February 14, 2008

Investment Advise Letter sent out November 12, 2007


I wanted to let some of my friends know that I have taken a rather radical investment stance for the time being and explain why. I have put almost all of my money in the basic money market accounts/cash accounts offered at the various brokerages. This decision is a difficult one, but one that I feel is warranted because of some of the fall-out from the sub-prime/CMO/CDO mess. Let me elaborate: Mortgage originators (the companies that finance house purchases) sell mortgages individually and in bunches to various other companies. If the mortgage has not been bundled together in a security yet, it is now bundled by these buyers. These are then sold to other entities, including money market account managers and they can either exist as one big mortgage security or be a part of a security with mortgages, bonds, other fixed income securities and other debt securities which are then available for individual consumers like you and me or corporations to purchase to earn interest income on available cash balances. These mortgage securities allowed the money market funds to pay a little more interest which everyone has been seeking in this relatively low interest rate environment.

The huge potential problem that I see right now stems not from the fact that these mortgage securities are worthless, because in reality they're not. But there is absolutely no one out there that wants to buy these securities at ANY price because they just don't know what the proper valuation is for them. And if private industry won't buy the CMOs and CDOs, the only one left to do something is the government. Maybe someone smarter than me will come up with a different line of thinking than this, but this is not unprecedented – this is kind of what happened in the S&L crisis from the 1980’s and more recently, albeit on a much smaller scale, from a few years ago with an investment called Auction Rate Securities. I just don't know what else can happen the problem is distributed so widely right now. This problem should never have gotten this big, but this is what happens when a normal market which buys and sells investments just evaporates. In this whole mess, I find the greatest fault in 2 places: 1) the demagogues in government who made it sound like every person had the right to live in a nice expensive house, regardless of their ability to actually PAY the monthly mortgage payment and all of the other costs that go with owning real property; and 2) the rating agencies (Standard & Poors, Moody's, and Fitch) who get paid to properly rate the creditworthiness of securities but who have NEVER been out in front to alert investors on ANY really bad investments. If private industry had any faith in the rating agencies, they would accept the CMO and CDO's ratings as being truly indicative of their risk and there would still be a viable trading market for those securities. But since private industry has no faith in the rating agencies, the ratings on the CDOs and CMOs aren't worth a plugged nickel.

I found an interesting web site that has a lot of articles that are saying the same thing (although much more eloquently) that I am saying along with a lot of other information on this subject: http://www.financialsense.com/fsu/editorials/nystrom/2007/1107.html This article was dated last Wednesday. I hope you read some of the articles and get a better appreciation of my concerns right now.

I always evaluate the risk and return equation for any investment that I make. Right now, I’m not so sure that the stock market is adequately compensating investors for the risk that is out there right now. At the end of the year, if there is still no market for these mortgage securities, lots and lots of companies are going to have to write them down to zero and take a hit to their the P&L Statement. Even if those companies later manage to sell those investments and not realize any real loss, they can never offset the loss they had to previously show at the end of the year because of some weird Accounting Rules. Additionally, at the end of the year when these companies are forced to dig into their investments and see if they may be holding any of these mortgage securities, they may be in technical default of their Credit Agreements and other debt agreements because they will no longer be considered a “Cash Equivalent” which is another Accounting Rule.

I really hope that I am wrong about all of this. However, if I’m not, the situation could get really ugly really fast. The market is already weak and if this would happen and maybe some other unforeseen situation like another terrorist attack, there could be a mad rush for the exits. I am willing right now to forego missing out on any potential end-of-the-year or other rally to remove my exposure to this mess. I wanted to plant this seed in my friend’s minds so that you can also evaluate your level of risk tolerance and exposure and talk to another financial advisor if you so deem. I also urge everyone to read some of the articles on this situation. This is very unusual and I think merits some serious attention in order to protect your financial assets.

A good thing to come out, if this worst case comes to pass, is that there will be some EXCELLENT investment opportunities in the future that we will have the capital to take advantage of. Also, as soon as I hear something that lets me think that this temporary disruption in the market caused by the sub-prime mortgage mess is over, I’ll let you know. Like I said earlier, I hate doing something like this and I don’t recommend this action lightly, but this is a very unique and unusual situation that I don’t want to blow up in our faces.

Let me know if you have any questions.


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