BIG CORPORATE WRITEDOWNS 3/28/2008

Everyone has heard of the massive write-downs taken by major investment and commercial banks and lenders in the wake of the sub-prime mortgage problems and the declining real estate market. But what do these really mean and what is the likely long-term effect of these write-downs?

To understand, one first needs to understand how these companies hold these mortgage portfolios and how they are required to account for them on their balance sheets. The mortgage portfolios are held as assets, investments that the company has made – in this case by purchasing pools of mortgages packaged and sold by other banks, lenders and mortgage brokerages. These mortgages are collateralized against real estate, and the mortgage can’t really have a value that is any greater than the real estate against which it is secured since it is that real estate that can be captured and sold if the borrower defaults on the mortgage. Companies are required to represent the value of these types of assets on their balance sheets based on what they are really worth.

This process is sometimes referred to as ‘marking to the market’. In the case of these loans, they can be worth no more than the amount owed by the borrowers, but can be worth as little as the value of the collateral, adjusted for the potential expense the lender might incur if the loan defaults and the property is foreclosed on and is then sold.

When the value of real estate that collateralizes these loans decreases below the remaining principle owed on the mortgage, then the mortgage, as an investment, is worth less. Companies are required to reflect this reduction in value of these investments as ‘write downs’, or a non-recurring expense to the income statement, thus decreasing the company’s profitability, impacting shareholder equity, and usually decreasing the value of their stock. In this case, these decreases have been exaggerated by terms like ‘crisis’ and ‘meltdown’, and coupled with the real economic effect of a slower housing market, slower economic growth, and tightening credit standards has brought lower stock values and increased volatility in the investment markets.

There is another side to this that is almost totally ignored to this point and that isn’t allowed (by federal securities and accounting regulations) to be considered when looking at the income statement and balance sheet of a publicly held company. Two important points: 1) in real estate, what goes down will likely come back up in a reasonable period of time; 2) a minute portion of these mortgages will actually be foreclosed on and result in the sale of the underlying real estate at an amount that is less than the mortgage balance, and many of those borrowers that ‘walk away’ are still liable for the unpaid balance to the lender. When the housing market begins to improve, as the economy begins to see improved growth and as many of these sub-prime loans are refinanced the investment value of these mortgage portfolios will increase and much of what had been ‘written down’ will begin to ‘written up’ – increasing the apparent profitability of the companies that hold the portfolios and thereby increasing their stock value.

Today’s concerns over investment values may well be replaced by excitement over increasing returns and corporate profit as these portfolios are ‘marked to the market’ on the upside. Retirement account values will increase and the roller coaster we’ve been on these past months will fade into the distance. Some, however, those that over reacted to the economy and market’s weakness, may very well suffer the lasting effects, judgments made and opportunities missed.

Steve Forbes, in a recent issue of Forbes Magazine, writes about the effect that would be had on the stock markets if the SEC, Comptroller of The Currency, United States Treasury Department and Federal Reserve suspend the requirement to ‘mark to the market’ these mortgage backed portfolios for a period of twelve months in an attempt to allow stability to return to this important part of the investment markets. Forbes argues that most of these portfolios reflect ‘crisis’ values rather than real values, and that this not only weakens the U.S. stock market, but also holds down the value of the U.S. dollar. Forbes makes an excellent point and his idea deserves attention and consideration, but it would take courageous leadership with great political clout to make such changes, even though short term in nature. Federal Reserve chairman Bernanke and Treasury Secretary Paulson have recently evidenced some of the fortitude to support these changes, but by the time the legislative bodies act, the ‘crisis’ will likely be behind us and the damage, both short and long term, will have already been done – has already been done.

So, what does this mean to you? Over the long term, not much. In the short term, concerns over investment values, your future, the stability of your job, and your ability to take care of your family – only a few of those things that keep some of us awake at night. Remember that in investments, just as in real estate, what goes down almost certainly will come back up and history would suggest that the upward trend will lead to higher heights than we’ve ever seen before.

Rick Haskell – Signature Wealth Management

WHEN MARKETS REACH THEIR HIGHS AND LOWS 3/19/2008

When most of the news you hear about any given market is great, when most of the people you speak to are excited about buying into that market, and when the media is falling over themselves to report how wonderful things are, it is an almost certain sign that that market has reached its height and that the short term opportunity is over. It’s the time when everyone else looks like they’re making money in that market and those that aren’t are just clamoring to get in. That’s when professionals in the market look to sell - while most others are either buying or wishing they had the funds to buy. The theory behind this phenomenon is sometimes called the ‘Every Man Theory’.

We saw this in the earliest months of the year 2000 at the height of the dot com bubble. At the same time that professionals were becoming cautious, the average investor was willing to do almost anything to get in and strike while the iron appeared to be hot. Little did most investors understand that the ‘heat’ was more like the moment before an incandescent light bulb burns out – it glows so brightly for just a fleeting moment, and then it is gone.

We also saw this same phenomenon play out at the height of the recent real estate boom. During one short period of time we had several clients want to pull funds from their hard-earned investment accounts - accounts that were doing well - and use those funds to speculate the real estate market. When that happened, we looked at each other and agreed that this marked the top of the market. We haven’t specifically tracked what happened to those client resources that were pulled out of investment accounts, but the reports we’ve heard haven’t been encouraging. We did track the continued upward movement of the DOW and S&P 500 from that point, even with the recent market pullback.

Now, the inverse of those signs that can be observed at the top of the market, that likely foretell of a short-term market weakening, are those signs that suggest a bottom has been reached. Consider what we’re hearing almost daily at this point: gloom and doom on Wall Street, stories regarding the weakened U.S. Dollar, real estate foreclosures and mortgage defaults abounding, the price of oil, gold and other commodities hitting all-time highs and ongoing recession fears. When most of the news is this bad, when more people are pessimistic than not, and when the average investor is concerned about just what might happen next, that’s when the professionals want to buy and others are more than willing to sell. The ‘Every Man Theory’ suggests that this is a sure sign that a market bottom has been reached, and even though the weeks directly ahead might not be extraordinarily profitable, they likely won’t represent ongoing losses either. The months and years ahead, however, most likely include a period of robust growth and profitability.

In the markets we’re now experiencing, we believe this bottom likely came near the end of January – a few weeks after most of our client assets transitioned into relatively defensive allocations. Since then, we have seen ongoing volatility and some pretty concerning news from Washington and New York, but the markets have stayed above those January lows.

Yesterday, Goldman Sachs, one of the most well respected names on Wall Street, adjusted their 1^st quarter earning expectations to the positive. In response, the DOW Industrials offered an impressive rally (likely to be followed by a partial sell-off on Wednesday). Later the same day, the Federal Reserve decreased the discount rate by ¾ of a percent, and the market replied with even more upward movement. But the evening news focused more on the Federal Reserve’s ‘bailout’ and JP Morgan Chase’s heavily discounted purchase of Bear Sterns – news to be sure, but literally yesterday’s news! More attention was given to which presidential candidate offered the most offensive rhetoric for the day than the fact that the U.S. Dollar increased against other foreign currencies, the price of gold and oil fell in late trading, and VISA was about to become the largest public offering in U.S. history.

It’s not that all of this portends blue skies and roses for the markets in the short term, but it is indicative of the playing out of the ‘Every Man Theory’. Those investors that have the fortitude to buy while markets are low are the same investors that end up owning highly valued assets that they can sell at their discretion, maybe even when markets and values are high.

Rick Haskell – Signature Wealth Management