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'Pandelirium' 2

September 29, 2008

By Tim Chapman

Today we had the largest one day drop in the history of the stock market. The Dow was down 777 points (6.98%); the S&P 500 lost 106 points (8.79%) and the NASDAQ was down 199 points (9.14%).

Stocks were lower most of the day but the sell-off really accelerated when Congress voted down the $700 billion 'bail-out' package. It will be interesting to see where the market - and Congress - go from here, but the question I've been asked most often is, "How did we get in this mess in the first place?"

First, a little background. In 1977, Congress passed the Community Reinvestment Act (CRA) to require banks to make real estate loans in areas they might not otherwise consider. In 1995, some additional teeth were put into the CRA regulations and banks had to step up the effort or else run afoul of the banking regulators.

In 1999, to continue the effort to extend the possibility of home ownership for low and moderate income earners, the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac") loosened their loan requirements, which gave birth to more adjustable rate mortgages, no documentation loans, lower down payments, etc. (Today we call those riskier loans 'sub-prime'.)

It is important to understand that banks and mortgage companies typically only 'originate' home loans to collect a fee and then sell them. With Freddie and Fannie's lower standards for buying the loans, the mortgage lenders could pay less attention to the borrower's qualifications, write new loans and collect more fees to their hearts content. Wall Street jumped on board and bundled these mortgages into 'packages' called Collateralized Mortgage Obligations and Collateralized Debt Obligations (CMOs and CDOs). They would split these packages into pieces, even get mortgage insurance on some of them to get an AAA rating, and sell them to other investors. This gave banks and mortgage companies another outlet, in addition to Fannie and Freddie, to sell the loans which means they could write even more.

More people were enjoying the American Dream, banks were booking nice fees that helped the bottom line, and Wall Street was making a fortune selling these 'derivatives' that represented a pool of loans. Everybody in the loop was happy as could be . . . while real estate prices were going up.

Warren Buffett once said "When the tide goes out you can see who's been swimming naked.

" When the real estate market started to soften a couple of years ago, there were definitely a lot of folks feeling pretty naked. When the real estate bubble began to leak air the situation turned ugly quickly. Homeowners struggling to make their payments started to default in huge numbers, when it was apparent their homes weren't worth what they'd borrowed. That started a chain of events that resulted in the market for sub-prime paper drying up.

One factor that accelerated this problem was a change in the accounting rules that required firms to 'mark to market' their holdings on a regular basis. (Mark to market means 'tell me what it's worth today, not what you expect to get at maturity'.) It was a post-Enron legislative action to create transparency and 'protect' investors, but as these investment banks were forced to continually write down the value of their holdings, they were in turn required to put up more capital. When the appetite for sub-prime loans went away - there were no buyers to be found - companies without additional collateral to put up, like Bear Stearns and Lehman Brothers simply went out of business.

The problem from my perspective is what I call the Law of Unintended Consequences. The idea of home ownership is certainly a noble one that is tough to argue against; greater transparency for investors is a noble idea too. But these legislative initiatives set in motion a chain of events that have taken the past 9 years to completely unfold. There's plenty of other blame to go around here too. Mortgage lenders selling loans to folks who obviously couldn't afford them, home buyers buying homes beyond their means, and Wall Street pouring gasoline on the fire by providing the vehicles to really accelerate the opportunity. The resulting financial meltdown was no doubt unintended, but it is very real nonetheless.

So the question is this: Politicians got us into this mess, can politicians get us out of it? And my answer is, I simply don't know. I can understand the argument that something needs to be done to keep our markets liquid and operating efficiently. It's like a drunk driver in an auto accident - he's clearly at fault but that doesn't mean the paramedics ignore him.

My worry is just like it's taken a long time for the ramifications of the change in lending restrictions to come to fruition, it will likely be years before we know the effects of any current Congressional actions.

The only thing we can do is make sure we protect you against the downside as much as we possibly can, which we are doing. We are as defensive as we are allowed to be in every investment objective across the board. Even our most 'aggressive' objectives are 50% in cash, and our more conservative objectives are almost 100% in cash. That means our losses won't even be close to the carnage most investors are feeling right now and more importantly, we will be in a better position to recover when the market gets good again. And please be assured, it will go back up at some point. There have been challenges in our economy before. The stock market has gone down in a big way before, but it has never stayed down. (On a percentage basis, today didn't even make the top 15 biggest one day losses). And it won't this time either!

It's a great time to be a PMFM client and we appreciate your trust in us. We will work diligently every day to watch after your money. Remember, all of us at PMFM are standing right beside you because PMFM manages our retirement plan too - and I've never appreciated our "winning by not losing" approach more than I do right now!

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Each of the PMFM Strategies involves active asset allocation, with an emphasis on risk management. The Managed Strategy is PMFM's more conservative strategy, and has the ability to invest 100% in money market instruments during difficult market conditions. The Core Advantage Strategy is PMFM's more aggressive approach in that it will always maintain a "core" position, or approximately 50% equity exposure to all market conditions. The remaining 50%, or "satellite", exposure is allocatied to equities or money market instruments based upon market conditions and risk levels of the market.

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