Commentary For January 2008

The stock market (S&P 500) is down over 16% or $2.17 trillion since its high on October 9 of last year. This decline exceeds the 10% threshold to be considered a correction and is knocking on the door of the 20% decline which would be defined as a bear market. If the latter were to occur, we don’t believe it will be a drawn out like 2000-2002.

The catalyst for this decline is the meltdown in the subprime mortgage market, which made loans to borrowers who might have blemishes on their credit history or wouldn’t otherwise qualify for a conventional mortgage. They represent $1.3 trillion or just under 11% of the total residential mortgage debt outstanding, which exceeds $11.84 trillion.

There are a couple of dynamics that play into this decline. First, are the mortgages themselves where many of the borrowers are faced with interest rate resets that will significantly increase their mortgage payments. The issue here is whether the borrower will be able to make the payments or default on the loan, which in some cases may be higher than the home value itself. Then the lender has the Catch-22 decision whether to modify the terms of the loan to allow the borrower to make payments or to foreclose on the loan and sell the house causing downward pressure on housing prices. If you assume in a worst-case scenario that 20% of the above $1.3 trillion were foreclosed on and written-off to zero that would amount to $260 billion. Our GDP for 2007 was north of $13 trillion; this would only be 2.06% of our GDP. Hard to understand why the market would decline as much as it has. This is not intended to play down the crisis rather to put it in perspective.

The second dynamic is that the loans were securitized and sold to investors with a twist. They were so sophisticated that an investor could actually make the decision whether they wanted to buy the “prime” or “sub-prime” portion of the security. In the case of the latter, you were willing to assume the additional risk for the potential for higher returns of buying much lower quality securities. The situation was turbocharged by the fact that interest rates were so low those investors could borrow “cheap” money and invest it in “higher” interest rate investments.

The market panicked when it realized that some of these sub-prime mortgages might not be able to completely be paid back. This created a domino effect, which was accelerated by leverage, and when investors tried to sell them, there were no buyers and in some cases prices literally fell to zero. This led to a credit crunch that the Fed Reserve feared would lead to a recession.

In response to this, the Fed has lowered the Fed Funds rate by 1.75% from 5.25% to 3.50%, which is the lowest since August 9, 2005. During the same period, the prime rate has fallen from 8.25 % to 6.50%. Since June of last year, the 5 and 10 year treasury yield has dropped from 4.92% and 5.03% to 2.86% and 3.66%, respectively. All these rates factor into the resets of over $365 billion in ARMs that are to occur tin 2008. The decline in interest rates will directly benefit the “sub-prime” borrowers because when their rates reset, the rates will be lower and not creating payment shock.

With the recent interest rate cut, very attractive valuation for stocks on a historical basis, falling energy cost and the US being a net exporter for the first time in many years, we believe the market is poised to erase the market decline and move it into to positive territory.