If Yogi Berra were asked to give his views on the current economic environment one can hear him say, “This is like deja vu all over again.” The first quarter was characterized by fear, uncertainty and a financial system that came close to a complete breakdown. The second quarter, supported by the Fed’s unprecedented policy initiatives in late March, saw the first tentative indications of market stabilization.

The first two weeks of the third quarter have seen a re-emergence of uncertainty, volatility and fear that characterized aspects of the first quarter. The Fed and the economy continue to face a handful of overlapping multi-dimensional issues including the broad housing crisis, surging energy costs, the threat of escalating inflationary expectations, a declining dollar, a slowing global economy and a financial/credit system under significant strain. It is and has been our view that the epicenter of our current difficulties is the declining housing market. If housing prices continue to decline, the value of mortgage portfolios will also decline causing additional write-offs by financial institutions. This in turn would lead to further job losses, more pressure on consumer confidence, and deepen the credit pressures that already exist. Potentially, exacerbating this situation is the lack of transparency as to who owns what in specific institutional portfolios. It also leaves unclear whether these portfolio are appropriately valued.

Subprime paper has received most of the attention and focus undermining the understanding of the inherent risks associated with Alt-A and Option-Arm paper. Federal regulators seized IndyMac, the twelfth largest mortgage lender in the U.S. on Friday. IndyMac specialized in Alt-A loans, otherwise known as “no doc” loans. These loans allowed potential borrowers not to fully disclose their incomes or assets. The Alt-A segment of the mortgage market dwarfs the subprime component. The Option-Arm and Subprime sectors are thought to have an equivalent amount of paper outstanding. Options-Arms structures provide borrowers with four options: minimum payments, interest only, full principal and interest payments, and accelerated principal and interest payments. Most borrowers opt for the minimum payment structure, which allows the borrower to make a small monthly payment with the unpaid segment added to the loan balance. The combination of unpaid balances and falling home price has left many borrowers with negative equity in their homes.

We are not surprised by the current re-emergence of heightened volatility and uncertainty. We do not downplay the role surging energy costs play both economically and psychologically. We do reiterate our beliefs that declining home prices and home price affordability are critical to long-term economic growth and rational risk pricing and risk taking. At the end of March 2008, home ownership rates were 67.80% and had declined from the high of 69.20% in December of 2004. We suggest that a return to percentages that prevailed in the late 1990’s (65.50%) would be very supportive of the broad housing market. Until we see stabilization in these areas, we expect a continuation of volatility and uncertainty and a concern for risk taking. Yogi would simply put it this way “it ain’t over till it’s over.”

Current Views

• Economy – Last weeks May trade balance surprised the street when the gap narrowed to $59.8 billion from $60.8 billion. Exports rose approximately 1.0%. The fact that net exports increased strongly suggests that GDP for the second quarter will be higher than previous street estimates. Current estimates – 2 ½% to 3.0%
• Equities – Expect volatility to continue with limited upside until housing prices stabilize. Financial stocks even at these depressed levels are a risk until the threat of more write-downs has abated.
• Bonds – The bond market is the beneficiary of the problems currently facing the economy and the equity market. The concept of a “flight to quality” is back in vogue. Bond valuations are supported by the strong likelihood that the Fed is on hold through the end of the year.
• Oil – Eventually the global slowdown will affect oil prices. The supply/demand curve is shifting to such an extent that it’s hard to justify current prices.
• Inflation – We expect headline inflation to move above 5.0% during the summer. We expect core inflation to hover slightly above the Fed’s comfort zone of 1 ½% to 2.0%. We believe that there are merging deflationary forces led by the real estate decline, moderating money supply growth, and a broad slowdown in global growth, which will reign in inflation over the near-term.
• We were encouraged by Chairman Bernanke’s comment linking the weak dollar with an “unwelcome rise in import prices and consumer inflation.” The dollar has been relatively stable since he has made those comments. We do not foresee any fundamental changes in the administration’s long held position of benign neglect regarding the dollar.

Treasury/Fed announcement regarding Fannie Mae and Freddie Mac – Sunday, July 13, 2008 The Fed and Treasury Department announced on Sunday a plan designed to support both Fannie Mae and Freddie Mac. The Fed has in effect offered the mortgage giants access to a discount window through the Federal Reserve Bank of New York. The exact language stated “should it prove necessary.” The discount structure being utilized was put in place in late March as the Fed attempted to provide liquidity and reduce disruptions in the financial markets. Fannie and Freddie Mac would pay 2.25%, the same rate that commercial and investment banks are currently being charged. The Treasury is seeking additional authority from Congress to expand current lines of credit and to possibly make equity investments in both companies.

Issues to watch today -

• Watch the reception Freddie gets as it attempts to raise $3 billion at auction in three and six month securities.
• Investor reaction to the package – this is not how an implied guarantee of the U.S. government was thought to work. Investors may question the entire notion of implicit guarantees.
• Financial stocks should come under additional pressure. Expect to see additional commentary from PMC on Fannie and Freddie as information becomes available.

Bob Andres

Chief Investment Strategist

This perspective is provided for informational and educational purposes only. It is not intended as and should not be used to provide investment advice and does not address or account for individual investor circumstances. Investment decisions should always be made based on the client’s specific financial needs and objectives, goals, time horizon and risk tolerance. The statements contained herein are based solely upon the opinions of PMC. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. Information was obtained from third party sources, which we believe to be reliable but not guaranteed. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS.

© 2008 Portfolio M