Credit Crisis

The first, harbinger wave struck in early September with the nationalization of Fannie Mae and Freddie Mac. In the following weeks, the full tsunami hit with the bankruptcy of Lehman Brothers, Merrill Lynch selling itself to Bank of America, AIG accepting an $85 Billion federal credit infusion, Goldman Sachs and Morgan Stanley becoming banks and WAMU and Wachovia collapsing into the hands of stronger institutions. It’s difficult to put a period at the end of that last sentence since many fear that there is more to come in this stunningly vast and rapid transformation of the US financial services landscape.

In the article that follows, Rich Palmer traces the history and denouement of the government sponsored entities, Fannie and Freddie, that illustrates the risk of unintended consequences that can result from inadequate design and oversight. Each one of those subsequent events could (and no doubt will) spawn several books. Our remarks will be relatively brief.

While it’s difficult to be optimistic about near-term outcomes from here, we still believe long-term optimism is appropriate. In our view, an energetic and creative global government policy response will combine with a resilient private sector to galvanize and…eventually…move the economy and capital markets back to a growth-oriented equilibrium. We plan to communicate our thoughts about this road map in more detail soon.

For the present, however, the story for clients’ investment portfolios is grim. With a July and August that overall were relatively flat for equities, the third quarter ended with deep losses in September.

In contrast to more normal times when diversification can easily demonstrate its investment advantage, recently there has been “nowhere to hide”. Virtually all asset classes suffered significant losses for the quarter. A sad adage of the investment world is that, in times of great stress, all correlations approach one. Still, some of the subtle differences even here have given us opportunities to rebalance portfolios to remain in line with their target long term strategic allocations.

Not a “Bailout”, but a Catalyst

Sadly, most media and many politicians have characterized the $700 billion rescue legislation (the Emergency Economic Stabilization Act of 2008) as a “bailout” of banks and Wall Street firms for their poor performance. In fact it is, in our view, another necessary catalyst to reignite the confidence essential to the even rudimentary functioning of credit markets. When investors and banks are paralyzed by fear of loss and refuse to lend to even high quality borrowers, even to other banks, the entire edifice of trust in repayment can rapidly collapse. That in turn severely constrains all forms of essential economic activity and the contagion can quickly spread around the world. Bringing the US Treasury, and other global governments and central banks, as the convincing purchasers of last resort, to the market can break that paralysis. And, importantly, the US rescue is not a give-away but the purchase of distressed assets, some of which will actually perform at some level at some time. If the Treasury doesn’t pay too much, the US taxpayer could end up suffering only modest losses or could even turn a profit.

Much of the opposition to this catalyst hinged on the moral grounds of not rescuing bad economic behavior. Appropriate as a sentiment, in practicality, it’s not clear where the punishment should fall. There is plenty of blame to go around: interest rates held too low too long; overly aggressive lending; exotic mortgage securitization strategies; “mark to market” accounting rules being applied even when markets ceased to function on normal terms; fraud by borrowers and mortgage brokers; inadequate regulation; and an excessive confidence in real estate value appreciation. At some level, many are guilty and the moral hazard of too easy a rescue from bad decisions or bad behavior could be very widespread. The fingers of blame point in many directions. Blame is not the answer to this problem; rather, learning from mistakes and establishing improved structures and processes should be the outcome.

Recession or Not?

Whether we’re already in or about to enter a recession has moved beyond any notion of technical definitions to one of psychology.

By that measure, we can all agree that the “R” word applies. Without even one quarter of observed negative GDP growth so far, investors and consumers are very pessimistic. At the risk of seeming insensitive to the actual areas of pain, we believe that some important economic fundamentals are in decent shape. Inflation is low, energy prices have returned to more tolerable levels, the jobless rate is still in a historically low range, and, leaving the financial sector aside, corporate earnings are at historically high levels. Of course, investors are rightly concerned with the future direction of growth, corporate profits, and employment. From that perspective, Warren Buffet’s investment in Goldman Sachs and Wells Fargo’s efforts to pay much more for Wachovia than CitiGroup offered suggests that careful, patient, and very successful investors see long-term opportunity even (especially?) among the devastated financials.

Some of our clients, who are still accumulating assets or have excess cash positions, may also see the current environment as a rare buying opportunity, an excellent time to deploy available cash or, in the right circumstances, even to add margin. As we discuss in Mike Angell’s and Ray Edwards’ article below, it’s also an opportunity to take advantage of temporarily lower asset values and low interest rates to optimize family wealth transfer goals.

However, the safest course of investment action will be to persevere in the portfolio strategy already in place. Markets are far too volatile at present to make any confident defensive moves. More importantly, a defensive strategy would forego the upside opportunity that market recoveries, someday, will surely provide and that may be necessary for our clients to accomplish their goals.

We really do understand how difficult it is to be brave in the face of fear on all sides. Our personal portfolios are suffering, side by side, with yours.

Meanwhile, we are taking some tactical action, as appropriate, in managing our clients’ current strategies. We’re capturing tax losses and rebalancing portfolios to target allocations. More strategically, as we described in our Annual Report at the end of September, we are carefully reviewing our long range view of the risks, returns, and correlations of global asset classes to see if any modifications to clients’ portfolio strategies are appropriate. We expect than any changes, on balance, will be fairly modest and that for quite a few clients, there may be no change at all.

Consequently, as unsatisfying as we know it must be for many clients, we urge continued patience with the unsettling present and optimism for a far better future.

Tim Kochis, CEO
Editor

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