

Question 3 (Ethan Silver): I want to take a point a little farther and see what you think of it.Weve gone from inflation fears to slowdown fears. And in my estimation this financial crisis,which is reappearing, is much longer and deeper than people in denial are thinking about.

Level three assets are about 500 billion. Level two assets about 300 billion. And if you look atthe last five years of earnings, which were basically paper earnings that were created by financialengineering, my estimation is that the brokerage model is basically evaporating. Because the IPObusiness is dead. The advisory business is dead. Fixed income is not going to happen any morefor a while. The earnings were fake and these companies were hedge funds and Im not suregiven the leverage thats going to be coming down based on regulatory issues that theyre notgoing to be punished, including the leveraged private equity firms, dramatically from here whichis going to scare the overall market. Because a financial meltdown in Wall Street ultimately iswhat drives the stock market.

So Im curious. I mean, I think potentially its much more extreme and people who are optimisticbecause of phantom men and liquidity and valuation are going to be quite negatively surprised.


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DC: Thank you. Well watching the political conventions, one of the heaviest advertisers has beenMerrill Lynch. And theyve had these terrific ads showing a bull and talking about how MerrillLynch has been guiding people through difficult markets for a long time. Theyre terrificcommercials, but theres nothing in that that says the people at Merrill Lynch managing theirown money have managed to blow billions and billions of dollars. It was a good news and a

reassuring commercial for dealing with equity bear markets, but this is different than simply anequity bear market as you point out, because its the basic structure of the financial system thatsat bay. And thats not been the case of any bear market in your lifetime or mine.

So yeah, we need all the cheerleaders we can get but I dont know how long the cheering canwork. Certainly the cheering starts in a football season the first few games. Theres lots ofcheering and enthusiasm but if the team starts losing seven games in a row what you see is someempty seats and people start booing the quarterback and demanding that we get a new coach.

Thats going to happen but - and then you say, Well in that kind of case the scale of the equitybear market will be worse, and thats true. But are you saying, Well does that mean that the

commodity stocks could outperform simply because they continue to make money and theydont have financial problems and it would just be relative performance?

My view is simply they will make money in this kind of environment and that could be doneeven if the Dow falls you know another 20-25%. And in fact at some point what we might get isfinally the reverse flow where people would say, I want to invest in companies that actuallymake money and I can be confident about their earnings forecast. And that will happen, but Idont know when.

By the way just interpolation the Rasmussen tracking report has come out - this is the first onethat was done after Sarah Palin - and its now 46 Obama - 45 McCain which, yeah, were in a

true toss up situation. And again that tends to reinforce my view that this enthusiasm of thepopulace at large saying that the only big new game out there for the US economy is thedevelopment of domestic oil and gas reserves is going to become a very safe haven for investors.


Question 4 (Stephen O): I find it amusing in maybe in a bit of a wry way that commentators areall going on about the price of commodities all going down together and yet for the miningcompanies the price of oil going down quite dramatically is really very beneficial to them as itsa major cost to their production.

DC: Good point and you know despite the huge selloff, weve still got copper above three bucksa pound and any company that isnt making a lot of money at that price doesnt deserve to be inthe copper business because there wasnt a forecaster who could be found two years ago whothought wed be above $3 on copper.

So, yeah youre right that the price of steel and the price of energy is a big factor in the coststructure of developing mines. So yeah, its profit margins, and its a very good point you make,that count. So yeah, its not all bad news. But I have to say though that people who buy


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commodity stocks are people who say generally that they like the outlook for commoditiesrelative to other asset classes. It would be hard to make the case that I should be buying a miningstock because I think they would be beneficiaries of $50 oil, but yeah, its a good argument.


Operator: Thank you. There are no further questions registered.

and hank and ben looked at their handiwork and they were glad

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