“A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves money from the public treasure. From that moment on the majority always votes for the candidates promising the most money from the public treasury, with the result that a democracy always collapses over loose fiscal policy followed by a dictatorship. The average age of the world’s great civilizations has been two hundred years. These nations have progressed through the following sequence: from bondage to spiritual faith, from spiritual faith to great courage, from courage to liberty, from liberty to abundance, from abundance to selfishness, from selfishness to complacency, from complacency to apathy, from apathy to dependency, from dependency back to bondage.” – Author unknown

“Section 8: The Congress shall have power To coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures; To provide for the punishment of counterfeiting the securities and current coin of the United States.” – U.S. Constitution

“Section 10: No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.” – U.S. Constitution

The first quarter provided investors with an almost non-stop barrage of bad news as severe strains in the credit markets toppled one of Wall Street’s biggest firms, led to huge write-downs at many banks, and threatened to freeze up the domestic financial system. In most respects, the issues are no different than we have been discussing in this space for years. Too much leverage – by the government, consumers and financial institutions – has created dangerous instability. The difference now is that the risks are much more apparent, and greed temporarily has taken a backseat to fear. A surge of defaults among the least-qualified borrowers has led to a dramatic evaporation of liquidity for an alphabet soup of esoteric investment vehicles linked to the declining real estate market. Given the nearly ubiquitous nature of these vehicles, many of which lurked off the balance sheets of major banks and investment firms, the potential for a broader crisis is on vivid display.

Volatility spiked during the quarter, with the stock market rising or falling more than 2% in a dozen sessions. The S&P 500 finished the quarter down 9.4%, including dividends. The Dow Jones Industrials suffered their biggest first-quarter point decline in the history of the index, shedding 7.6%. The Russell 2000 lost 10.2%. Foreign markets were hammered, with India dropping 19.3% in local currency and the Shanghai Composite plummeting 32%, leaving it down 45% from its October 2007 high. Investors had few places to hide, with the exception of gold, certain foreign currencies, cash and commodities, which remained on an epic tear as prices soared around the world for basic goods such as rice, wheat and oil.

Baker Ellis accounts performed well on a relative basis (if poorly on an absolute one), with our composite dropping about 4.8%.* We managed to avoid most of the more serious land mines of the quarter, and a slug of short-term Treasuries – disdained by many clients until recently – helped cushion the descent. Nonetheless, we would expect our diversified portfolios to participate in a broad retrenchment of the markets, as they did. For now, we are willing to pay that price to avoid the greater risk of wholesale market timing or the risks inherent in running highly concentrated portfolios.

Although global equity diversification provides some benefits, it has not completely protected us from the risks we saw developing in the U.S. The decoupling hypothesis now looks overly simplistic, and it is increasingly clear that global stock market correlation is a more powerful force than the Asian domestic-demand story. The world has become so tightly interconnected that even UBS, a virtual mascot for prudence and caution in Switzerland with $2.2 trillion in assets, has shocked investors by writing down $37 billion in losses on risky American mortgage securities – more than even Citigroup or Merrill Lynch. At a meeting attended by thousands of angry shareholders recently in Basel, a shareholder activist charged the podium after demanding that company officials “Put an end to the Americanization of the Swiss economy!”

By now, most Americans share an intuitive sense that something is not right with our economy. Over most of our nation’s history, money meant gold and silver. Money was not particularly easy to obtain, and could not be created in infinite quantities. Today, America has grown accustomed to spending more than it earns, borrowing against future taxes and living standards to pay for today’s expenditures. Proposals to defer the pain of an adjustment in housing prices through a political “solution” – rejecting the mechanism of supply and demand – threaten our economy’s ability to stage a healthy recovery and achieve its maximum long-term growth rate. We wonder what our grandfathers would think of proposals to modify contracts between more than 1 million lenders and borrowers, with the government dictating new terms and assuming shaky collateral to bail out borrowers who often put nothing down to gamble on ever-increasing asset prices. Not that long ago, buying a house meant scrimping and saving to put 20% down on a 30-year fixed-rate mortgage – not getting a no-doc adjustable-rate loan with a teaser period, writing off interest on up to $1 million of loan value for multiple residences and flipping after a year to pocket up to $500,000 in gains tax-free.

Our financial institutions reflect this same sort of heads-I-win, tails-the-taxpayers-lose mentality. Banks and financial institutions have bent over backwards to lend money to anyone with a signature, figuring that they could quickly repackage the loans and sell them to unsuspecting investors, pocketing some hefty fees. The loans often came with an implicit government guarantee through a federal agency or an AAA credit rating, compliments of a complicit rating agency and/or undercapitalized monoline insurance company. That worked as long as asset prices continue to defy gravity. What we are seeing now is what happens to such a house of paper when prices go even modestly in the other direction.

The current crisis contains many of the elements common to the meltdowns that hit Wall Street every decade or two, including murky off-balance-sheet risks, specialized vehicles that even experts profess not to understand, and the liquidity issues that occur when everybody needs to sell something at once. But instead of a resolution in which the marketplace punishes those who exercised poor judgment, something else is happening. Not only has the Federal Reserve attempted to reignite growth by cutting its benchmark rate to 2.25% from 4.25% at the beginning of the year, penalizing prudent savers, but it also has taken the extraordinary step of intervening to engineer the bailout of a major Wall Street firm.

