What's Going On Here?

When we last wrote, just one month ago, we were in the thick of what had quickly become the biggest worldwide credit crisis in 37 years. For all intents and purposes, both the short-term and long-term fixed income markets had come to a virtual standstill and the stock market had dropped like a stone from a record July high, even though most non-financial companies were only minimally affected by problems in the credit markets.

Major individual players in the markets were interceding with the Federal Reserve to “wake up and do something.” (See the attached file “What Do They Know” by Bill Gross of PIMCO describing the situation: http://www2.pimco.com/pdf/IO%20Oct_07_web.pdf ) . As it turned out, they apparently were listening, and out of the blue on August 17th, took the unusual step of dropping the Fed discount rate by 50 basis points, while strongly encouraging member banks to bring asset-backed commercial paper to the Fed discount window. While that move was largely symbolic and had very little to do with problems in the housing market and ballooning defaults on sub-prime mortgages, it did pour oil on the commercial paper market waters and stopped what was becoming a rampant flight from supposedly secure money market funds by professional money managers. Subsequently, at their regularly scheduled open market committee meeting on September 18th, the Fed dropped the discount rate by another 50 basis points and lowered its federal funds rate by a larger than expected 50 basis points, which had the effect of making floating rate consumer debt of all kinds immediately less expensive.

That was all the stock market needed to see, and it immediately shifted away from discounting a recession (or worse) and returned to its all too familiar “nothing is wrong in the world” exuberance, reaching a new record high on October 1st.

So, really, what is going on here? First of all, we would like you to know that our portfolios have done just fine during this confusing time. As we have often said, our investments are designed to weather exactly the kind of environment that materialized in August, and they did, outperforming our S&P 500 benchmark during the entire downtrend and subsequently keeping right up with the market as it rocketed off its August lows to new record levels.

Despite the seemingly “irrational exuberance” of the markets, the underlying housing and sub-prime mortgage default problems have not gone away, even though some marginal home owners have been helped by the reduction in rates. The related longer-term problem that touched off the credit crisis in the first place, namely the extremely leveraged holdings by many hedge funds and financial institutions of collateralized debt obligations (CDOs), whose viability is in question because of rising defaults in the sub-prime mortgage components of these securities, has not been resolved. So there is probably more bad news to come on that front. Quoting Bill Gross’ concluding sentence in the attached article, speaking of the Fed: “What do they know? I suspect at the very least they know they’re in a pickle, and a sour one at that.”

For our part, we will conclude with the same statement we made at the end of our letter a month ago: “In summary, our portfolios are performing as expected in this environment. We think the housing and credit markets have further trouble ahead and believe that uncertainty will continue to plague the markets into 2008. This necessary (and long overdue) process will correct an inflated real estate market and eliminate dangerous consumer lending practices. While we see opportunities developing, we will continue to be careful with our investment decisions in an effort to protect capital.”

Peter and Jack Falker