Title: Musings on a Credit Crisis Date: 4/01/08 4/1/08 Dear Clients, The last nine months were as tumultuous as any period in the capital markets since the Great Depression. The reasons are plentiful and layered and they vary depending on who is doing the explaining. Subprime mortgages certainly appear on most lists as does an overly easy Federal Reserve policy for the past five years. I would like to elucidate on the causes and more importantly discuss what it means for your portfolio. There are numerous bad guys in this financial crisis and they certainly are complicit, but there is a larger more systemic problem that lies at the caissons of this upheaval: leverage. The amount of capital devoted to trading is greatly exaggerated by the multiple loans that many investment firms make. Most investment banks borrow approximately $25 for every $1 dollar they own. Then they trade with $25 on a daily basis not $1. It does not end there. These investment banks then lend money to hedge funds that are leveraged as least as much and sometimes more. Hence you have a financial system of loans layered on loans. How do you think Wall Street firms produce such outsized gains? Do you think they are all so much smarter than you? That their quantitative abilities are so extraordinary? No, they just borrow money to make bigger bets. And it works well as long as you have more winners than losers and your source of funds is steady. The problem occurred this time when small cracks appeared in the dam. That is subprime mortgages started to default at higher rates than predicted by the models. Remember most models are based on past or empirical information not future information. So unexpectedly the securities that contained mortgages were worth less than stated. Meaning their value in the market place was considerably lower. Suddenly, they were not good as collateral so the banks and investment firms could not borrow against them. Now they could not sell them either so the whole system started to bog down. The lending almost stopped completely as the values of all debt instruments were questioned. Hedge funds, mortgage companies, investment banks, and other larger players were unable to borrow to maintain their holdings and were forced to start selling debt instruments to raise cash. The trouble is easy to see. Who are you going to sell to? With everyone deleveraging and final investors (that is you and me) getting cautious and equally unwilling to buy theses debt instruments the financial machine began to stop and many firms faced that dark abyss of bankruptcy. The Federal Reserve lowered rates multiple times during the crisis, however this helped very little as no one was lending money regardless of the rate. Finally, the Fed started exchanging safe US Treasuries for some of the poorly performing instruments like mortgages from the banks and investment banks to ease their distress. Although this helped, there still was a huge sell off of any securities that had a buyer. And as could be expected, only the better instruments had a willing buyer and even then at much lower prices. Losses started to mount and failures occurred the largest being Bear Stearns. So this crisis forced a systematic deleverging of the markets which in the long term is good and over due. Now risk is being priced correctly meaning questionable debt is paying a high rate of interest just as it should. This should ease volatility somewhat, but the borrowing will not stop entirely as capital is the essence of financial markets. For your portfolios this means some losses as you can glean from your monthly statements. It does not mean the end of the world. Markets, like business cycles, will always have excesses and corrections. This is neither the first one nor the last one. That is why prudent investors diversify their portfolios and keep dissimilar assets even though some may appear to drag on performance. Of course, there are some defensive measures such as moving a higher percentage of total assets to cash or bonds and many of you will notice more of these instruments in your portfolios. Selling everything and buying bottled water is not wise. Anyway, you probably still have some canned foods left over from Y2K. So relax, market upheaval is necessary for growth. Creative construction and destruction will occur ceaselessly in financial markets. Remember, over the long term stocks go up approximately 2/3% of the time and lose value 1/3% on the time. So the law of probability tells us two things: on any given day it is better to be long than short and timing the markets precisely is harder than winning the Power Ball. Marty Gallagher <- Back Home