In engineering the Bear Stearns takeover by JP Morgan and offering billions to big investment firms through its discount window for the first time since the Depression, the Fed showed a willingness to risk its balance sheet – and, ultimately, taxpayer funds – to protect from bankruptcy entities that it does not even oversee. This appears at odds with what Fed Chairman Ben Bernanke said in Jackson Hole, Wyoming last August: “It is not the responsibility of the Federal Reserve – nor would it be appropriate – to protect lenders and investors from the consequences of their financial decisions.” Bernanke appears to believe the rescue was more systemic. As he acknowledged in Congressional testimony after the Bear bailout, “If you want to say we bailed out markets in general, I guess that’s true.” We see the urgency of the situation that the Fed faced. Sources have indicated the Fed’s biggest concern was Bear’s exposure to the $45 trillion credit default swap (CDS) market. On an equity base of around $12 billion, Bear levered itself up about 30-to-1. Within this balance sheet, Bear reportedly was involved as counterparty in around $2.5 trillion of credit default swap agreements – basically insurance policies that pay if the issuer of the corporate debt defaults.

In our opinion, this unregulated derivative, utilized on the scale that it now is incorporated into the markets, does more harm than good. Maybe we are too simplistic here at Baker Ellis, but if an investor is concerned about holding Home Depot bonds, there is a very simple way to protect himself: don’t buy them. The economy worked just fine without credit default swaps. Bizarrely, although a company may only have $1 billion of bonds outstanding, credit default swaps can be sold up to any amount. So although the real losses of a credit event may be only the entire face amount of all outstanding bonds, sellers of credit default swaps theoretically could be on the hook for any multiple of that amount. As this market has grown to gigantic proportions and credit insurance has been written on virtually all of the largest publicly traded companies, in essence the entire system has been insured. This reminds us a bit of the ill-fated portfolio insurance of the 1980s, through which institutions felt that they could protect themselves against stock market declines by buying portfolio insurance designed by Wall Street banks. This insurance – sold too cheaply – precipitated the 1987 stock market crash. Insurance is only as good as the company that writes the policy. If risk is underpriced, insolvency is often the outcome when an unforeseen event strikes. In bailing out “the markets,” including taking the unprecedented step of lending directly to investment banks, the Fed was acting to prevent a generalized insolvency – and who can blame them? But the Fed action does little to solve the underlying problems of the economy, and arguably exacerbates them. In a severe economic contraction, we think bad credit default swaps in conjunction with other derivatives could pose a bigger threat to the economic system than the subprime collapse.

Rescuing firms is messy and there is a limit to how many times the Fed can pull this trick until confidence erodes. The government, Fed and banking system seem to believe it is better to “fix” the price of assets than leave it to the marketplace. The unspoken thinking goes something like this: If you can boost the prices of homes so that borrowers will not default, then banks assets will not be impaired, and we can avoid more bailouts. Allowing the government to manipulate prices, however, is always a bad idea. The laws of supply and demand are the best pricing mechanism as the collective buying and selling decisions of millions of participants establish correct levels. While in the short run prices may get away from equilibrium – markets tend to overshoot both on the upside and the downside – fundamental value will win out over time. The federal government’s role in creating the housing finance crisis cannot be overstated, from myriad elements of the tax code that encourage overinvestment in real estate to artificially low interest rates and entire agencies designed to create demand for mortgage debt.

We are by no means opposed to affordable housing. In fact, we would like the Fed to do more to ensure price stability which, along with maximizing employment, forms its dual mandate. Over the long term, we believe that low and stable inflation contributes to improved efficiency and lower unemployment. The problem with the economic expansion that just ended was that it was based not on increasing real income but instead on asset-price inflation. Why Americans cheered as housing became unaffordable for many homebuyers, especially first-time buyers, is something of a paradox.

What happens next in the stock market depends largely on the government’s response and whether the necessary deleveraging process occurs gradually or all at once. A prolonged recession would pressure stock prices further, and the Fed’s actions have the potential to unleash an inflationary cycle that would be difficult to control. However, if the economy holds together, interest rates stay low and corporate profits remain robust, stocks offer reasonable upside. We will fine-tune our investment strategy depending on how we see the process unfolding, but many of our companies continue to chug along just fine, far from the world of Alt-A paper and collateralized debt obligations. Northwest Pipe (NWPX) continues to win new contracts for water transmission pipe to replace aging municipal infrastructure. General Mills (GIS) is still making Cheerios, and SABMiller (SAB.L) has an array of tasty and popular brews to ease economic anxiety.

We continue to sacrifice yield for credit quality in our fixed-income allocation, and favor positions in high-quality companies that have the strength to invest during the downturn and emerge stronger in the eventual upswing.

Sincerely,

Brian C. Baker, CFA Barnes C. Ellis

*Composite return represents accounts over $100,000 held at Fidelity Investments. Composite may exclude accounts with legacy positions or investment restrictions. Performance is size-weighted. Individual returns vary based on risk tolerance, timing of investment and other factors. Consult your performance report for details. Size-weighted dispersion for Q1 was 1.3%. Performance is net of fees. S&P index data includes gross dividends; other index returns are price change only. Investors cannot own an index, a hypothetical portfolio without fees or expenses. S&P 500 data provided for purposes of comparison only and may not be the most relevant benchmark. Data is believed to be accurate but is not audited or guaranteed. Past performance is no guarantee of future results. Further information is available upon request.

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